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

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CHAPTER 1INTRODUCTIONQUESTIONS1.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 notavailable in unlimited amounts. When resources are available in unlimited amounts, economistsconsider them to be “free” goods. Because of the scarcity of resources, choices have to be madeabout their allocation among competing uses. Each choice is considered by economists to involvean “opportunity cost” because the use of scarce resources in one activity implies that they cannot beused in an alternative one. In other words, this opportunity cost is the amount that is sacrificedwhen choosing one activity over its next best alternative.It is reasonable to assume that all organizations have to work with scarce resources, no matter howlarge or profitable. A key role that managers play is to decide how best to allocate theirorganizations’ scarce resources. From an economic standpoint, optimal decisions involve theirweighing of the benefits associated with a particular decision against the opportunity cost of thisdecision.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 ofparticular goods or services (e.g., capital intensive versus labor intensive, domestic productionversus foreign production etc.).“For whom?”—This involves deciding how to distribute a country’s total output of goods andservices (e.g., income and wealth distribution).3.a.howb.whatc.for whomd.howe.how4.Market Process: The use of supply, demand and material incentives (e.g., the profit motive) todecide how scarce resources are to be allocated. It answers the three questions of what, how and forwhom in the following ways:“What?”—Whatever is profitable will be produced. Profitability in turn depends on the strength ofa society’s demand for a particular good or service and the cost to producers of providing such agood 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 ableto pay for them. Of course the ability to pay depends on the country’s distribution of income. Many

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2Introductionfactors may account for the distribution of income in a market economy. For economists, one of themost important is the “productivity principle.” This states that income is allocated according to therelative 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 intheir economic decisions, we have observed that command and tradition continue to play animportant role in the decision-making process. In particular:Command Process: Strategic, long-term or “political” decisions that are made by some centralauthority in an organization (in a large company it might be for example the CEO, the corporatemanagement committee, in a small company it might be the owner/operator) can be considered partof the command process. For example, a manager might believe that a particular product is notprofitable and recommend that it be dropped for the company’s product line. However, uppermanagement might believe that the product might have some long-term or strategic value andoverride 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 strategicdecision to stay in the business of making typewriters, even though analysis indicated that it wouldbecome increasingly more difficult for it to be profitable in this business as typewriters becameelectronic rather that electromechanical and as PCs and word processors performed more and moreof the basic typing functions. It invested approximately $500 million to completely modernize andautomate its production facilities in Lexington, Kentucky. A major reason for maintaining andinvesting 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 companycalled Lexmark. (We do not know whether it was because the typewriter division was notprofitable.)Of course, managers in a market economy must also deal with the command process whenevergovernment rules, regulations, or laws have to be considered. Chapter 15 of this text is devoted tothis possibility.Traditional Process: As pointed out in the text, customs and traditions play a more important rolefor managers in developing countries. However, we have observed or read about certain instancesin which they affect management decisions here in the United States. For example, some years backit was reported in the Wall Street Journal that the CEO of International Harvester (now operating asNavistar) lamented that the company should have sold off its farm equipment long before it actuallydid. However, he pointed out that he and the rest of the management found it very difficult to divestitself 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 ofoccupations for men and women. For example, years ago, suitable professional work for womenwas usually confined to teaching and nursing. Obviously, this traditional view of the role of womenin the workplace has changed in the United States. However, in the rest of the world, even in thedeveloped countries such as Japan and those in Western Europe, tradition is still an importantfactor.

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Introduction3Instructors may also wish to consider the traditional view and acceptance of various unethicalpractices such as kick-backs in government contracts and the practice of nepotism in the hiring ofpersonnel that exists today in many developing countries.6.This question is subject to considerable interpretation and the instructor may choose to use his orher own distinctions between the two concepts. We believe that management skills have to do morewith the organizing and management of scarce resources (particular the managing of people) andentrepreneurship has more to do with the taking of certain risks in such activities as the introductionof goods and services to the marketplace. Ideally, the successful manager or entrepreneur shouldhave both capabilities.7.Microeconomics focuses on individual markets for goods and services, while macroeconomicsfocuses on aggregate economic activity. Managers should understand the macroeconomy in order toprepare for or operate more effectively over different phases of the business cycle. For example, ifmanagers believe that the economy will soon come out of a recession, they may want to beginbuilding inventories or making certain capital investments in order to better handle the increaseddemand which accompanies a recovery. Alternatively, managers may want to consider diversifyingtheir 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 ofmarketing”: pricing, product, promotion, and placement. Production is also important. Recently,PepsiCo has been buying a selected number of independently owned bottlers because it believes itcan operate them more efficiently and also gain certain economies of scale.Our background paper on this industry should give instructors further information to discuss thisquestion with the class.9.Note to Instructors: Here are some suggested answers. These may be modified depending onchanging events.a.Telecommunications: This is a rapidly changing industry for all types of companies. Let ussuggest an answer for the regional bell operating companies (RBOCs).Competition: Certain states like California are already allowing other companies such as AT&Tand 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 wirelesscompetition.b.Retail Merchandising:Competition: “Category busters” such as Home Depot, Sports Authority, and Borders Bookshave 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 toheadquarters, enabling financial analysts to track closely inventory and product category sales.

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4Introductionc.Higher Education: The Internet has enabled institutions to offer online, distance learningclasses. 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 hasfinally spawned the kind of competition that was intended. For example, the low cost approachof 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 2THE FIRM AND ITS GOALSQUESTIONS1.Yes. The company can profit from this action in several ways. Graduate students, impressed withthe computers, may become recruits for the computer firm. This increases the employment marketfor the firm, and it may become able to hire some superior graduates. Or, these students, aftergraduation, will work for other firms and recommend the computer made by this manufacturer foruse in their work place. In short, if the additional profits from future sales exceed the cost of thedonation, then such a policy is quite consistent with profit maximization.2.Thisisanincompleteobjective,andmaynotbeconsistentwiththeobjectiveofprofitmaximization. Setting a profit margin too high may result in smaller profits than could possibly beachieved with a lower profit margin. In other words, setting a profit margin may not result in profitmaximization. The profit maximization goal should be stated in absolute values, since a high ratioapplied to a small base could yield a lower absolute profit, while a low ratio applied to a high basecould 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, legalrequirements and warranty requirements may raise a company’s costs above what they would havebeen in their absence. But such costs will now be included in a company’s cost calculations. Giventhese costs, a company can still attempt to maximize its profits under the new circumstances. Thetotal profit level will be lower than if these costs did not exist, but the process of profitmaximization will still be in place.4.Shareholder wealth maximization is the more comprehensive of the two. Profit maximization is aperiod of value that may be obtained by short-term management action which could be detrimentalto profits in future periods.But a company with longer range horizons will want to consider a stream of earnings (or cashflows) over time. This stream is then discounted at the company’s cost of capital to the present toobtain the present value of this stream. This present value is the value of the firm or that of thestockholders. When such an objective is used, the company is considering the shape and duration ofthe cash flow stream and the return required by stockholders (i.e. the equity cost of capital). Therequired rate of return is affected by risk, and, thus, risk enters into the valuation. Obviously, thismeasure 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, theywill look for a satisfactory return (both dividend and price appreciation). Company managementwill not be held to maximization but will manage the corporation in a way as to satisfy theshareholders. The term often used to describe this is “satisficing.”6.The “principal-agent problem” refers to the possible divergence of objectives between the ownersand managers of an enterprise.While the owners of a firm (stockholders, when the firm is acorporation) are interested mainly in the increase in the firm’s value, managers may have otherinterests.Managers may be more interested in their own incomes and perquisites.They may also

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6The Firm and Its Goalsstrive for revenue growth rather than profits.They may, in the interest of their own security, bemore conservative in running the business, and may forgo investments with high potential that mayentail some risk.7.Since the ownership in a corporation is widely dispersed, and thus individual stockholders havelittle power, it may be believed by managers that it is not necessary to endeavor to maximizecompany 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 bemore interested in maximizing their own incomes and perquisites. They may also not take prudentrisks to maximize returns, since a severe reversal in business fortunes could cause them to lose theirpositions. Not taking the appropriate risks may result in rather mediocre but still satisfactoryshareholder returns.8.There are several forces which will tend to create a convergence between the interests ofstockholders and managers, and thus cause managers to be interested in maximizing a corporation’sprofits or value:a.Corporate shares are not only owned by widely dispersed stockholders but by large institutionalholders (banks, insurance companies, mutual funds, pension funds). These organizationsemploy analysts who continually study stock performance. Non-performing companies wouldbe sold from these institutions’ portfolios, and lead to decreased prices of these stocks. Thiscould then result in takeovers by other companies, proxy fights, etc. which could lead to thedismissal of present management.b.Competitive pressures could lead to stock price declines for a non-performing company, andagain result in takeovers, proxy contests, etc.c.Inmanycorporations,managementremunerationistiedtoperformanceandmanagersfrequently 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 stillappear to be the most inclusive objectives. Further, it is much more possible to test this hypothesisthan some of the others.10.No. Accounting depreciation is calculated on historical costs. Thus, depreciating a machine whichcost $10,000 when originally purchased can result only in a maximum of $10,000 of depreciationcharges 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 purchaseit. 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 includewhat is usually referred to as normal profit.12.You would compare the amount of time spent on each employment, projected business profitsversus salaries that could be earned from working for others,the interest that you could earn onyour investment in your business against keeping your funds invested elsewhere (i.e. savings

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The Firm and Its Goals7account or other), and the risk involved in the two alternatives. You may even include someestimate (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 theequipment’s replacement cost.14.A multinational corporation is usually faced with different legal, economic, cultural and taxconditions in the many countries in which it operates. Such considerations will complicate greatlythe tasks of a corporation’s managers and create constraints on theiractions. However, ifmanagement learns to live with such additional risk and restrictions, corporations can still pursuethe goal of profit maximization.15.Transaction costs are costs which a company incurs in dealing with other entities. Among thecostsincurredarethoseofinvestigation,contractnegotiation,contractenforcement,andtransaction coordination. Opportunistic behavior occurs when one of the parties to the transactiontakes advantage of the other. This may happen when the transactions involve specialized productsor specialized equipment, that may be affected by changes in future market conditions ortechnology. The possibility of opportunistic behavior thus makes the transaction more risky andwill 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 anintegrated company. This has become true for highly technical products and services. The existenceof the Internet has brought about significant decreases in transaction costs, such as the costs ofsearch, investigation, contracting and coordination.17.High transaction costs will cause a firm to internalize some of its costs. Some of the reasons forhigh 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 = D1/(k-g), and noting that the $2 dividend waspaidlastyear, 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 share30.29 x 2,000,000 = $60,571,42819.Shareholder wealth is calculated by multiplying the number of shares outstanding by the price of thestock. MVA is the difference between the market value of the company (including both stocks andbonds) and the capital contributed by the investors. The latter concept is more meaningful since itmeasures the increase in wealth of the investors above what they have contributed. A companycould have a very high market value, but investors may have actually contributed more than thecompany is worth. In such a case, there has been a destruction of investors’ value. General Motorsappears to be an example of such a situation.

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CHAPTER 3SUPPLY AND DEMANDQUESTIONS1.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 “quantitydemanded” refers to one particular amount that people are ready to buy out of the entire set ofpossibilities. The former is represented by the entire demand curve; the latter is represented by apoint 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 buyersSupply:1)costs;2)technology;3)pricesofotherproductssoldbysuppliers;4)futureexpectations; 5) number of sellers; 6) weather conditions3.An important part of the functioning of the market process is the determination of the price of aparticular product as well as the relative prices of all goods and services in the market. As we haveshown in this chapter, it is the price that serves as the rationing agent in the short run whenever themarket 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 concerningonwhat markets to focus their purchasesand production efforts.4.Comparative statics analysis is an approach to studying a problem that is frequently used ineconomics. In the analysis of the market process, it begins by stating certain assumptions aboutmarket conditions and then establishing equilibrium price and quantity. One (or more) of theassumptions is changed, creating a disequilibrium in the market. As a result, new equilibrium priceand output levels are then determined. The new equilibrium levels are then compared to the originalones.5.The rationing function involves the increase or decrease in price to clear the market of any shortageor surplus. It is a function that takes effect in the short run in response to supply or demandchanges. If the price did not change accordingly, buyers would face long lines, waiting lists, andother inconvenient manifestations of a market shortage, or sellers would be left with surplusinventories of goods. Thus pricerationsthe 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 aresult of increases or decreases in the price.For example, if the price of a good increases, morefirms will enter the market in the long run.Resources are guided into the market by the higherprice, a reflection of the higher value that society places on the production of this product.

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Supply and Demand9Conversely, if the price of a good decreases to the point where the product no longer meets theprofit requirements of sellers, firms will exit the market in the long run and resources will bereallocated 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) bychanging their variable factors of production.Long Run, Producers’ Perspective: Time enough to react to changes in demand (and price) bychanges all factors of production.Short Run, Consumers’ Perspective: Time enough to react to changes in supply (and price) bychanging the quantity demanded. (For example, if the price of gasoline rises, people will react inthe short run simply by buying less at the higher price.)Long Run, Consumers’ Perspective: Time enough to react to changes in supply (and price) bychanging demand. (For example, if the price of gasoline rises, people will react in the long run bycar pooling, buying more fuel efficient cars, and changing their patterns of automobile usage, thuscausing demand for gasoline to shift to the left.)8.From an economic standpoint, a shortage exists when the quantity demanded exceeds the quantitysupplied at some given price. In other words, it exists because the price is too low relative to itsmarket clearing or equilibrium point; this is adisequilibriumsituation.Scarcity is a relative situation reflected in the marketequilibriumprice. For example, if the price ofa particular good rises, then we can say that in economic terms, it has now become scarcer. If theprice of a particular good is higher than another one, then we can say that the former is scarcer thanthe latter.We can use the contrast between the short run and long run market time periods (along withcomparative statics analysis) to illustrate the difference between a shortage and a surplus. Let usassume that we are analyzing the market for oranges.*A late frost destroys a sizable proportion of the Florida orange crop. Supply for oranges shifts tothe left.*As a result in the decrease in supply, ashortageis 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 arescarcer.9.It is important because it will help them to analyze what might be currently happening as well aswhatmighthappen in a particular market.For example, suppose the managers of a firm that produces bottled water experience an unexpectedincrease in the demand for their product because of changing consumer tastes and preferences andthe increasing concern over the purity of available tap water. Simply enjoying the benefits of thisrise in demand will not be advisable, because they should realize that over time (i.e., in the “longrun”) many new companies will seek to enter the now more lucrative bottled water market. (In the

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10Supply and DemandU.S. Perrier has met with considerable competition from Evian and others. To be sure, their saleswere hurt because of quality control problems. However, a point can be made that because of theincrease in competition which inevitably faces successful companies in the long run, it should havebeen 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 forover $30,000. This tax certainly increases the actual price of the car to the consumer. Assuming anormal downward sloping demand curve, fewer cars will be demanded (i.e., there will be amovement along the demand curve for luxury cars).Thus the original statement is certainlyincorrect 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 forluxury cars might shift to the left but then again it might not. This is because in reality, all “otherfactors” do not remain constant. For example, tastes and preferences may change in favor of luxurycars or the economy may experience a strong recovery and expansion. (If all other things are heldconstant, the price will return to the original price only if the demand for luxury cars is perfectlyelastic and the supply of luxury cars is not perfectly elastic, conditions unlikely to hold.SeeChapter 4 for further discussion of elasticity.)11.Economists make the distinction between “demand” and “quantity demanded” in order to facilitatethe use of the supply and demand diagrams in explaining the rationing and guiding functions ofprice. However, in the business world, this distinction is usually not made. For business people, theterm “demand” is generally used in reference to both “demand” and “quantity demanded.” Whetherthe former or the latter term is being considered depends on the context in which they are used. Inthe above statement, “demand” clearly refers to the economist’s “quantity demanded.”As instructors, we have noticed that economics texts books (particularly principles texts) greatlystress the difference between these two terms, and rightfully so. However, this question is to remindstudents that in applying demand analysis to actual situations, business people usually ignore thisdistinction.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 demandfor convenience foods to increase.b.Demand is already increasing drastically for goods purchased on the Internet and is posed toexplode 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 ofentertainment cheaper and easier to use.g.Longer term trends point in an upward direction.

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Supply and Demand11h.It is difficult to tell, but if demand for SUV’s and trucks continues to rise, there will also be asteady increase in demand (particularly in the U.S. and Western Europe). Also, if emergingmarkets continue to grow (particularly in countries such as China and Brazil), there will bemore 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 batteryfor electric car: supply decreases—particularly in the long run as companies shift theirresources from oil production to battery production. (3) Mergers or acquisitions (as have beengoing on in the late 90s with BP and Amoco as well as Exxon and Mobil):—these mergers maycause supply to increase or decrease depending on the intentions of the larger companies thathave even more power over supply.b.(1) Cattle ranching declines as it becomes harder to earn a good return in the market for beef (inthis 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. governmentallowed 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 marketshare by building new hotels).e.U.S. or European based multinationals such as McDonald’s and Burger King build newrestaurants 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 theirresources in this product segment in an attempt to offset the shrinking profit margins in the PCbusiness--supply increases.PROBLEMS1.a.800 capsb.$10c.$20d.Note to Instructors: If you assign this question, be sure to point out to your students that theanswer is covered in Appendix 2A. It is also discussed in greater detail in Chapter 4. We askthis question simply as a prelude to the material in Chapter 4.

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12Supply and DemandFigure 3.1Figure 3.22.a.Figure 3.3b.25,000P = 50,000-10,000PQd= 50,000-10,000 (1.4286) = 35,71435,000P = 50,000Qs= 25,000 (1.4286) = 35,714P*= $1.4286-505101520250500100015002000Q$ P, MRDMR0246810120500100015002000Q$ (Thousands)TR00.511.5201020304050Q (Thousands)P ($)SDP* = 1.4286Q* = 35,714(approx.)

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Supply and Demand133.a.Surplus orPriceQSQDShortage$6.0055,0005,00050,0005.0040,00015,00025,0004.0025,00025,00003.0010,00035,000-25,0002.00045,000-45,0001.00055,000-55,000b.Equilibrium price = $4.00 because it equates QDwith QS.4.a.$300b.$100c.Figure 3.4d.P*= $200 Q*= 1000e.P*= $225 Q*= 1250f.P*= $200 Q*= 1500g.See graph above5.a.Q = 10,000-200P + .03(1,000,000) + .6(30,000) + .2(15,000)QD= 61,000-200Pb.PQD$20000017526,00015031,00012536,000c.P = $80.6.a.Q = 200-300(2.50) + 120(10) + 65(60)-250(15) + 400(10)Q = 200-750 + 1200 + 3900-3750 + 4000Q*= 4800QD= 5550-300P05010015020025030035005001000150020002500300035004000QPD1D2S1S2

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14Supply and Demandb.QD= 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 reducedthe world market price for sugar.Figure 3.58.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 ofCDs (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 thanthe 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 couldbe 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 combinedimpact 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 inadvertising expenses.10.a.Q = 1,500–4(400) + 25(20) +10(15) + 3(500)= 1,650b.Advertising would have to increase by $60,000 in order for the firm to regain the loss of 300units resulting from its competitor’s reduction in price of $100.Without cost data, it is notpossible to determine whether it would be worthwhile for the firm to increase advertising tooffset the competitor’s move.However, one thing that this firm would probably want is toavoid is a price war.c.The price of substitute products such as cruise packages.P1PQP2S1S2D1D2Q1

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Supply and Demand15d.If time series data were collected on a quarterly basis, then seasonal factors such as summer orwinter could be introduced in the form of dummy variables.11.a.Q = 250-10P can be transformed into:P = 25-.1QFigure 3.6Figure 3.7b.Q = 1300-140P can be transformed into:P = 9.29-.007QFigure 3.80501001502002500510152025PQQ = 250 - 10P0510152025050100150200250QPP = 25 - .1Q00.10.20.30.40.50.60.70.80.911.11.21.31.40123456789PQ (Thousands)Q = 1300-140P

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16Supply and DemandFigure 3.9c.Q = 45-.5P can be transformed into:P = 90-2QFigure 3.10Figure 3.1101234567891011040180320460600740880102011601300QPP = 9.29 - .007P0510152025303540450102030405060708090PQQ = 45 - .5P0102030405060708090051015202530354045QPP = 90 - 2Q

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Supply and Demand1712.Figure 3.12Certain consumer electronics products could exhibit this type of demand. This curve indicates thatonce 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.Found in the graph itself and in the equation found in cells A6 and A7: P = 20–0.5Qb.Found in cell C4. Q = 100c.Change A4 from-20 to-10 or-25 and watch what happens to the graph and equations in A6,A7 and C4One final scenario:Cells D2=200, D3=12.5, D4=-16.a.C = $12.50 and D =-16.b.P = 25–0.0625Q01234567891011050100150200250300350400QP

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18Supply and Demand$-$2$4$6$8$10$12$14$16$18$20$22$24$260255075100125150175200225250275300Price per glass, PNumber of glasses per week, QTwo BTG ScenariosPre-Adv.Post-Adv.NOTE TO INSTRUCTORS: You can use theMultiple Demandsworksheet to create new scenarios andthen have students tell you the story shown by the scenario (by filling in new values for C and D, forexample), or you could give them the two scenarios in verbal format and have them show you the graphas a homework problem.

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CHAPTER 4DEMAND ELASTICITYQUESTIONS1.Elasticity refers to the percentage change in one variable relative to a percentage change in anothervariable. It is a relative measure of how responsive the change in one variable’s value will be to thechange in the values of some other variables.Price elasticity of demand is defined as the percentage change in quantity demanded resulting froma one percent change in price.2.Point elasticity (in connection with the price elasticity of demand) refers to the elasticity at a givenpoint 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 changecontinuously. Arc elasticity measures the elasticity over a certain discrete segment of the demandcurve.If arc elasticity were defined aschange in quantity/quantitychange in price/pricethen the elasticity coefficient would differif we moved up on a demand curve as against movingdown on it.To make an upward movement have the same elasticity coefficient as a movement down, averagequantity and average price are used in the formula.In practical business situations, arc elasticity would probably be the more useful concept, because abusinessperson would most likely be interested in the effect on quantity of a change in price ofsome 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 demandfor skilled crafts people is probably more inelastic than the demand for industrial workers, since thedegree of input substitutability is less for the former than the latter. Thus a substantial increase inthe wage of skilled crafts people would cause a smaller decrease in employment than a similarpercentage 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 aperson’s or a family’s total budget.b.Probablyfairlyelastic,sincetherearemanygoodsubstitutesforaspecificbrandofmayonnaise.c.Probably relatively elastic since there are numerous substitutes. Also, it represents a relativelylarge 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 Elasticity19elasticity could also be quite low. The answer probably depends on whether other high-pricedcars (Mercedes, BMW, Infinity, etc.) are considered to be close substitutes.e.Probablyratherelastic.Itrepresentsasignificantexpenditure.Further,arepairmaysignificantly prolong its life.f.Probably rather elastic since other vacation arrangements (driving, bus, train) could besubstituted. 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’sbudget.h.Probably quite elastic since they represent a large expenditure. If given as a gift, there areprobably many good substitutes.5.The income elasticity for restaurant food is probably quite high. Thus, during declines in economicactivity (and thus, possibly declines in incomes), spending on restaurant food would most likelydecline more than spending at home. Actually, since the two are substitutes, spending on food athome 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 significantlydifferent than zero).Whilethere is no relationship between these two products,both of thesemay compete for budget dollars. From a total budget viewpoint, they could be considered to besubstitutes. 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 inelasticportion of the demand curve would result in a decrease in total revenue for every additional unitsold.8.Most likely automobiles, since they represent a larger expenditure and are more likely to bepurchased 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 ingasoline consumption would have been expected. In fact, gasoline prices decreased to pre-crisislevels rather quickly.10.A five-cent increase probably did not affect consumption of gasoline significantly since it was arelatively small change. The demand for gasoline is probably relatively inelastic in such a smallrange. This is quite different from the doubling of prices, which had occurred during the oilembargo 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. Thetax revenue from such products would be considerably larger than from products whose demandcurve was rather elastic and whose consumption would decrease greatly upon the imposition of anadditional tax.12.No. Since the percentage changes between quantity and price are different at each point of thedemand curve.

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20Demand Elasticity13.This firm is faced by considerable competition. Theoretically, if it raises its price by any smallamount, it would lose all of its business, because there are many other firms in the industry that areoffering 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 itsells more, its costs should rise more than its revenue, the price action would decrease thecompany’s profit. So, if the company wants to maximize its profits, it will not lower its price in thiscase.15.a.Less than 1. Elasticity may actually be negative if consumers switch tomoreexpensivebutteras their incomes increase.b.Most likely greater than 1. This is a luxury item and increased income may bring about a largerthan proportional increase in consumption.c.Probably close to 1. But, as incomes increase, consumers may switch to more expensivefurniture. Thus elasticity could be greater than 1.d.Probably greater than 1. Since lobsters are generally an expensive food, people with increasingincomes 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 carprices 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 isinelastic, and that the price increase will bring about a smaller than proportional percentagedecrease in quantity demanded, thus resulting in an increase in revenue. This may very well be truein the short run. However, it may not be a good policy for the long run. Given time, more postalcustomers may adjust their consumption patterns, and switch to alternative services. As wasdiscussed in the text, in the long run, demand curves become more elastic.Also, the increase insubstitute services available over time would increase the price elasticity of demand for mailservice, 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 increaserelative to their increase in advertising expenses. They apparently turned out to be right.

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Demand Elasticity21PROBLEMS1.% change Q.2—————=—=-2% change P-.12.a.Q = 20-2P; slope ∆Q/∆P =-2At P = 5 Q = 20-2 x 5 = 10At P = 9 Q = 20-2 x 9 = 2When Q = 10 and P = 5 εp=-2 x 5/10 =-1 Unitary elasticWhen Q =2 and P = 9 εp=-2 x 9/2=-9 Elasticb.At P = 5, Q = 10At P = 6, Q =8c.PriceQuantityTotal Revenue412485105068487642At a price of $5, revenue reaches its peak. This is also where point price elasticity is 1, asshown in part a. of this problem.3.a.Q = 2000–100(6)Q = 2000–600 = 1400b.1800 = 2000–100P100P = 2000–1800100P = 200P = 2c.Q = 2000–100(0)Q = 2000d.0 = 2000–100P100P = 2000–0P = 20e.Slope = ΔQ/ΔP = 100εP= 100x6/1400εP=100 x 0.0043εP= 0.434.a.When price changes by 1,quantity will change by 10 in the opposite direction. When incomechanges by 1, quantity will change by .5 in the same direction.b.Point elasticity:

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22Demand ElasticityQ= 100-(10)(7) + (.5)(50)= 100-70 + 25= 55Slope =-10εp= (-10) x (7/55) =-1.27Arc elasticity, between P = 7 and P = 6:at P = 6, Q = 100-(10)(6) + (.5)(50) = 65Ep= ((65-55)/(65 + 55)) / ((6-7)/(6 + 7)) =-1.08c.Point elasticitySlope = 0.5εy= (.5) x (50/55) = 0.45Arc elasticity, between Y = 50 and Y = 60at Y = 60, Q = 100-(10)(7) + (.5)(60) = 60Ey= ((60-55)/(60 + 55)) / ((60-50)/(60 + 50)) = 0.48d.Point elasticityQ = 100-(10)(8) + (.5)(70) = 55εp= (-10) x (8/55) =-1.45Arc elasticity, between P = 8 and P = 7Q = 100-(10)(7)+ (.5)(70) = 65Ep= ((65-55)/(65 + 55)) / ((7-8)/(7 + 8)) =-1.255.a.At P = 7, Q = 30-(2)(7) = 16Slope =-2εp= (-2) x (7/16) =-0.88b.At P = 5, Q = 30-(2)(5) = 20P = 6, Q = 30-(2)(6) = 18Ep= ((18-20)/(18 + 20)) /((6-5)/(6 + 5)) =-0.58c.Elasticity will be the same. Equation is nowQ = 3000-200PAt P = 7, Q = 3000-(200)(7) = 1600

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Demand Elasticity23Slope =-200εp=-200 x (7/1600) =-0.886.a.(x-4000)(63-70)-2.5 =————/————(x + 4000)(63 + 70)x =5212At P = 70, TR = 4000 x 70 = 280,000P = 63, TR = 5212 x 63 = 328,356Revenue 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 = 28658.If price elasticity is-4, and the Redbirds wish to increase attendance from 50,000 to 80,000, theprice (x) must be:(80000-50000)(x-30)-4 =——————/———(80000 + 50000)(x + 30)x = 26.73If price is lowered from $30 to 27, and attendance rises from 50,000 to 60,000, price elasticity is:(60000-50000)(27-30)Ep=———————/————(60000 + 50000)(27 + 30)=-1.7279.Arc price elasticity for spreadsheet program:(120-100)(350-400)Ep=—————,—————(120 + 100)(350 + 400)

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24Demand Elasticity=-1.36Arc cross elasticity for graphics program:(56-50)(350-400)Ex=————,—————(56 + 50)(350 + 400)=-0.85The quantity demanded for spreadsheets increased due to the price change. The price elasticity isgreater 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 quantitysold benefited from the price decrease in the spreadsheet program. The cross-elasticity is-0.85 (thenegative sign shows complementarity), and is quite strong.10.Demand ElasticityTotalMarginalPriceQuantityArcPointRevenueRevenue7.001007006.50200-9.00-6.5013006.006.00300-5.00-4.0018005.005.50400-3.29-2.7522004.005.00500-2.33-2.0025003.004.50600-1.73-1.5027002.004.00700-1.31-1.1428001.003.50800-1.00-0.8828000.003.00900-0.76-0.672700-1.002.501000-0.58-0.502500-2.002.001100-0.43-0.362200-3.001.501200-0.30-0.251800-4.0011.a.Negative: television sets andDVRs 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 bethought of as substitutes in the competition for a consumer’s budget dollars.12.a.130–702.50–3.50Ep=——————/————130 + 702.50 + 3.50EP= 1.8b.90-402.50–3.50

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Demand Elasticity25Ex=——————/————90 + 402.50 + 3.50Ex= 2.313.a.The price elasticity for shoes in the U.S. is 0.7. However, the elasticity for Brown ShoeCompany's shoes may be higher, since a particular make of shoes has more substitutes thanshoes in general. The exact demand elasticity for Brown's product is not known, but it couldeasily be greater than 1 (or less than negative one), and thus a price decrease could lead to anincrease 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 elasticitycoefficient of-1.4.b.Syrup is a complementary good in relation to ice cream. Cross elasticity would measure thiseffect.+0.1/-0.143 =-0.7The 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 closecomplements.c.Yes, revenues for both ice cream and syrup rise. Unless costs rise more quickly (a very dubiousconclusion), this action should increase the supermarket's profit.16.In computing the elasticities, remember that an elasticity measure can be calculated only if all otherthings remain constant.Price elasticitiesMonths 3-4-1.0020/(220+240)/2-10/(120+110)/2Months 4-5-0.96-10/(240+230)/25/(110+115)/2Months 7-8-0.4910/(220+230)/2-10/(115+105)/2Cross elasticitiesMonths 1-20.4510/(200+210)/215/(130+145)/2Months 5-60.46-15/(230+215)/2-20/(145+125)/2Month 9-100.79-15/(235+220)/2

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26Demand Elasticity-10/(125+115)/2Income elasticitiesMonths 2-30.9510/(210+220)/2200/(4000+4200)/2Months 6-70.495/(215+220)/2200/(4200+4400)/2Months 8-90.485/(230+235)/2200/(4400+4600)/217.a.18002000-200b.$02000 = 2000-20P$1000 = 2000-20P$251500 = 2000-20Pc.Q = 2000-20P20P = 2000-QP = 100-.05QTR = PQ = 100Q-.05Q2MR = 100-.1Qd.Q = 2000-20(70) = 600TR = 600 x 70 = 42000orTR = 100Q-.05Q2= 60000-.05(600)2= 60000-18000= 42000MR = 100-.1(600)= 100-60 = 40e.ε = dQ/dP x P/Q= 20 x 70/600= 1400/600 = 2.33f.Q = 2000-20(60)= 800TR = 800 x 60 = 48000MR = 100-.1(800)= 20

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Demand Elasticity27ε = 20 x 60/800= 1200/800 = 1.5g.At ε = 1MR = 00 = 100-.1Q.1Q = 100Q = 1000Proof: 1000 = 2000-20P20P = 1000P = 50ε = 20 x 50/1000 = 1000/1000 = 118.a.672,000 x $1$672,000623,000 x $1.15716,450Revenue increase$44,450b.Ep = ((672000-623000)/(672000+623000)) / ((1-1.15)/(1+1.15))= .037838/-.069767=-.542c.Increases in gasoline pricesand automobile insurance during the year may have mitigated thebus fare increases, thus causing fewer commuters to switch away from using buses. Increases inpersonal income may also have been instrumental. These changes would have affected thedemand curves for commuting, rather than be an example of price elasticity.19.Ep= ((355000-518000)/(355000+518000))/((45-30)/(45+30))=-.18671/.2=-.934Revenue before price decrease355000 x .45£159750Revenue after price decrease518000 x .30155400Decrease in revenue£435020.EA=1050–900x10000 + 1500015000–10000900 + 1050=150x2500050001950=0.03 x 12.82 = 0.38The elasticity of 0.38 means that for every 1% increase in advertisingexpense, sales will increase by 0.38%.Whether this move was wise depends on the production cost of the

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28Demand Elasticityyoga apparel. To make things simple we will assume that the unit cost oftheapparelwill be the same at both quantities.If the cost is $80 pergarment, then:Advertising = $10000Advertising = $15000Sales900 x 1201080001050 x 120126000Cost900 x80720001050 x80840003600042000Advertising1000015000Profit2600027000By increasing its advertising expenses, the company increased itsprofit by $1,000. If, however, the unit cost of thegarmentwas $100then the profit would decrease from $8,000 to $6,000.21.a.EI=12000-10000/34000-3200012000 + 1000034000 + 32000=2000/2000_2200066000=0.0909 / 0.0303 = 3b.EP=11500-12000/100______11500 + 120001600 + 1500=-500/100_235003100=.02128 / 0.03226 = 0.66Company’s revenue: Before price increase12000 x 1500 = 18,000,000After price increase11500 x 1600 = 18,400,000c.The demand curve appears to be inelastic; thus a further increase in price could increaserevenue.22.Using the arc elasticity formula:P1 = 599 and P2 = 434; Q1 = 270 and Q2 = 1,119So /E/ = 3.99 or 4.0.This is very elastic.In the months between Apple’s setting of the twoprices, we can assume that the market’s enthusiasm for the product increased. Thus, there wasprobably a shift to the right in the demand curve as well as a movement downward and to theright of the existing demand curve.

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CHAPTER 5DEMAND ESTIMATION AND FORECASTINGQUESTIONSDemand Estimation1.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 totalquantity demanded of pizza per week, annual income per capita.Cross-sectional data: Information concerning a particular variable at a specific point in time for agiven unit of observation. For example, the average price of corn in April 1995 for all countries inthe world who produce this good, the total quantity of pizza demanded on November 21, 1995, byeach college campus in the United States, income per capita in 1995 for all countries that belong tothe 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 oravailability of credit should be used. This particular variable would not be considered an importantfactor in the demand for fast-moving consumer goods.(Instructors may wish to discuss other possible differences such as the inclusion of a dummyvariable indicating a period of recession in the time-series analysis of consumer durables,orexpectations concerning rates of price inflation which would be applicable to the timing ofpurchases of consumer durable goods but not “fast-moving consumer goods.”)3.R2is a measure of the explanatory power of the regression model. It is also referred to as a measureof “the goodness of fit” (of the regression line through the scatter of data points). Specifically, itindicates the percentage of the variation in the dependent variable Y explained or accounted for bythe variation in the independent variable(s) X.Other factors held constant, time series data generally produce a higher R2than cross-sectional databecause both dependent and independent variables often move together over time simply because ofsome upward trend. A good example of this is a time-series analysis of aggregate consumptionregressed on aggregate disposable income. Regression analysis of this consumption functioncommonly produces R2of .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 ttable).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 nullhypothesis. 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 .05level of significance, the level most commonly used in economic research.

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