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Solution Manual For Managerial Economics: Economic Tools for Today's Decision Makers, 7th Edition

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    CHAPTER 1 INTRODUCTION QUESTIONS 1. Scarcity is a condition that exists when resources are limited relative to the demand for their use. Another way of describing this condition is to state that scarcity exists when resources are not available in unlimited amounts. When resources are available in unlimited amounts, economists consider them to be “free” goods. Because of the scarcity of resources, choices have to be made about their allocation among competing uses. Each choice is considered by economists to involve an “opportunity cost” because the use of scarce resources in one activity implies that they cannot be used in an alternative one. In other words, this opportunity cost is the amount that is sacrificed when choosing one activity over its next best alternative. It is reasonable to assume that all organizations have to work with scarce resources, no matter how large or profitable. A key role that managers play is to decide how best to allocate their organizations’ scarce resources. From an economic standpoint, optimal decisions involve their weighing of the benefits associated with a particular decision against the opportunity cost of this decision. 2. “What?” — This involves deciding what goods and services to produce and in what quantities (e.g., guns versus butter, capital goods versus consumer goods, etc.) “How?” — This involves deciding how best to allocate a country’s resources in the production of particular goods or services (e.g., capital intensive versus labor intensive, domestic production versus foreign production etc.). “For whom?” — This involves deciding how to distribute a country’s total output of goods and services (e.g., income and wealth distribution). 3. a. how b. what c. for whom d. how e. how 4. Market Process: The use of supply, demand and material incentives (e.g., the profit motive) to decide how scarce resources are to be allocated. It answers the three questions of what, how and for whom in the following ways: “What?” — Whatever is profitable will be produced. Profitability in turn depends on the strength of a society’s demand for a particular good or service and the cost to producers of providing such a good or service. “How?” — Resources should be allocated and combined in the least costly way. “For whom?” — The output of goods and services should be allocated to whoever is willing and able to pay for them. Of course the ability to pay depends on the country’s distribution of income. Many

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    2 Introduction factors may account for the distribution of income in a market economy. For economists, one of the most important is the “productivity principle.” This states that income is allocated according to the relative productivity of the various factors of production. 5. As much as managers in a market economy rely on demand, cost, and profitability to guide them in their economic decisions, we have observed that command and tradition continue to play an important role in the decision - making process. In particular: Command Process: Strategic, long - term or “political” decisions that are made by some central authority in an organization (in a large company it might be for example the CEO, the corporate management committee, in a small company it might be the owner/operator) can be considered part of the command process. For example, a manager might believe that a particular product is not profitable and recommend that it be dropped for the company’s product line. However, upper management might believe that the product might have some long - term or strategic value and override this decision. The opposite might also be true. A good example of this is the case of the IBM typewriter. In 1984, IBM made a major strategic decision to stay in the business of making typewriters, even though analysis indicated that it would become increasingly more difficult for it to be profitable in this business as typewriters became electronic rather that electromechanical and as PCs and word processors performed more and more of the basic typing functions. It invested approximately $500 million to completely modernize and automate its production facilities in Lexington, Kentucky. A major reason for maintaining and investing further in this business was because upper management believed that for strategic reasons, IBM needed to have its own capability of making keyboards for its computers. In 1990, IBM decided to spin off its typewriter division to a separate, privately owned company called Lexmark. (We do not know whether it was because the typewriter division was not profitable.) Of course, managers in a market economy must also deal with the command process whenever government rules, regulations, or laws have to be considered. Chapter 15 of this text is devoted to this possibility. Traditional Process: As pointed out in the text, customs and traditions play a more important role for managers in developing countries. However, we have observed or read about certain instances in which they affect management decisions here in the United States. For example, some years back it was reported in the Wall Street Journal that the CEO of International Harvester (now operating as Navistar) lamented that the company should have sold off its farm equipment long before it actually did. However, he pointed out that he and the rest of the management found it very difficult to divest itself of the product line on which the company was founded. If the instructor wishes, he or she may wish to bring up the whole issue of the traditional view of occupations for men and women. For example, years ago, suitable professional work for women was usually confined to teaching and nursing. Obviously, this traditional view of the role of women in the workplace has changed in the United States. However, in the rest of the world, even in the developed countries such as Japan and those in Western Europe, tradition is still an important factor.

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    Introduction 3 Instructors may also wish to consider the traditional view and acceptance of various unethical practices such as kick - backs in government contracts and the practice of nepotism in the hiring of personnel that exists today in many developing countries. 6. This question is subject to considerable interpretation and the instructor may choose to use his or her own distinctions between the two concepts. We believe that management skills have to do more with the organizing and management of scarce resources (particular the managing of people) and entrepreneurship has more to do with the taking of certain risks in such activities as the introduction of goods and services to the marketplace. Ideally, the successful manager or entrepreneur should have both capabilities. 7. Microeconomics focuses on individual markets for goods and services, while macroeconomics focuses on aggregate economic activity. Managers should understand the macroeconomy in order to prepare for or operate more effectively over different phases of the business cycle. For example, if managers believe that the economy will soon come out of a recession, they may want to begin building inventories or making certain capital investments in order to better handle the increased demand which accompanies a recovery. Alternatively, managers may want to consider diversifying their firm’s portfolio of goods and services to include some products that are “recession proof” (i.e., those with income elasticities that are very low or negative). 8. Marketing is the key to success in this industry. Specifically, this includes all of the “four P’s of marketing”: pricing, product, promotion, and placement. Production is also important. Recently, PepsiCo has been buying a selected number of independently owned bottlers because it believes it can operate them more efficiently and also gain certain economies of scale. Our background paper on this industry should give instructors further information to discuss this question with the class. 9. Note to Instructors: Here are some suggested answers. These may be modified depending on changing events. a. Telecommunications: This is a rapidly changing industry for all types of companies. Let us suggest an answer for the regional bell operating companies (RBOCs). Competition: Certain states like California are already allowing other companies such as AT&T and MCI to offer competing local service. Technology: Wireless communications in the form of cellular phone service is rapidly growing. Personal communications service (PCS) could well be another competing type of wireless competition. b. Retail Merchandising: Competition: “Category busters” such as Home Depot, Sports Authority, and Borders Books have become real threats to the existence of smaller retail stores. Everyday low price (EDLP) stores such as Wal - Mart and K - Mart continue to grow and dominate the retail scene. Technology: Large chains such as Wal - Mart are able to send sales data on a daily basis back to headquarters, enabling financial analysts to track closely inventory and product category sales.

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    4 Introduction c. Higher Education: The Internet has enabled institutions to offer online, distance learning classes. It is now possible to obtain a degree without attending any classes on a “physical” campus. The “virtual” campus is now a reality. d. Airlines: After more than 20 years of deregulation in the United States, the airline industry has finally spawned the kind of competition that was intended. For example, the low cost approach of Southwest Airlines, JetBlue and others has resulted in serious ongoing losses for the “incumbent” airlines such as United, U.S. Air, American and Delta.

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    CHAPTER 2 THE FIRM AND ITS GOALS QUESTIONS 1. Yes. The company can profit from this action in several ways. Graduate students, impressed with the computers, may become recruits for the computer firm. This increases the employment market for the firm, and it may become able to hire some superior graduates. Or, these students, after graduation, will work for other firms and recommend the computer made by this manufacturer for use in their work place. In short, if the additional profits from future sales exceed the cost of the donation, then such a policy is quite consistent with profit maximization. 2. This is an incomplete objective, and may not be consistent with the objective of profit maximization. Setting a profit margin too high may result in smaller profits than could possibly be achieved with a lower profit margin. In other words, setting a profit margin may not result in profit maximization. The profit maximization goal should be stated in absolute values, since a high ratio applied to a small base could yield a lower absolute profit, while a low ratio applied to a high base could yield a high amount. For example, a 10% profit margin on revenue of $10 million results in $1 million in profits, while a 5% margin on revenue of $30 million yields $1.5 million in profits. 3. This comment is incorrect. It is quite true that the existence of consumer organizations, legal requirements and warranty requirements may raise a company’s costs above what they would have been in their absence. But such costs will now be included in a company’s cost calculations. Given these costs, a company can still attempt to maximize its profits under the new circumstances. The total profit level will be lower than if these costs did not exist, but the process of profit maximization will still be in place. 4. Shareholder wealth maximization is the more comprehensive of the two. Profit maximization is a period of value that may be obtained by short - term management action which could be detrimental to profits in future periods. But a company with longer range horizons will want to consider a stream of earnings (or cash flows) over time. This stream is then discounted at the company’s cost of capital to the present to obtain the present value of this stream. This present value is the value of the firm or that of the stockholders. When such an objective is used, the company is considering the shape and duration of the cash flow stream and the return required by stockholders (i.e. the equity cost of capital). The required rate of return is affected by risk, and, thus, risk enters into the valuation. Obviously, this measure is much more inclusive than the maximization of profit for any one period. 5. Stockholders generally may not know what maximum profits their firm could generate. Thus, they will look for a satisfactory return (both dividend and price appreciation). Company management will not be held to maximization but will manage the corporation in a way as to satisfy the shareholders. The term often used to describe this is “satisficing.” 6. The “principal - agent problem” refers to the possible divergence of objectives between the owners and managers of an enterprise. While the owners of a firm (stockholders, when the firm is a corporation) are interested mainly in the increase in the firm’s value, managers may have other interests. Managers may be more interested in their own incomes and perquisites. They may also

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    6 The Firm and Its Goals strive for revenue growth rather than profits. They may, in the interest of their own security, be more conservative in running the business, and may forgo investments with high potential that may entail some risk. 7. Since the ownership in a corporation is widely dispersed, and thus individual stockholders have little power, it may be believed by managers that it is not necessary to endeavor to maximize company profits. Since the managers usually own only a small fraction of the corporation’s stock, their interest may not be served best by maximizing the value of the corporation. Thus they may be more interested in maximizing their own incomes and perquisites. They may also not take prudent risks to maximize returns, since a severe reversal in business fortunes could cause them to lose their positions. Not taking the appropriate risks may result in rather mediocre but still satisfactory shareholder returns. 8. There are several forces which will tend to create a convergence between the interests of stockholders and managers, and thus cause managers to be interested in maximizing a corporation’s profits or value: a. Corporate shares are not only owned by widely dispersed stockholders but by large institutional holders (banks, insurance companies, mutual funds, pension funds). These organizations employ analysts who continually study stock performance. Non - performing companies would be sold from these institutions’ portfolios, and lead to decreased prices of these stocks. This could then result in takeovers by other companies, proxy fights, etc. which could lead to the dismissal of present management. b. Competitive pressures could lead to stock price declines for a non - performing company, and again result in takeovers, proxy contests, etc. c. In many corporations, management remuneration is tied to performance and managers frequently are awarded stock options which gain value as the price of shares rises. Thus, managers will have an interest in maximizing stockholder welfare. 9. It probably does. Other types of objectives may be partial; but profit and wealth maximization still appear to be the most inclusive objectives. Further, it is much more possible to test this hypothesis than some of the others. 10. No. Accounting depreciation is calculated on historical costs. Thus, depreciating a machine which cost $10,000 when originally purchased can result only in a maximum of $10,000 of depreciation charges set aside toward the purchase of a replacement machine. If this machine (due to inflation) now costs $20,000, then the funds earmarked for the new machine will be insufficient to purchase it. For economists, replacement costs are the relevant quantities. 11. Implicit costs can include in them costs not considered by accountants, such as the owners’ opportunity costs. Thus, accounting profit would generally be higher than economic profit. Economists would include opportunity costs in their calculation of costs; economists’ costs include what is usually referred to as normal profit. 12. You would compare the amount of time spent on each employment, projected business profits versus salaries that could be earned from working for others, the interest that you could earn on your investment in your business against keeping your funds invested elsewhere (i.e. savings

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    The Firm and Its Goals 7 account or other), and the risk involved in the two alternatives. You may even include some estimate (hard to quantify) of any psychic value you derive from being your own boss. 13. Depreciation should reflect the actual change in the value of the equipment and the change in the equipment’s replacement cost. 14. A multinational corporation is usually faced with different legal, economic, cultural and tax conditions in the many countries in which it operates. Such considerations will complicate greatly the tasks of a corporation’s managers and create constraints on their actions. However, if management learns to live with such additional risk and restrictions, corporations can still pursue the goal of profit maximization. 15. Transaction costs are costs which a company incurs in dealing with other entities. Among the costs incurred are those of investigation, contract negotiation, contract enforcement, and transaction coordination. Opportunistic behavior occurs when one of the parties to the transaction takes advantage of the other. This may happen when the transactions involve specialized products or specialized equipment, that may be affected by changes in future market conditions or technology. The possibility of opportunistic behavior thus makes the transaction more risky and will tend to increase transaction costs. 16. As markets expand, companies specializing in particular products will grow and become efficient, and will tend to be able to produce these products at costs that are lower than if produced by an integrated company. This has become true for highly technical products and services. The existence of the Internet has brought about significant decreases in transaction costs, such as the costs of search, investigation, contracting and coordination. 17. High transaction costs will cause a firm to internalize some of its costs. Some of the reasons for high transaction costs are: a. The negotiation and enforcement of contracts. b. Uncertainty and frequency of transactions. c. Assets - specificity which may lead to opportunistic behavior. 18. Using the constant dividend growth formula P = D 1 /(k - g), and noting that the $2 dividend was paid last year, so this year’s dividend would be expected to be 6% higher: 2*(1.06) /(0.13 - 0.06) = 2*(1.06)/0.07 = $30.29 per share 30.29 x 2,000,000 = $60,571,428 19. Shareholder wealth is calculated by multiplying the number of shares outstanding by the price of the stock. MVA is the difference between the market value of the company (including both stocks and bonds) and the capital contributed by the investors. The latter concept is more meaningful since it measures the increase in wealth of the investors above what they have contributed. A company could have a very high market value, but investors may have actually contributed more than the company is worth. In such a case, there has been a destruction of investors’ value. General Motors appears to be an example of such a situation.

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    CHAPTER 3 SUPPLY AND DEMAND QUESTIONS 1. Demand: Quantities of a good or service that people are ready to buy within a given time period (day, week, month, etc.) at different prices, other factors held constant. Supply: Quantities of a good or service that people are ready to sell within a given time period (day, week, month, etc.) at different prices, other factors held constant. “Demand” encompasses all possible quantities demanded at different prices, while “quantity demanded” refers to one particular amount that people are ready to buy out of the entire set of possibilities. The former is represented by the entire demand curve; the latter is represented by a point on the curve, given a specific price. A similar distinction can be made about “supply” and “quantity supplied.” 2. Demand: 1) income; 2) tastes and preferences; 3) prices of related products; 4) future expectations; 5) number of buyers Supply: 1) costs; 2) technology; 3) prices of other products sold by suppliers; 4) future expectations; 5) number of sellers; 6) weather conditions 3. An important part of the functioning of the market process is the determination of the price of a particular product as well as the relative prices of all goods and services in the market. As we have shown in this chapter, it is the price that serves as the rationing agent in the short run whenever the market is not in equilibrium (i.e., shortages or surpluses exist). It is also the price that serves as a “signal” in the long run to buyers and sellers concerning on what markets to focus their purchases and production efforts. 4. Comparative statics analysis is an approach to studying a problem that is frequently used in economics. In the analysis of the market process, it begins by stating certain assumptions about market conditions and then establishing equilibrium price and quantity. One (or more) of the assumptions is changed, creating a disequilibrium in the market. As a result, new equilibrium price and output levels are then determined. The new equilibrium levels are then compared to the original ones. 5. The rationing function involves the increase or decrease in price to clear the market of any shortage or surplus. It is a function that takes effect in the short run in response to supply or demand changes. If the price did not change accordingly, buyers would face long lines, waiting lists, and other inconvenient manifestations of a market shortage, or sellers would be left with surplus inventories of goods. Thus price rations the goods available in the short run. 6. The guiding function takes effect in the long run. Resources are guided into or out of markets as a result of increases or decreases in the price. For example, if the price of a good increases, more firms will enter the market in the long run. Resources are guided into the market by the higher price, a reflection of the higher value that society places on the production of this product.

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    Supply and Demand 9 Conversely, if the price of a good decreases to the point where the product no longer meets the profit requirements of sellers, firms will exit the market in the long run and resources will be reallocated to other markets whose products are valued more highly. 7. Short Run, Producers’ Perspective: Time enough only to react to changes in demand (and price) by changing their variable factors of production. Long Run, Producers’ Perspective: Time enough to react to changes in demand (and price) by changes all factors of production. Short Run, Consumers’ Perspective: Time enough to react to changes in supply (and price) by changing the quantity demanded. (For example, if the price of gasoline rises, people will react in the short run simply by buying less at the higher price.) Long Run, Consumers’ Perspective: Time enough to react to changes in supply (and price) by changing demand. (For example, if the price of gasoline rises, people will react in the long run by car pooling, buying more fuel efficient cars, and changing their patterns of automobile usage, thus causing demand for gasoline to shift to the left.) 8. From an economic standpoint, a shortage exists when the quantity demanded exceeds the quantity supplied at some given price. In other words, it exists because the price is too low relative to its market clearing or equilibrium point; this is a disequilibrium situation. Scarcity is a relative situation reflected in the market equilibrium price. For example, if the price of a particular good rises, then we can say that in economic terms, it has now become scarcer. If the price of a particular good is higher than another one, then we can say that the former is scarcer than the latter. We can use the contrast between the short run and long run market time periods (along with comparative statics analysis) to illustrate the difference between a shortage and a surplus. Let us assume that we are analyzing the market for oranges. * A late frost destroys a sizable proportion of the Florida orange crop. Supply for oranges shifts to the left. * As a result in the decrease in supply, a shortage is created at the existing market price for oranges. * Because of the shortage, the price of oranges rises. * This rise in the equilibrium price of oranges indicates to market participants that oranges are scarcer. 9. It is important because it will help them to analyze what might be currently happening as well as what might happen in a particular market. For example, suppose the managers of a firm that produces bottled water experience an unexpected increase in the demand for their product because of changing consumer tastes and preferences and the increasing concern over the purity of available tap water. Simply enjoying the benefits of this rise in demand will not be advisable, because they should realize that over time (i.e., in the “long run”) many new companies will seek to enter the now more lucrative bottled water market. (In the

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    10 Supply and Demand U.S. Perrier has met with considerable competition from Evian and others. To be sure, their sales were hurt because of quality control problems. However, a point can be made that because of the increase in competition which inevitably faces successful companies in the long run, it should have been even more careful to control the purity of its product.) 10. We can use the actual example of the additional tax of 10 percent levied on luxury cars sold for over $30,000. This tax certainly increases the actual price of the car to the consumer. Assuming a normal downward sloping demand curve, fewer cars will be demanded (i.e., there will be a movement along the demand curve for luxury cars). Thus the original statement is certainly incorrect and confuses a change in demand with a change in quantity demanded. It is also not certain whether the price will actually fall in the long run. Over time, the demand for luxury cars might shift to the left but then again it might not. This is because in reality, all “other factors” do not remain constant. For example, tastes and preferences may change in favor of luxury cars or the economy may experience a strong recovery and expansion. (If all other things are held constant, the price will return to the original price only if the demand for luxury cars is perfectly elastic and the supply of luxury cars is not perfectly elastic, conditions unlikely to hold. See Chapter 4 for further discussion of elasticity.) 11. Economists make the distinction between “demand” and “quantity demanded” in order to facilitate the use of the supply and demand diagrams in explaining the rationing and guiding functions of price. However, in the business world, this distinction is usually not made. For business people, the term “demand” is generally used in reference to both “demand” and “quantity demanded.” Whether the former or the latter term is being considered depends on the context in which they are used. In the above statement, “demand” clearly refers to the economist’s “quantity demanded.” As instructors, we have noticed that economics texts books (particularly principles texts) greatly stress the difference between these two terms, and rightfully so. However, this question is to remind students that in applying demand analysis to actual situations, business people usually ignore this distinction. 12. (Other answers are possible for all of the following, given correct reasoning.) a. Busier life styles, two - income families, single - parent households will continue to cause demand for convenience foods to increase. b. Demand is already increasing drastically for goods purchased on the Internet and is posed to explode in the next five years. c. Will decline as usage of internal fax modems and e - mail attachments continue to rise. d. May decrease as digital cameras become less expensive and in greater demand. e. Pay - per - view and satellite TV programs will continue to erode video rental demand. f. Pay - per - view should increase as broader band connections to the home make this form of entertainment cheaper and easier to use. g. Longer term trends point in an upward direction.

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    Supply and Demand 11 h. It is difficult to tell, but if demand for SUV’s and trucks continues to rise, there will also be a steady increase in demand (particularly in the U.S. and Western Europe). Also, if emerging markets continue to grow (particularly in countries such as China and Brazil), there will be more automobiles and hence an increase in world demand for gasoline. 13. a. (1) Discovery of new sources of oil: supply increases. (2) Invention of new long - lasting battery for electric car: supply decreases — particularly in the long run as companies shift their resources from oil production to battery production. (3) Mergers or acquisitions (as have been going on in the late 90s with BP and Amoco as well as Exxon and Mobil): — these mergers may cause supply to increase or decrease depending on the intentions of the larger companies that have even more power over supply. b. (1) Cattle ranching declines as it becomes harder to earn a good return in the market for beef (in this case it is actually supply decreasing in response to demand falling in the long run). (2) Increase in beef imports from countries such as Argentina (recently the U.S. government allowed the importation of Argentine beef into the country) — supply increases. c. Increase in the building of new manufacturing facilities in Asian countries such as Taiwan — supply increases. d. Mergers and acquisitions in the hotel industry (could increase or decrease number of rooms — would probably increase number of rooms as the larger companies try to expand their market share by building new hotels). e. U.S. or European based multinationals such as McDonald’s and Burger King build new restaurants in an attempt to expand their global businesses — supply increases. f. New co - branded cards are offered by financial institutions — supply increases. g. More manufacturing, assembly and distribution capacity by key companies such as Dell, Compaq, IBM and Gateway 2000 — supply increases. h. More PC companies such as Dell and Compaq 2000 enter the server market or increase their resources in this product segment in an attempt to offset the shrinking profit margins in the PC business -- supply increases. PROBLEMS 1. a. 800 caps b. $10 c. $20 d. Note to Instructors: If you assign this question, be sure to point out to your students that the answer is covered in Appendix 2A. It is also discussed in greater detail in Chapter 4. We ask this question simply as a prelude to the material in Chapter 4.

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    12 Supply and Demand Figure 3.1 Figure 3.2 2. a. Figure 3.3 b. 25,000P = 50,000 - 10,000P Q d = 50,000 - 10,000 (1.4286) = 35,714 35,000P = 50,000 Q s = 25,000 (1.4286) = 35,714 P * = $1.4286 -5 0 5 10 15 20 25 0 500 1000 1500 2000 Q $ P, MR D MR 0 2 4 6 8 10 12 0 500 1000 1500 2000 Q $ (Thousands) TR 0 0.5 1 1.5 2 0 10 20 30 40 50 Q (Thousands) P ($) S D P* = 1.4286 Q* = 35,714 (approx.)

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    Supply and Demand 13 3. a. Surplus or Price Q S Q D Shortage $6.00 55,000 5,000 50,000 5.00 40,000 15,000 25,000 4.00 25,000 25,000 0 3.00 10,000 35,000 - 25,000 2.00 0 45,000 - 45,000 1.00 0 55,000 - 55,000 b. Equilibrium price = $4.00 because it equates Q D with Q S . 4. a. $300 b. $100 c. Figure 3.4 d. P * = $200 Q * = 1000 e. P * = $225 Q * = 1250 f. P * = $200 Q * = 1500 g. See graph above 5. a. Q = 10,000 - 200P + .03(1,000,000) + .6(30,000) + .2(15,000) Q D = 61,000 - 200P b. P Q D $200 000 175 26,000 150 31,000 125 36,000 c. P = $80. 6. a. Q = 200 - 300(2.50) + 120(10) + 65(60) - 250(15) + 400(10) Q = 200 - 750 + 1200 + 3900 - 3750 + 4000 Q * = 4800 Q D = 5550 - 300P 0 50 100 150 200 250 300 350 0 500 1000 1500 2000 2500 3000 3500 4000 Q P D1 D2 S1 S2

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    14 Supply and Demand b. Q D = 3550, a reduction of 1250 (or 5 X 250) c. Advertising expenditure would have to increase by 3.125 or $3,125 (i.e., 400 x 3.125 = 1250)) 7. Supply curve shifts to right and demand curve shifts to left. The combined shifts drastically reduced the world market price for sugar. Figure 3.5 8. The main cause for the increase in the demand for CDs is the decrease in the price of CD players, the complementary product. Other factors might be the change in tastes and preferences in favor of CDs (favored for their durability, convenience, and clarity of sound), and the increase in income, particularly doing the booming second half of the 1980s. Although the demand for CDs has increased, the supply of CDs has probably increased more than the demand. Over the long run, new sellers enter, the production capacity of CD producers increase, the number of artists and CD titles increase, etc. See the diagrams on the following pages. 9. (To Instructor: This problem is a precursor to the discussion of the elasticity concept, and could be discussed in conjunction with Chapter 4.) a. No, because point elasticity is - 0.625. b. Yes. Although the number of units sold would drop from 12,000 to 10,000, the combined impact of an inelastic demand and the increase in advertising would raise total revenue from $36,000 to $40,000. Moreover, the incremental revenue is far greater than the $100 increase in advertising expenses. 10. a. Q = 1,500 – 4(400) + 25(20) +10(15) + 3(500) = 1,650 b. Advertising would have to increase by $60,000 in order for the firm to regain the loss of 300 units resulting from its competitor’s reduction in price of $100. Without cost data, it is not possible to determine whether it would be worthwhile for the firm to increase advertising to offset the competitor’s move. However, one thing that this firm would probably want is to avoid is a price war. c. The price of substitute products such as cruise packages. P 1 P Q P 2 S 1 S 2 D 1 D 2 Q 1

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    Supply and Demand 15 d. If time series data were collected on a quarterly basis, then seasonal factors such as summer or winter could be introduced in the form of dummy variables. 11. a. Q = 250 - 10P can be transformed into: P = 25 - .1Q Figure 3.6 Figure 3.7 b. Q = 1300 - 140P can be transformed into: P = 9.29 - .007Q Figure 3.8 0 50 100 150 200 250 0 5 10 15 20 25 P Q Q = 250 - 10P 0 5 10 15 20 25 0 50 100 150 200 250 Q P P = 25 - .1Q 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1.1 1.2 1.3 1.4 0 1 2 3 4 5 6 7 8 9 P Q (Thousands) Q = 1300-140P

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    16 Supply and Demand Figure 3.9 c. Q = 45 - .5P can be transformed into: P = 90 - 2Q Figure 3.10 Figure 3.11 0 1 2 3 4 5 6 7 8 9 10 11 0 40 180 320 460 600 740 880 1020 1160 1300 Q P P = 9.29 - .007P 0 5 10 15 20 25 30 35 40 45 0 10 20 30 40 50 60 70 80 90 P Q Q = 45 - .5P 0 10 20 30 40 50 60 70 80 90 0 5 10 15 20 25 30 35 40 45 Q P P = 90 - 2Q

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    Supply and Demand 17 12. Figure 3.12 Certain consumer electronics products could exhibit this type of demand. This curve indicates that once the price falls to a threshold, the quantity demanded starts to “take off.” Hand - held calculators, compact disk players, and perhaps even home computers could very well fit this situation. 13. The Problem: a. F ound in the graph itself and in the equation found in cells A6 and A7: P = 20 – 0.5Q b. F ound in cell C4. Q = 100 c. Change A4 from - 20 to - 10 or - 25 and watch what happens to the graph and equations in A6, A7 and C4 One final scenario: Cells D2=200, D3=12.5, D4= - 16. a. C = $12.50 and D = - 16. b. P = 25 – 0.0625Q 0 1 2 3 4 5 6 7 8 9 10 11 0 50 100 150 200 250 300 350 400 Q P

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    18 Supply and Demand $ - $2 $4 $6 $8 $10 $12 $14 $16 $18 $20 $22 $24 $26 0 25 50 75 100 125 150 175 200 225 250 275 300 Price per glass, P Number of glasses per week, Q Two BTG Scenarios Pre - Adv. Post - Adv. NOTE TO INSTRUCTORS: You can use the Multiple Demands worksheet to create new scenarios and then have students tell you the story shown by the scenario (by filling in new values for C and D, for example), or you could give them the two scenarios in verbal format and have them show you the graph as a homework problem.

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    CHAPTER 4 DEMAND ELASTICITY QUESTIONS 1. Elasticity refers to the percentage change in one variable relative to a percentage change in another variable. It is a relative measure of how responsive the change in one variable’s value will be to the change in the values of some other variables. Price elasticity of demand is defined as the percentage change in quantity demanded resulting from a one percent change in price. 2. Point elasticity (in connection with the price elasticity of demand) refers to the elasticity at a given point on a demand curve. It measures the percentage change in quantity caused by a very small (actually infinitesimally small) percentage change in price , assuming these values can change continuously. Arc elasticity measures the elasticity over a certain discrete segment of the demand curve. If arc elasticity were defined as change in quantity/quantity change in price/price then the elasticity coefficient would differ if we moved up on a demand curve as against moving down on it. To make an upward movement have the same elasticity coefficient as a movement down, average quantity and average price are used in the formula. In practical business situations, arc elasticity would probably be the more useful concept, because a businessperson would most likely be interested in the effect on quantity of a change in price of some discrete magnitude rather than an infinitesimally small change in price. 3. This result follows from an application of the notion of elasticity of derived demand. The demand for skilled crafts people is probably more inelastic than the demand for industrial workers, since the degree of input substitutability is less for the former than the latter. Thus a substantial increase in the wage of skilled crafts people would cause a smaller decrease in employment than a similar percentage increase in the wages of less skilled workers. 4. a. Probably fairly inelastic since mayonnaise is a staple and accounts for a small portion of a person’s or a family’s total budget. b. Probably fairly elastic, since there are many good substitutes for a specific brand of mayonnaise. c. Probably relatively elastic since there are numerous substitutes. Also, it represents a relatively large portion of a person’s budget. d. As a “luxury,” the demand elasticity for a Jaguar could be considered to be relatively elastic. But since such automobiles are purchased by people in a high income category, the demand

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    Demand Elasticity 19 elasticity could also be quite low. The answer probably depends on whether other high - priced cars (Mercedes, BMW, Infinity, etc.) are considered to be close substitutes. e. Probably rather elastic. It represents a significant expenditure. Further, a repair may significantly prolong its life. f. Probably rather elastic since other vacation arrangements (driving, bus, train) could be substituted. Also, it represents a significant portion of total vacation cost. g. Quite inelastic, since it is considered a staple, and usually represents a small part of a person’s budget. h. Probably quite elastic since they represent a large expenditure. If given as a gift, there are probably many good substitutes. 5. The income elasticity for restaurant food is probably quite high. Thus, during declines in economic activity (and thus, possibly declines in incomes), spending on restaurant food would most likely decline more than spending at home. Actually, since the two are substitutes, spending on food at home may actually go up during economic declines. 6. a. Negative – they are complements.. b. Positive — they are substitutes. c. Positive — they are substitutes. d. They appear to be unrelated products (thus, cross - elasticity of demand is not significantly different than zero). While there is no relationship between these two products , both of these may compete for budget dollars. From a total budget viewpoint, they could be considered to be substitutes. But usually, the relationship between the two would be very tenuous. 7. When the demand curve is inelastic, marginal revenue is negative. Thus, selling on the inelastic portion of the demand curve would result in a decrease in total revenue for every additional unit sold. 8. Most likely automobiles, since they represent a larger expenditure and are more likely to be purchased by borrowing on a longer term basis. 9. Yes. Elasticity of demand is expected to be higher in the long run. Thus, a larger decrease in gasoline consumption would have been expected. In fact, gasoline prices decreased to pre - crisis levels rather quickly. 10. A five - cent increase probably did not affect consumption of gasoline significantly since it was a relatively small change. The demand for gasoline is probably relatively inelastic in such a small range. This is quite different from the doubling of prices, which had occurred during the oil embargo in 1973, for instance. 11. Since the demand curve for cigarettes and alcohol is generally thought to be rather inelastic, imposing a tax on these products would not be expected to decrease consumption a great deal. The tax revenue from such products would be considerably larger than from products whose demand curve was rather elastic and whose consumption would decrease greatly upon the imposition of an additional tax. 12. No. Since the percentage changes between quantity and price are different at each point of the demand curve.

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    20 Demand Elasticity 13. This firm is faced by considerable competition. Theoretically, if it raises its price by any small amount, it would lose all of its business, because there are many other firms in the industry that are offering this same product at the lower price. 14. False. If a company’s demand curve is elastic, a price decrease will increase its revenue. But if, as it sells more, its costs should rise more than its revenue, the price action would decrease the company’s profit. So, if the company wants to maximize its profits, it will not lower its price in this case. 15. a. Less than 1. Elasticity may actually be negative if consumers switch to more expensive butter as their incomes increase. b. Most likely greater than 1. This is a luxury item and increased income may bring about a larger than proportional increase in consumption. c. Probably close to 1. But, as incomes increase, consumers may switch to more expensive furniture. Thus elasticity could be greater than 1. d. Probably greater than 1. Since lobsters are generally an expensive food, people with increasing incomes may increase their expenditure on lobster more than proportionally. 16. A one percent increase in income will bring about a .25% increase in spending on tomatoes. 17. Elasticity would indicate a movement along the demand curve. However, the drop in used car prices may have resulted from movements in both the demand curve and the supply curve. 18. The decision - makers at the U.S. Postal Service are assuming that the demand for mail services is inelastic, and that the price increase will bring about a smaller than proportional percentage decrease in quantity demanded, thus resulting in an increase in revenue. This may very well be true in the short run. However, it may not be a good policy for the long run. Given time, more postal customers may adjust their consumption patterns, and switch to alternative services. As was discussed in the text, in the long run, demand curves become more elastic. Also, the increase in substitute services available over time would increase the price elasticity of demand for mail service, thereby making future postage rate increases more likely to reduce total revenues. 19. Providing the U.S. Olympic Team with free clothing items would qualify as an advertising expense. The management of Roots expected sales quantities to experience a high percentage increase relative to their increase in advertising expenses. They apparently turned out to be right.

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    Demand Elasticity 21 PROBLEMS 1. % change Q .2 ————— = — = - 2 % change P - .1 2. a. Q = 20 - 2P; slope ∆Q/∆P = - 2 At P = 5 Q = 20 - 2 x 5 = 10 At P = 9 Q = 20 - 2 x 9 = 2 When Q = 10 and P = 5 ε p = - 2 x 5/10 = - 1 Unitary elastic When Q = 2 and P = 9 ε p = - 2 x 9/2 = - 9 Elastic b. At P = 5, Q = 10 At P = 6, Q = 8 c. Price Quantity Total Revenue 4 12 48 5 10 50 6 8 48 7 6 42 At a price of $5, revenue reaches its peak. This is also where point price elasticity is 1, as shown in part a. of this problem. 3. a. Q = 2000 – 100(6) Q = 2000 – 600 = 1400 b. 1800 = 2000 – 100P 100P = 2000 – 1800 100P = 200 P = 2 c. Q = 2000 – 100(0) Q = 2000 d. 0 = 2000 – 100P 100P = 2000 – 0 P = 20 e. Slope = ΔQ/ΔP = 100 ε P = 100 x 6/1400 ε P = 100 x 0.0043 ε P = 0.43 4 . a. When price changes by 1, quantity will change by 10 in the opposite direction. When income changes by 1, quantity will change by .5 in the same direction. b. Point elasticity:

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    22 Demand Elasticity Q = 100 - (10)(7) + (.5)(50) = 100 - 70 + 25 = 55 Slope = - 10 ε p = ( - 10) x (7/55) = - 1.2 7 Arc elasticity, between P = 7 and P = 6: at P = 6, Q = 100 - (10)(6) + (.5)(50) = 65 E p = ((65 - 55)/(65 + 55)) / ((6 - 7)/(6 + 7)) = - 1.08 c. Point elasticity Slope = 0.5 ε y = (.5) x (50/55) = 0.45 Arc elasticity, between Y = 50 and Y = 60 at Y = 60, Q = 100 - (10)(7) + (.5)(60) = 60 E y = ((60 - 55)/(60 + 55)) / ((60 - 50)/(60 + 50)) = 0.48 d. Point elasticity Q = 100 - (10)(8) + (.5)(70) = 55 ε p = ( - 10) x (8/55) = - 1.45 Arc elasticity, between P = 8 and P = 7 Q = 100 - (10)(7) + (.5)(70) = 65 E p = ((65 - 55)/(65 + 55)) / ((7 - 8)/(7 + 8)) = - 1.25 5 . a. At P = 7, Q = 30 - (2)(7) = 16 Slope = - 2 ε p = ( - 2) x (7/16) = - 0.88 b. At P = 5, Q = 30 - (2)(5) = 20 P = 6, Q = 30 - (2)(6) = 18 E p = ((18 - 20)/(18 + 20)) / ((6 - 5)/(6 + 5)) = - 0.58 c. Elasticity will be the same. Equation is now Q = 3000 - 200P At P = 7, Q = 3000 - (200)(7) = 1600

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    Demand Elasticity 23 Slope = - 200 ε p = - 200 x (7/1600) = - 0.88 6 . a. (x - 4000) (63 - 70) - 2.5 = ———— / ———— (x + 4000) (63 + 70) x = 5212 At P = 70, TR = 4000 x 70 = 280,000 P = 63, TR = 5212 x 63 = 328,356 Revenue will increase, because demand curve is elastic. (x - 3000) (22 - 25) 7 . a. - 3 = ———— / ———— (x + 3000) (22 + 25) x = 4421 (x - 3000) (24 - 28) b. .3 = ———— / ———— (x + 3000) (24 + 28) x = 2865 8 . If price elasticity is - 4, and the Redbirds wish to increase attendance from 50,000 to 80,000, the price (x) must be: (80000 - 50000) (x - 30) - 4 = —————— / ——— (80000 + 50000) (x + 30) x = 26.73 If price is lowered from $30 to 27, and attendance rises from 50,000 to 60,000, price elasticity is: (60000 - 50000) (27 - 30) E p = ——————— / ———— (60000 + 50000) (27 + 30) = - 1.727 9 . Arc price elasticity for spreadsheet program: (120 - 100) (350 - 400) E p = ————— , ————— (120 + 100) (350 + 400)

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    24 Demand Elasticity = - 1.36 Arc cross elasticity for graphics program: (56 - 50) (350 - 400) E x = ———— , ————— (56 + 50) (350 + 400) = - 0.85 The quantity demanded for spreadsheets increased due to the price change. The price elasticity is greater than (absolute) 1, and therefore revenue will rise from $40,000 to $42,000. The graphics program is a complementary commodity to the spreadsheet program, and its quantity sold benefited from the price decrease in the spreadsheet program. The cross - elasticity is - 0.85 (the negative sign shows complementarity), and is quite strong. 10 . Demand Elasticity Total Marginal Price Quantity Arc Point Revenue Revenue 7.00 100 700 6.50 200 - 9.00 - 6.50 1300 6.00 6.00 300 - 5.00 - 4.00 1800 5.00 5.50 400 - 3.29 - 2.75 2200 4.00 5.00 500 - 2.33 - 2.00 2500 3.00 4.50 600 - 1.73 - 1.50 2700 2.00 4.00 700 - 1.31 - 1.14 2800 1.00 3.50 800 - 1.00 - 0.88 2800 0.00 3.00 900 - 0.76 - 0.67 2700 - 1.00 2.50 1000 - 0.58 - 0.50 2500 - 2.00 2.00 1100 - 0.43 - 0.36 2200 - 3.00 1.50 1200 - 0.30 - 0.25 1800 - 4.00 1 1 . a. Negative: television sets and DV Rs are complements. b. Positive: rye bread and whole - wheat bread are substitutes. c. Negative: construction of residential housing and furniture purchases are complements. d. Probably zero: breakfast cereal and men’s shirts are unrelated products. However, they may be thought of as substitutes in the competition for a consumer’s budget dollars. 12. a. 130 – 70 2.50 – 3.50 E p = —————— / ———— 130 + 70 2.50 + 3.50 E P = 1.8 b. 90 - 40 2.50 – 3.50

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    Demand Elasticity 25 E x = —————— / ———— 90 + 40 2.50 + 3.50 E x = 2.3 1 3 . a. The price elasticity for shoes in the U.S. is 0.7. However, the elasticity for Brown Shoe Company's shoes may be higher, since a particular make of shoes has more substitutes than shoes in general. The exact demand elasticity for Brown's product is not known, but it could easily be greater than 1 (or less than negative one), and thus a price decrease could lead to an increase in revenue. b. The quantity of shoes sold in the U.S. would rise by 9%. 14 . 1. 5 = - 30%/ - 20%. UBS would lose 30% of its sales. 15 . a. There is a 14.3% decrease in price. With a 20% increase in quantity, this implies an elasticity coefficient of - 1.4. b. Syrup is a complementary good in relation to ice cream. Cross elasticity would measure this effect. +0.1/ - 0.143 = - 0.7 The coefficient of cross elasticity is - 0.7, confirming complementarity of syrup to ice cream. The coefficient is quite high, and thus one could conclude that the two products are fairly close complements. c . Yes, revenues for both ice cream and syrup rise. Unless costs rise more quickly (a very dubious conclusion), this action should increase the supermarket's profit. 1 6 . In computing the elasticities, remember that an elasticity measure can be calculated only if all other things remain constant. Price elasticities Months 3 - 4 - 1.00 20/(220+240)/2 - 10/(120+110)/2 Months 4 - 5 - 0.96 - 10/(240+230)/2 5/(110+115)/2 Months 7 - 8 - 0.49 10/(220+230)/2 - 10/(115+105)/2 Cross elasticities Months 1 - 2 0.45 10/(200+210)/2 15/(130+145)/2 Months 5 - 6 0.46 - 15/(230+215)/2 - 20/(145+125)/2 Month 9 - 10 0.79 - 15/(235+220)/2

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    26 Demand Elasticity - 10/(125+115)/2 Income elasticities Months 2 - 3 0.95 10/(210+220)/2 200/(4000+4200)/2 Months 6 - 7 0.49 5/(215+220)/2 200/(4200+4400)/2 Months 8 - 9 0.48 5/(230+235)/2 200/(4400+4600)/2 1 7. a. 1800 2000 - 200 b. $0 2000 = 2000 - 20P $100 0 = 2000 - 20P $25 1500 = 2000 - 20P c. Q = 2000 - 20P 20P = 2000 - Q P = 100 - .05Q TR = PQ = 100Q - .05Q 2 MR = 100 - .1Q d. Q = 2000 - 20(70) = 600 TR = 600 x 70 = 42000 or TR = 100Q - .05Q 2 = 60000 - .05(600) 2 = 60000 - 18000 = 42000 MR = 100 - .1(600) = 100 - 60 = 40 e. ε = dQ/dP x P/Q = 20 x 70/600 = 1400/600 = 2.33 f. Q = 2000 - 20(60 ) = 800 TR = 800 x 60 = 48000 MR = 100 - .1(800) = 20

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    Demand Elasticity 27 ε = 20 x 60/800 = 1200/800 = 1.5 g. At ε = 1 MR = 0 0 = 100 - .1Q .1Q = 100 Q = 1000 Proof: 1000 = 2000 - 20P 20P = 1000 P = 50 ε = 20 x 50/1000 = 1000/1000 = 1 1 8 . a. 672,000 x $1 $672,000 623,000 x $1.15 716,450 Revenue increase $44,450 b. Ep = ((672000 - 623000)/(672000+623000)) / ((1 - 1.15)/(1+1.15)) = .037838/ - .069767 = - .542 c. Increases in gasoline prices and automobile insurance during the year may have mitigated the bus fare increases, thus causing fewer commuters to switch away from using buses. Increases in personal income may also have been instrumental. These changes would have affected the demand curves for commuting, rather than be an example of price elasticity. 19 . E p = ((355000 - 518000)/(355000+518000))/((45 - 30)/(45+30)) = - .18671/.2 = - .934 Revenue before price decrease 355000 x .45 £159750 Revenue after price decrease 518000 x .30 155400 Decrease in revenue £4350 20 . E A = 1050 – 900 x 10000 + 15000 15000 – 10000 900 + 1050 = 150 x 25000 5000 1950 = 0.03 x 12.82 = 0.38 The elasticity of 0.38 means that for every 1% increase in advertising expense, sales will increase by 0.38%. Whether this move w as wise depends on the production cost of the

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    28 Demand Elasticity yoga apparel . To make things simple we will assume that the unit cost of the apparel will be the same at both quantities. If the cost is $80 per garment , then: Advertising = $10000 Advertising = $15000 Sales 900 x 120 108000 1050 x 120 126000 Cost 900 x 80 72000 1050 x 80 84000 36000 42000 Advertising 10000 15000 Profit 26000 27000 By increasing its advertising expenses, the company increased its profit by $1,000. If, however, the unit cost of the garment was $100 then the profit would decrease from $8,000 to $6,000. 21. a. E I = 12000 - 10000 / 34000 - 32000 12000 + 10000 34000 + 32000 = 2000 / 2000 _ 22000 66000 = 0 .0909 / 0. 0 303 = 3 b. E P = 1 1500 - 1 2 000 / 100 ______ 11500 + 12000 1600 + 1500 = - 5 00 / 1 00 _ 23500 3100 = .02128 / 0.03226 = 0.66 Company’s revenue: Before price increase 12000 x 1500 = 18,000,000 After price increase 11500 x 1600 = 18,400,000 c. The demand curve appears to be inelastic; thus a further increase in price could increase revenue. 22. Using the arc elasticity formula: P1 = 599 and P2 = 434; Q1 = 270 and Q2 = 1,119 So /E/ = 3.99 or 4.0. This is very elastic. In the months between Apple’s setting of the two prices, we can assume that the market’s enthusiasm for the product increased. Thus, there was probably a shift to the right in the demand curve as well as a movement downward and to the right of the existing demand curve.

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    C HAPTER 5 DEMAND ESTIMATION AND FORECASTING QUESTIONS Demand Estimation 1. Time series data: Information concerning a particular variable over time at specified intervals (e.g., weekly, monthly, quarterly, annually). For example, the average monthly price of corn, the total quantity demanded of pizza per week, annual income per capita. Cross - sectional data: Information concerning a particular variable at a specific point in time for a given unit of observation. For example, the average price of corn in April 1995 for all countries in the world who produce this good, the total quantity of pizza demanded on November 21, 1995, by each college campus in the United States, income per capita in 1995 for all countries that belong to the United Nations. 2. In both cases, as many of the price and non - price factors that influence demand should be included. However, in the demand equation for consumer durables, some variable indicating the cost or availability of credit should be used. This particular variable would not be considered an important factor in the demand for fast - moving consumer goods. (Instructors may wish to discuss other possible differences such as the inclusion of a dummy variable indicating a period of recession in the time - series analysis of consumer durables , or expectations concerning rates of price inflation which would be applicable to the timing of purchases of consumer durable goods but not “fast - moving consumer goods.”) 3. R 2 is a measure of the explanatory power of the regression model. It is also referred to as a measure of “the goodness of fit” (of the regression line through the scatter of data points). Specifically, it indicates the percentage of the variation in the dependent variable Y explained or accounted for by the variation in the independent variable(s) X. Other factors held constant, time series data generally produce a higher R 2 than cross - sectional data because both dependent and independent variables often move together over time simply because of some upward trend. A good example of this is a time - series analysis of aggregate consumption regressed on aggregate disposable income. Regression analysis of this consumption function commonly produces R 2 of .95 and above. 4. a. State the null hypothesis and the alternative hypothesis. b. Select the level of significance (e.g., a = .05) and the associated critical value of t (using the t table). c. Compute the t value (if the software package does not do it for you). d. Compare the t value with the critical value. If the former exceeds the latter, reject the null hypothesis. If it does not, then do not reject the null hypothesis. The “rule of 2” is useful, because in most cases, the critical value of t is approximately 2 for the .05 level of significance, the level most commonly used in economic research.

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