P5.5 Elasticity.

The demand for personal computers can be characterized by the

following point elasticities: price elasticity = -5, cross-price elasticity with software
= -4, and income elasticity = 2.5. Indicate whether each of the following statements
is true or false, and explain your answer.

A. A price reduction for personal computers will increase both the number of
units demanded and the total revenue of sellers.

B. The cross-price elasticity indicates that a 5% reduction in the price of

personal computers will cause a 20% increase in software demand.

C. Demand for personal computers is price elastic and computers are cyclical
normal goods.

D. Falling software prices will increase revenues received by sellers of both

computers and software.

E. A 2% price reduction would be necessary to overcome the effects of a 1%

decline in income.

P5.5 SOLUTION

A. True. A price reduction always increases units sold, given a downward sloping
demand curve. The negative sign on the price elasticity indicates that this is indeed
the case here. The fact that price elasticity equals -5 indicates that demand is elastic
with respect to price, and that a price reduction will increase total revenues.

B. False. The cross-price elasticity indicates that a 5% decrease in the price of software
programs will have the effect of increasing personal computer demand by 20%.

C. True. Demand is price elastic (see part A). Since the income elasticity is positive,
personal computers are a normal good. Moreover, since the income elasticity is
greater than one, personal computer demand is also cyclical.

D. False. Negative cross-price elasticity indicates that personal computers and software
are compliments. Therefore, falling software prices will increase the demand for
computers and resulting revenues for sellers. However, there is no information
concerning the price elasticity of demand for software, and therefore, one does not
know the effect of falling software prices on software revenues.

E. False. A 2% reduction in price will cause a 10% increase in the quantity of personal
computers demanded. A 1% decline in income will cause a 2.5% fall in demand.
These changes will not be mutually offsetting.
P5.9 Cross-Price Elasticity. B. B. Lean is a catalog retailer of a wide variety of sporting
goods and recreational products. Although the market response to the company's
spring catalog was generally good, sales of B. B. Lean's $140 deluxe garment bag
declined from 10,000 to 4,800 units. During this period, a competitor offered a
whopping $52 off their regular $137 price on deluxe garment bags.

A. Calculate the arc cross-price elasticity of demand for B. B. Lean's deluxe

garment bag.

B. B. B. Lean's deluxe garment bag sales recovered from 4,800 units to 6,000
units following a price reduction to $130 per unit. Calculate B. B. Lean's arc
price elasticity of demand for this product.

C. Assuming the same arc price elasticity of demand calculated in Part B,

determine the further price reduction necessary for B. B. Lean to fully recover
lost sales (i.e., regain a volume of 10,000 units).

P5.9 SOLUTION
A. EPX =

= 1.5 (Substitutes)

B. EP =

= -3 (Elastic)

C. EP =

-3 =

-3 =

-12P2 + $1,560 = P2 + $130

13P2 = $1,430

P2 = $110

This implies a further price reduction of $20 because:

ΔP = $130 - $110 = $20
P5.10 Advertising Elasticity. Enchantment Cosmetics, Inc., offers a line of cosmetic and
perfume products marketed through leading department stores. Product Manager
Erica Kane recently raised the suggested retail price on a popular line of mascara
products from $9 to $12 following increases in the costs of labor and materials.
Unfortunately, sales dropped sharply from 16,200 to 9,000 units per month. In an
effort to regain lost sales, Enchantment ran a coupon promotion featuring $5 off the
new regular price. Coupon printing and distribution costs totaled $500 per month
and represented a substantial increase over the typical advertising budget of $3,250
per month. Despite these added costs, the promotion was judged to be a success, as
it proved to be highly popular with consumers. In the period prior to expiration,
coupons were used on 40% of all purchases and monthly sales rose to 15,000 units.

A. Calculate the arc price elasticity implied by the initial response to the
Enchantment price increase.

B. Calculate the effective price reduction resulting from the coupon promotion.

C. In light of the price reduction associated with the coupon promotion and
assuming no change in the price elasticity of demand, calculate
Enchantment's arc advertising elasticity.

D. Why might the true arc advertising elasticity differ from that calculated in
part C?

P5.10 SOLUTION
A. EP =

= -2

B. The effective price reduction is $2 since 40% of sales are accompanied by a coupon:

ΔP = -$5(0.4) or P2 = $12 - $5(0.4)

= -$2 = $10

ΔP = $10 - $12

= -$2
C. To calculate the arc advertising elasticity, the effect of the $2 price cut implicit in the
coupon promotion must first be reflected. With just a price cut, the quantity
demanded would rise to 13,000, because:

EP =

-2 =

-2 =

-2(Q* + 9,000) = -11(Q* - 9,000)

-2Q* - 18,000 = -11Q* + 99,000

9Q* = 117,000

Q* = 13,000
Then, the arc advertising elasticity can be calculated as:

EA =

= 1

D. It is important to recognize that a coupon promotion can involve more than just the
independent effects of a price cut plus an increase in advertising as is implied in Part
C. Synergistic or interactive effects may increase advertising effectiveness when the
promotion is accompanied by a price cut. Similarly, price reductions can have a
much larger impact when advertised. In addition, a coupon is a price cut for only the
most price sensitive (coupon-using) customers, and may spur sales by much more
than a dollar equivalent across-the-board price cut.
Synergy between advertising and the implicit price reduction that
accompanies a coupon promotion can cause the estimate in Part C to overstate the
true advertising elasticity. Similarly, this advertising elasticity will be overstated to
the extent that targeted price cuts have a bigger influence on the quantity demanded
than similar across-the-board price reductions, as seems likely.