Chapter5 New

Chapter 5
DEMAND ANALYSIS
QUESTIONS & ANSWERS
Q5.1
Is the economic demand for a product determined solely by its usefulness?
Q5.1
ANSWER
No, two basic conditions must be met before economic demand is created. First,
there must be value associated with acquiring and using the good or service. For
individuals, this value is in terms of utility, well being, or satisfaction thro
ugh
consumption. For firms, this value is measured in terms of the profit created th
rough
resource employment. Second, there must be an ability to pay. Both individuals a
nd
firms must demonstrate an economic capability to acquire, or their wants will re
main
unfulfilled, and no economic demand will result.
Q5.2
John Baptiste Say, a French economist from the early 19th century, is credited w
ith
stating, Asupply creates its own demand.@
Today, some economists appear to argue
that Ademand creates its own supply.@ Explain why neither statement is precisely
correct, and how demand and supply together create the market for goods and
services.
Q5.2
ANSWER
In simplistic terms, supply is what is available, and demand is what is desirabl
e. In
the can-do world of the new millennium, some consumers have come to believe that
everything is possible and that Ademand creates its own supply.@ Alas, that is n
ot
yet the case. While many companies continue to invent new and innovative product
s
to meet consumer needs, not everything customers desire can be supplied. For
example, there is no comprehensive cure for cancer. The forces of demand and
supply work together to provide consumers what they want, within the realm of
technological feasibility.
The point Say was trying to make in arguing Asupply creates its own demand@
was simply that there can be no general glut or oversupply of goods and services
in
free and competitive markets. While it is possible for temporary Agluts@ to aris
e for
particular goods and services, these gluts will be balanced by temporary shortag
e or
under supply in the markets for other goods and services. In a freely competitiv
e
market, permanent oversupply of all goods and services is not possible.
Presented by Suong Jian & Liu Yan, MGMT Panel , Guangdong University of Finance.
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Chapter 5
On a historical note, it is perhaps worth mentioning that while the popular
expression of Say's Law is Asupply creates its own demand,@ this quotation does
not
appear in Say's writings, nor in the writings of other prominent economists of h
is
time. This Alaw@ was developed in the economics literature at a time when
economists had begun to notice that the economic system could be subject to seve
re
recessions. The nature of these crises, their causes, and relationship to the ec
onomic
system became a topic of hot debate. A major figure on one side of the debate wa
s
Thomas Malthus, who argued that crises were a result of a Ageneral glut@ of good
s
and services. Because production could outrun people=s ability to purchase goods
and services, Malthus argued that it was under consumption that led to recession
s.
On the other side of the debate were David Ricardo, James and John Stuart Mill,
and
Say who together argued that the under consumption thesis was wrong. Their ideas
are today called Say's Law.
Q5.3
Why might customers be unwilling or unable to provide accurate demand
information? When might this prove helpful?
Q5.3
ANSWER
Customers are often unable to supply accurate information about their demand for
particular products given an inability to verbalize the method by which they sel
ect
goods and services for consumption. Even when the decision process is understood
and objective enough to provide relevant demand information, consumers might
hesitate to supply such data because it could place them in a poorer bargaining
position with suppliers. For example, a consumer might be reluctant to tell a re
tailer
that he or she is willing to pay $3,000 for a sophisticated personal computer on
the
grounds that by withholding this information an even lower price might be obtain
ed.
Of course, providing suppliers with demand information can prove beneficial when
such information improves the reliability or lowers the cost of supplied product
s.
For example, projections of demand quantities are often provided to allow suppli
ers
to develop the capacity necessary to meet demand, and better deal with demand
fluctuations.
Q5.4
When is use of the arc elasticity concept valid as compared with the use of the
point
elasticity concept?
Q5.4
ANSWER
The arc versus the point elasticity concepts differ only in terms of the magnitu
de of
the change in a given independent variable. Strictly speaking, the point elastic
ity
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Demand Analysis
concept is appropriate for measuring the responsiveness of a dependent Y variabl
e to
a change in an independent X variable at a given point on a function. The point
elasticity concept is often used to measure the effect on Y of small, say 0-5%,
changes in X. Use of the arc elasticity concept is appropriate when considering
the
effect of larger changes in X. The arc elasticity is an average elasticity over
a range
along a given function.
Q5.5
AWhen I go to the grocery store, I find cents-off coupons totally annoying. Why
can=t they just cut the price and do away with the clutter?@ Discuss this statem
ent
and explain why coupon promotions are an effective means of promotion for grocer
y
retailers, and popular with many consumers.
Q5.5
ANSWER
At the grocery store, cents-off promotions remain an effective means of promotio
n.
A 254 coupon turned in by 10% of all customers is said to have a 10% Aresponse
rate.@ Retailers have found that a 254 coupon turned in by 10% of all customers
has
a much more beneficial effect on sales than an across-the-board price reduction
of
2.54. By restricting price discounts to those customers conscientious enough to
clip,
retain, and turn in little bits of paper, retailers are able to target their pri
ce discounts
to the most price-sensitive portion of the market. Price-conscious consumers lov
e
>em. Interestingly, many retailers have discovered that a substantial number of
customers attracted by coupon and rebate promotions buy the product, but then fa
il
to claim the coupon or rebate. For such customers, the idea of a price discount
is just
as good as a real price discount!
Q5.6
Market demand is influenced by price, the price of substitutes and complements,
product quality, advertising, income, and related factors. Explain why companies
often find price changes to be the most important determinant of short-term chan
ges
in sales.
Q5.6
ANSWER
For consumer and industrial products, market demand is influenced by price, the
price of substitutes and complements, product quality, advertising, income, and
a
host of related factors. Among such factors, companies often find price changes
to
be the most important determinant of short-term changes in market demand. Price
changes are easily discovered, and both customers and competitors typically resp
ond
to them quickly. For example, when McDonald=s cuts the price of a jumbo order of
fries, price-sensitive customers immediately recognize the change and the quanti
ty
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Chapter 5
demanded rises accordingly. On the other hand, when there is a slight change in
the
quality of potatoes used, or a modest change in cooking style, consumers and
competitors may be slow to react. Similarly, while income is an important
determinant of demand, changes in income affect all competitors, and the effect
on
any single competitor is thereby muted.
Q5.7
An estimated 80% increase in the retail price of cigarettes is necessary to caus
e a
30% drop in the number of cigarettes sold. Would such a price increase help or h
urt
tobacco industry profits? What would be the likely effect on industry profits if
this
price boost was simply caused by a $1.50 per pack increase in cigarette excise t
axes?
Q5.7
ANSWER
The price elasticity of demand for cigarettes is highly inelastic if an 80% incr
ease in
retail prices would cause only a 30% drop in the number of cigarettes sold. An a
rc
price elasticity for cigarettes on the order of EP = -0.375 (= -30%/80%) implies
that
tobacco industry revenues would rise sharply following a big price increase. Sin
ce
the variable costs of producing and selling cigarettes would fall with a 30% dro
p in
the number of cigarettes sold, a significant industry-wide increase in cigarette
prices
could cause industry profits to explode on the upside.
It is less certain what would happen to tobacco industry profits if the price
increase described above were the simple result of an increase in excise taxes o
n
each pack of cigarettes sold. For example, a new $1.50 tax on a pack of cigarett
es
would increase typical retail prices from $1.88 to $3.38 per pack, or by roughly
80%.
If all new revenues went to the government in the form of taxes, then industry
revenues and variable costs would both fall by 30% following a 30% drop in unit
sales. Unless the tobacco industry cut fixed expenses, industry profits would fa
ll in
the long run. On the other hand, with such inelastic demand and government-
sanctioned price increases, the tobacco industry might be expected to lobby hard
for
further profit-enhancing price increases in the post tax-increase era.
Q5.8
Is the price elasticity of demand typically greater if computed for an industry
or for a
single firm in the industry? Why?
Q5.8
ANSWER
The price elasticity of demand for a firm will typically be greater than that fo
r the
industry as a whole. Unless the firm is the industry, as in the case of monopoly
, it
will face a demand curve that is flatter than that faced by the industry as a wh
ole.
This stems from the fact that demand for the industry's product faces competitio
n
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Demand Analysis
from goods that consumers view as alternatives as opposed to close substitutes.
The
firm, on the other hand, faces competition from substitute products produced by
others in the industry, as well as competition from goods in general, for a plac
e in the
consumer's overall market basket.
Q5.9
Is the cross-price elasticity concept useful for identifying the boundaries of a
n
industry or market?
Q5.9
ANSWER
Yes, the cross-price elasticity concept provides a practical means for identifyi
ng the
boundaries of an industry or market. By definition, a direct relation between th
e
price of one product and the demand for a second product holds for all substitut
es. A
price increase for a given product increases demand for substitutes; a price dec
rease
for a given product will decrease demand for substitutes. This means that if the
cross-price elasticity of demand is a very small negative number, say ePX = -5,
a
strong substitute good relation exists, and the products involved directly compe
te for
a share of the consumer's dollar. If the cross-price elasticity of demand is a l
arge
negative number, say ePX = -0.05, a weak substitute good relation exists, and de
mand
for the products involved is only slightly related. The cross-price elasticity i
s always
positive for substitutes; the price of one good and the demand for the other alw
ays
move in the same direction. Cross-price elasticity is negative for complements;
price
and quantity move in opposite directions for complementary goods and services.
Finally, cross-price elasticity is zero, or nearly zero, for unrelated goods whe
re
variations in the price of one good have no effect on demand for the second.
The point to keep in mind is that the cross-price elasticity concept is an
economic measure of the similarity or dissimilarity between products. If the cro
ss-
price elasticity of demand is near zero, then even products that are similar in
physical
terms cannot be regarded as substitutes. The demand for apparel, cosmetics, spor
ting
goods, and a wide variety of services is such that many products that are genuin
ely
comparable in physical terms cannot be regarded as economic substitutes. Similar
ly,
identical products offered at different times or places are not economic substit
utes.
A Coca-Cola and a brat at the ball park are not offered at the same time and pla
ce as
those sold at the grocery store, and price differentials reflect that fact.
Q5.10
ACollecting, analyzing and verifying elasticity of demand information is costly,
and
that cost is an impediment to using these data help make better day-to-day prici
ng
decisions.@
Discuss this statement.
Q5.10
ANSWER
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Chapter 5
Collecting, analyzing and verifying elasticity of demand information is indeed c
ostly,
but that cost is scarcely an impediment to using these data to help business man
agers
make better day-to-day pricing decisions. In case after case, evidence suggests
that
businesses are easily able to justify the expense involved with collecting and
analyzing elasticity of demand information. Profit maximization requires a
comparison between the marginal benefits and marginal costs of production,
including the marginal benefits and marginal costs of producing correct market
demand information. For example, cents-off coupons are a well-accepted means for
probing the market demand curve at price-output combinations around the current
market equilibrium. In grocery stores, information gleaned from electronic scann
ers
is used to help adjust prices and price discounts for maximum effect. In car
dealerships, detailed information is collected to determine the relative effecti
veness
of price rebates versus low-cost financing. In case after case, evidence emerges
to
suggest that manufacturers and retailers carefully collect, analyze and verify
elasticity of demand information to accurately assess the market demand for thei
r
products.
SELF-TEST PROBLEMS & SOLUTIONS
ST5.1 Elasticity Estimation. Distinctive Designs, Inc., imports and distributes
dress and
sports watches. At the end of the company's fiscal year, brand manager J. Peterm
an
has asked you to evaluate sales of the sports watch line using the following dat
a:
Number of Sports Watch
Sports Watches Advertising Sports Watch Dress Watch
Month Sold Expenditures Price, P Price, PD
July 4,500 $10,000 26 50
August 5,500 10,000 24 50
September 4,500 9,200 24 50
October 3,500 9,200 24 46
November 5,000 9,750 25 50
December 15,000 9,750 20 50
January 5,000 8,350 25 50
February 4,000 7,850 25 50
March 5,500 9,500 25 55
April 6,000 8,500 24 51
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Demand Analysis
Month
May
June
Number of
Sports Watches
Sold
4,000
5,000
Sports Watch
Advertising
Expenditures
8,500
8,500
Sports Watch
Price, P
26
26
Dress Watch
Price, PD
51
57
In particular, Peterman has asked you to estimate relevant demand elasticities.
Remember that to estimate the required elasticities, you should consider months
only when the other important factors considered in the preceding table have not
changed. Also note that by restricting your analysis to consecutive months, chan
ges
in any additional factors not explicitly included in the analysis are less likel
y to
affect estimated elasticities. Finally, the average arc elasticity of demand for
each
factor is simply the average of monthly elasticities calculated during the past
year.
A.
Indicate whether there was or was not a change in each respective independent
variable for each month pair during the past year.
Sports Watch
Advertising Sports Watch Dress Watch
Month-Pair Expenditures, A Price, P Price, PD
July-August ____________ ____________ ____________
August-September ____________ ____________ ____________
September-October ____________ ____________ ____________
October-November ____________ ____________ ____________
November-December ____________ ____________ ____________
December-January ____________ ____________ ____________
January-February ____________ ____________ ____________
February-March ____________ ____________ ____________
March-April ____________ ____________ ____________
April-May ____________ ____________ ____________
May-June ____________ ____________ ____________
B. Calculate and interpret the average advertising arc elasticity of demand for
sports watches.
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Chapter 5
C.
Calculate and interpret the average arc price elasticity of demand for sports
watches.
D.
Calculate and interpret the average arc cross-price elasticity of demand
between sports and dress watches.
ST5.1
SOLUTION
A.
Sports Watch
Advertising Sports Watch Dress Watch
Month-Pair Expenditures, A Price, P Price, PD
July-August No change Change No change
August-September Change No change No change
September-October No change No change Change
October-November Change Change Change
November-December No change Change No change
December-January Change Change No change
January-February Change No change No change
February-March Change No change Change
March-April Change Change Change
April-May No change Change No change
May-June No change No change Change
B.
In calculating the arc advertising elasticity of demand, only consider consecuti
ve
months when there was a change in advertising but no change in the prices of spo
rts
and dress watches:
August-September
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Demand Analysis
.
Q A2+A1
EA = x
.
A Q2+Q1
4,500- 5,500 $9,200+ $10,000
=
x
$9,200 -$10,000 4,500+5,500
= 2.4
January-February
.
Q A2+A1
EA = x
AQ
.
Q2+ 1
4,000- 5,000 $7,850+ $8,350
=
x
$7,850- $8,350 4,000+ 5,000
= 3.6
On average, EA = (2.4 + 3.6)/2 = 3 and demand will rise 3%, with a 1%
increase in advertising. Thus, demand appears quite sensitive to advertising.
C.
In calculating the arc price elasticity of demand, only consider consecutive mon
ths
when there was a change in the price of sports watches, but no change in adverti
sing
nor the price of dress watches:
July-August
.
Q P2+P1
EP = x
.
P Q2+Q1
5,500 -4,500 $24+$26
= x
$24-$26 5,500 + 4,500
= -2.5
November-December
.
Q P2+P1
EP = x
PQ
.
Q2+ 1
15,000- 5,000 $20+ $25
=
x
$20-$25 15,000+ 5,000
= -4.5
April-May
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Chapter 5
.
Q P2+P1EP x
=
.
P Q2+Q1
4,000 - 6,000 $26+$24
= x
$26 -$24 4,000+ 6,000
= -5
On average, EP = [(-2.5) + (-4.5) + (-5)]/3 = -4. A 1% increase (decrease) in
price will lead to a 4% decrease (increase) in the quantity demanded. The demand
for sports watches is, therefore, elastic with respect to price.
D.
In calculating the arc cross-price elasticity of demand, we only consider consec
utive
months when there was a change in the price of dress watches, but no change in
advertising nor the price of sports watches:
September-October
.
Q PX2+PX1
=
EPX
x
.PX Q2 + Q1
3,500 -4,500 $46+$50
= x
$46-$50 3,500 + 4,500
= 3
May-June
.
Q PX2+PX1
EPX = x
.PX Q2 +
Q1
5,000- 4,000 $57 +$51
= x
$57-$51 5,000 + 4,000
= 2
On average, EPX = (3 + 2)/2 = 2.5. Since EPX > 0, sports and dress watches are
substitutes.
ST5.2
Cross-Price Elasticity. Surgical Systems, Inc., makes a proprietary line of
disposable surgical stapling instruments. The company grew rapidly during the
1990s as surgical stapling procedures continued to gain wider hospital acceptanc
e
as an alternative to manual suturing. However, price competition in the medical
supplies industry is growing rapidly in the increasingly price-conscious new
millennium. During the past year, Surgical Systems sold 6 million units at a pri
ce of
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Demand Analysis
$14.50, for total revenues of $87 million. During the current year, Surgical Sys
tems'
unit sales have fallen from 6 million units to 3.6 million units following a com
petitor
price cut from $13.95 to $10.85 per unit.
A.
Calculate the arc cross price elasticity of demand for Surgical Systems'
products.
B.
Surgical Systems' director of marketing projects that unit sales will recover
from 3.6 million units to 4.8 million units if Surgical Systems reduces its own
price from $14.50 to $13.50 per unit. Calculate Surgical Systems' implied arc
price elasticity of demand.
C.
Assuming the same implied arc price elasticity of demand calculated in Part B,
determine the further price reduction necessary for Surgical Systems to fully
recover lost sales (i.e., regain a volume of 6 million units).
ST5.2 SOLUTION
QY2 -QY1 PX2+ PX1
A.
EPX = x
PX2 -PX1 QY2+QY1
3,600,000 - 6,000,000 $10.85+$13.95
=
x
$10.85 -$13.95 3,600,000+ 6,000,000
= 2 (Substitutes)
QQ2 -
1 P2+ P1
B.
EP = x
PP2 -
1 Q2+Q1
4,800,000 -3,600,000 $13.50+$14.50
=
x
$13.50 -$14.50 4,800,000+3,600,000
= -4 (Elastic)
QQ2 -
1 P2+ P1
C.
EP = x
PP2 -
1 Q2+Q1
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Chapter 5
6,000,000 -4,800,000 P2+$13.50
-4 = x
P2-$13.50 6,000,000 + 4,800,000
P2 + $13.50
-4 =
9(P2 -$13.50)
-36P2 + $486 = P2 + $13.50
37P2 = $472.50
P2 = $12.77
This implies a further price reduction of 734 because:
.P = $12.77 - $13.50 = -$0.73.
PROBLEMS & SOLUTIONS

P5.1 Market Demand. Michael Kelso, a Wisconsin-based management consultant, has
been asked to calculate and analyze market demand for a new video game that is t
o
be marketed to retail (R) and wholesale (W) customers over the Internet.
Kelso=s client estimates fixed costs of $750,000 per year for the product, and
that licencing fees and other marginal costs will be $20 per unit. The client ha
s also
provided Kelso with the following annual demand information:
PR = $62.50 - $0.0005QR
Pw = $50 - $0.002QW
A. Express quantity as a function of price for both retail and wholesale custome
rs.
Add these quantities together to calculate the market demand curve. Graph
the retail, wholesale, and market demand curves for prices ranging from $65 to
$35 per unit.
B. Fill in the following table:
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Demand Analysis
Market Demand is Retail Plus Wholesale Demand
Retail Wholesale Market Total
Price
Total Cost Total Profit
Demand
Demand Demand Revenue
$65
$60
$55
$50
$45
$40
$35
C. What price-output combination will maximize total profits?

P5.1 SOLUTION
A.
To find the market demand curve, it is necessary to express quantity as a functi
on of
price for both retail and wholesale customers. Then, these quantities must be ad
ded
together to calculate the market demand curve. For retail customers,
PR = $62.50 - $0.0005QR
0.0005QR = 62.50 - PR
QR = 125,000 - 2,000PR
For wholesale customers,
PW = $50 - $0.002QW
0.002QW = 50 - PW
QW = 25,000 - 500PW
For retail plus wholesale customers, the market demand curve can be expressed wi
th
quantity as a function of price as:
Q = QR + QW
= 125,000- 2,000P + 25,000 -500P
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Chapter 5
= 150,000 - 2,500P
For retail plus wholesale customers, the market demand curve can be expressed wi
th
price as a function of quantity as:
Q = 150,000 - 2,500P
2,500P = 150,000 - Q
P = $60 - $0.0004Q
For graphic purposes, it is important to remember that the market demand curve i
s
typically expressed with price as the dependent variable on the vertical Y axis.
Quantity is usually shown as the independent variable on the horizontal X axis.
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Demand Analysis
B.
Market Demand is Retail Plus Wholesale Demand
Price Retail
Demand
Wholesale
Demand
Market
Demand
Total
Revenue Total Cost Total
Profit
$65 --750,000
-750,000
$60 5,000 - 5,000 300,000 850,000 -550,000
$55 15,000 -15,000 825,000 1,050,000 -225,000
$50 25,000 -25,000 1,250,000 1,250,000 0
$45 35,000 2,500 37,500 1,687,500 1,500,000 187,500
$40 45,000 5,000 50,000 2,000,000 1,750,000 250,000
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Chapter 5
$35 55,000 7,500 62,500 2,187,500 2,000,000 187,500
C.
From the table, the profit-maximizing activity level can be seen as the $40 pric
e and
50,000 unit activity level. Analytically, this can be found by first solving for
MR and
MC,
TR =
P . Q
= ($60 - $0.0004Q)Q
= $60Q - $0.0004Q2
MR = .TR/.Q = $60 - $0.0008Q
TC =
$750,000 + $20Q
MC = .TC/.Q = $20
The profit-maximizing activity level occurs where MR = MC, and where Mp = 0.
MR = MC
$60 - $0.0008Q = $20
0.0008Q = $40
Q = 50,000
At Q = 50,000,
P =
$60 - $0.0004(50,000)
= $40
p =
TR - TC
= $60Q - $0.0004Q2 - ($750,000 + $20Q)
= - $0.0004Q2 + $40Q - $750,000
= - $0.0004(50,000)2 + $40(50,000) - $750,000
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Demand Analysis
= $250,000
(Note: .2p/.Q2 < 0, and this is a profit maximum since profit is decreasing for
Q >
50,000.)
P5.2
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 statem
ents
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 persona
l
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.
P5.2
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 i
ndeed
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 s
oftware
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 posit
ive,
personal computers are a normal good. Moreover, since the income elasticity is
greater than one, personal computer demand is also cyclical.
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Chapter 5
D.
False. A 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 therefor
e,
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 pers
onal
computers demanded. A 1% decline in income will cause a 2.5% fall in demand.
These changes will not be mutually offsetting.
P5.3 Demand Curves. KRMY-TV is contemplating a T-shirt advertising promotion.
Monthly sales data from T-shirt shops marketing the AEye Watch KRMY-TV@ design
indicate that
Q = 1,500 - 200P,
where Q is T-shirt sales and P is price.
A. How many T-shirts could KRMY-TV sell at $4.50 each?
B. What price would KRMY-TV have to charge to sell 900 T-shirts?
C. At what price would T-shirt sales equal zero?
D. How many T-shirts could be given away?
E. Calculate the point price elasticity of demand at a price of $5.
P5.3 SOLUTION
A.
Q = 1,500- 200P
= 1,500 - 200($4.50)
= 600
B. Q
= 1,500- 200P
900 = 1,500 - 200P
200P = 600
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Demand Analysis
P
= $3
C.
Q = 1,500- 200P
0 = 1,500 - 200P
200P
= 1,500
P = $7.50
D.
Q = 1,500- 200P
Q = 1,500 - 200(0)
Q = 1,500
E.
The point price elasticity of demand at a price of $5 is calculated as follows:
.
QP
eP
= x
.
PQ
5
=
-200 x
500
= -2 (Elastic)
P5.4
Optimal Pricing. In an effort to reduce excess end-of-the-model-year inventory,
Harrison Ford offered a 1% discount off the average price of 4WD Escape Limited
SUVs sold during the month of August. Customer response was wildly enthusiastic,
with unit sales rising by 50% over the previous month's level.
A.
Calculate the point price elasticity of demand for Harrison Ford 4WD Escape
Limited SUVs sold during the month of August.
B.
Calculate the profit-maximizing price per unit if Harrison Ford has an average
wholesale (invoice) cost of $27,600 and incurs marginal selling costs of $330
per unit.
P5.4
SOLUTION
- 121 -
Chapter 5
Percentage change in quantity
A.
eP =
Percentage change in price
0.500
=
-0.01
= -50 (Elastic)
B.
The profit-maximizing price can be found using the optimal price formula:
MC
P =
1
(1 + )
e
P
$27,600 +$330
=
1
(1 + )
-50
= $28,500
P5.5
Cross-Price Elasticity. The South Beach Cafe recently reduced appetizer prices
from $10 to $6 for afternoon Aearly bird@ customers and enjoyed a resulting
increase in sales from 60 to 180 orders per day. Beverage sales also increased f
rom
30 to 150 units per day.
A.
Calculate the arc price elasticity of demand for appetizers.
B.
Calculate the arc cross-price elasticity of demand between beverage sales and
appetizer prices.
C.
Holding all else equal, would you expect an additional appetizer price
decrease to $5 to cause both appetizer and beverage revenues to rise? Explain.
P5.5
SOLUTION
A.
.
Q P2+P1 (180 - 60) ($6+$10)
EP= x = x =-2
.
PQ2 +Q1 ($6-$10) (180 +60)
- 122 -
Demand Analysis
B.
.
QPX2 +PX1 (150-30) ($6+$10)
EPX= x = x =-2.67
.PX Q2 +Q1 ($6-$10) (150 +30)
C.
Yes, the |EP| = 2 > 1 calculated in part A implies an elastic demand for appetiz
ers and
that an additional price reduction will increase appetizer revenues. EPX = -2.67
< 0
indicates that beverages and appetizers are complements. Therefore, a further
decrease in appetizer prices will cause a continued growth in beverage unit sale
s and
revenues. To determine the profit effects of appetizer price changes it is neces
sary to
consider revenue and cost implications of both appetizer and beverage sales.
P5.6 Income Elasticity. Ironside Industries, Inc., is a leading manufacturer of
tufted
carpeting under the Ironside brand. Demand for Ironside's products is closely ti
ed
to the overall pace of building and remodeling activity and, therefore, is highl
y
sensitive to changes in national income. The carpet manufacturing industry is hi
ghly
competitive, so Ironside's demand is also very price-sensitive.
During the past year, Ironside sold 30 million square yards (units) of carpeting
at an average wholesale price of $15.50 per unit. This year, household income is
expected to expected to surge from $55,500 to $58,500 per year in a booming
economic recovery.
A.
Without any price change, Ironside's marketing director expects current-year
sales to soar to 50 million units because of rising income. Calculate the
implied income arc elasticity of demand.
B.
Given the projected rise in income, the marketing director believes that a
volume of 30 million units could be maintained despite an increase in price of
$1 per unit. On this basis, calculate the implied arc price elasticity of demand
.
C.
Holding all else equal, would a further increase in price result in higher or
lower total revenue?
P5.6
SOLUTION
A.
- 123 -
Chapter 5
.
Q I2+I1
EI = x
.
I Q+
2 Q1
50 -30 $58,500+$55,500
=
x
$58,500 -$55,500 50+30
= 9.5
B.
Without a price increase, sales this year would total 50 million units. Therefor
e, it is
appropriate to estimate the arc price elasticity from a before-price-increase ba
se of 50
million units:
.
Q P2+P1
EP = x
.
P Q2+Q1
30 -50 $16.50 + $15.50
=
x
$16.50 - $15.50 30 + 50
= -8(Elastic)
C.
Lower. Since carpet demand is in the elastic range, EP = -8, an increase (decrea
se) in
price will result in lower (higher) total revenues.
P5.7
Cross-Price Elasticity. B. B. Lean is a catalog retailer of a wide variety of sp
orting
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).
P5.7
SOLUTION
QY2 -QY1 PX2+ PX1
A.
EPX = x
PX2-PX1 QY2+QY1
- 124 -
Demand Analysis
4,800 -10,000 $85+$137
=
x
$85 -$137 4,800+10,000
= 1.5 (Substitutes)
QQ +
2 -1 P2P1
B.
EP = x
PP2-1 Q2+Q1
6,000 -4,800 $130+$140
=
x
$130-$140 6,000 + 4,800
= -3 (Elastic)
QQ P
2 -1 2+ P1
C.
EP = x
PP2-1 Q2+Q1
10,000 - 6,000 P2+$130
-3 =
x
P2- $130 10,000+6,000
P2 + $130
-3 =
4(P2 -$130)
-12P2 + $1,560 = P2 + $130
13P2 = $1,430
P2 = $110
This implies a further price reduction of $20 because:
.P = $130 - $110 = $20
P5.8
Advertising Elasticity. Enchantment Cosmetics, Inc., offers a line of cosmetic a
nd
perfume products marketed through leading department stores. Product Manager
Erica Kane recently raised the suggested retail price on a popular line of masca
ra
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
- 125 -
Chapter 5
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 par
t
C?
P5.8 SOLUTION
.
Q P2+P1
A.
EP = x
PQ
.
Q2+ 1
9,000 -16,200 $12+$9
=
x
$12 -$9 9,000+16,200
= -2
B.
The effective price reduction is $2 since 40% of sales are accompanied by a coup
on:
.P = -$5(0.4) or P2 = $12 - $5(0.4)
= -$2 = $10
.P = $10 - $12
= -$2
- 126 -
Demand Analysis
C.
To calculate the arc advertising elasticity, the effect of the $2 price cut impl
icit in the
coupon promotion must first be reflected. With just a price cut, the quantity
demanded would rise to 13,000, because:
Q* -Q1
P2+ P1
EP = x
PP2-1 Q*+ Q1
Q* - 9,000 $10+ $12
-2 = x
$10- $12 Q*+ 9,000
-11(Q* -9,000)
-2 =
(Q* + 9,000)
-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:
Q2 - Q* A2+ A1
EA = x
2 -1 Q2+ Q*
AA
15,000 -13,000 $3,750+$3,250
=
x
$3,750 -$3,250 15,000+13,000
= 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 whe
n 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 onl
y the
most price sensitive (coupon-using) customers, and may spur sales by much more
than a dollar equivalent across-the-board price cut.
- 127 -
Chapter 5
Synergy between advertising and the implicit price reduction that accompanies
a coupon promotion can cause the estimate in Part C to overstate the true advert
ising
elasticity. Similarly, this advertising elasticity will be overstated to the ext
ent that
targeted price cuts have a bigger influence on the quantity demanded than simila
r
across-the-board price reductions, as seems likely.
P5.9
Profit Maximization. Rochester Instruments, Inc., operates in the highly competi
tive
electronics industry. Prices for its RII-X control switches are stable at $50 ea
ch.
This means that P = MR = $50 in this market. Engineering estimates indicate that
relevant total and marginal cost relations for the RII-X model are:
TC = $78,000 + $18Q + $0.002Q2
MC = .TC/.Q = $18 + $0.004Q
A.
Set MR = MC and solve for Q to calculate the output level that will maximize
RII-X profit. (Note: Setting MR = MC is equivalent to setting Mp
= 0, where
total profit is p
= TR - TC.)
B. Calculate this maximum profit.
P5.9 SOLUTION
A.
To find the profit-maximizing level of output, set MR = MC and solve for Q:
MR = MC
$50 = $18 + $0.004Q
0.004Q
= 32
Q = 8,000
(Note: .2p/.Q2 < 0, and this is a profit maximum because profits are decreasing
for
Q > 8,000.)
B.
The total revenue function for Rochester is:
TR = P . Q = $50Q
- 128 -
Demand Analysis
Then, total profit is:
p
= TR - TC
= $50Q - $78,000 - $18Q - $0.002Q2
= -$0.002Q2 + $32Q - $78,000
= -$0.002(8,0002) + $32(8,000) -$78,000
= $50,000
P5.10 Revenue Maximization. Desktop Publishing Software, Inc., develops and mark
ets
software packages for business computers. Although sales have grown rapidly
during recent years, the company's management fears that a recent onslaught of n
ew
competitors may severely retard future growth opportunities. Therefore, it belie
ves
that the time has come to "get big or get out."
The marketing and accounting departments have provided management with
the following monthly demand and cost information:
P
= $1,000 - $1Q TC = $50,000 + $100Q
MR
= .TR/.Q = $1,000 - $2Q MC = .TC/.Q = $100
A.
Set MR = 0 and solve for Q to calculate monthly quantity, price, revenue, and
profit at the short-run revenue-maximizing output level.
B.
Set MR = MC and solve for Q to calculate these same values for the short-run
profit-maximizing level of output.
C.
When would short-run revenue maximization lead to long-run profit
maximization?
P5.10 SOLUTION
A. To find the revenue-maximizing output level, set MR = 0 and solve for Q. Thus
,
MR
= 1,000 - 2Q = 0
2Q = 1,000
- 129 -
Chapter 5
Q = 500
At Q = 500,
P = $1,000 - $1(500)
= $500
TR
= P . Q
= $500(500)
= $250,000
p
= TR - TC
= ($1,000 - $1Q)Q - $50,000 - $100Q
= -$50,000 + $900Q - $1Q2
= -$50,000 + $900(500) - $1(5002)
= $150,000
(Note: .2TR/.Q2 < 0, and this is a revenue maximum since revenue is decreasing
for Q > 500.)
B.
To find the profit-maximizing output level set MR = MC, or Mp = 0, and solve for
Q.
Since,
MR = MC
1,000 - 2Q = 100
2Q = 900
Q = 450
At Q = 450,
- 130 -
Demand Analysis
P = $1,000 - $1(450)
= $550
TR = P . Q
= $550(450)
= $247,500
p
= -$50,000 + $900(450) - $1(4502)
= $152,500
(Note: .2p/.Q2 < 0, and this is a profit maximum since profit is decreasing for
Q >
450.)
C.
In pursuing a short-run revenue rather than a profit-maximizing strategy, Deskto
p
Publishing can expect to gain a number of important advantages, including:
enhanced product awareness among consumers, increased customer loyalty, potentia
l
economies of scale in marketing and promotion, and possible limitations in
competitor entry and growth. To be consistent with long-run profit maximization,
these advantages of short-run revenue maximization must be at least worth the
sacrifice of $2,500 per outlet in monthly profits.
CASE STUDY FOR CHAPTER 5
Optimal Level of Advertising for CSI, Inc.
The concept of multivariate optimization is important in managerial economics be
cause many
demand and supply relations involve more than two variables. In demand analysis,
the concept
is particularly important in markets where firms face the difficult question of
how to set both
prices and advertising at profit-maximizing levels. In demand analysis, it is of
ten typical to
consider the quantity sold as a function of the price of the product itself, the
price of other goods,
advertising, income, and other factors. In cost analysis, cost is determined by
output, input
prices, the nature of technology, and so on. As a result, the process of multiva
riate optimization
is often employed in the process of optimization.
- 131 -
Chapter 5
To further explore the concepts of multivariate optimization and the optimal lev
el of
advertising, consider a hypothetical multivariate product demand function for CS
I, Inc., where
the demand for product Q is determined by the price charged, P, and the level of
advertising, A:
Q = 5,000 - 10P + 40A + PA - 0.8A2 - 0.5P2
When analyzing multivariate relations such as these, one is interested in the ma
rginal effect of
each independent variable on the quantity sold, the dependent variable. Optimiza
tion requires
an analysis of how a change in each independent variable affects the dependent v
ariable,
holding constant the effect of all other independent variables. The partial deri
vative concept is
used in this type of marginal analysis.
In light of the fact that the CSI demand function includes two independent varia
bles, the
price of the product itself and advertising, it is possible to examine two parti
al derivatives: the
partial of Q with respect to price, or .Q/.P, and the partial of Q with respect
to advertising
expenditures, or .Q/.A.
In determining partial derivatives, all variables except the one with respect to
which the
derivative is being taken remain unchanged. In this instance, A is treated as a
constant when the
partial derivative of Q with respect to P is analyzed; P is treated as a constan
t when the partial
derivative of Q with respect to A is evaluated. Therefore, the partial derivativ
e of Q with respect
to P is:
.
Q
= 0 - 10 + 0 + A - 0 - P
.
P
= -10 + A - P
The partial with respect to A is:
.
Q
= 0 - 0 + 40 + P - 1.6A - 0
.
A
= 40 + P - 1.6A
The maximization or minimization of multivariate functions is similar to that fo
r single variable
functions. All first-order partial derivatives must equal zero. Thus, maximizati
on of the function
Q = f(P,A) requires:
.
Q
= 0,
.
P
and
.
Q
= 0.
.
A
To maximize the value of theCSI, demand function, each partial must equal zero:
- 132 -
Demand Analysis
.
Q
= -10 + A - P = 0,
.
P
and
.
Q
= 40 + P -1.6A = 0.
.
A
Solving these two equations simultaneously yields the optimal price-output-adver
tising
combination. Because -10 + A - P = 0, P = A -10. Substituting this value for P i
nto 40 +
P - 1.6A = 0, gives 40 + (A - 10) - 1.6A = 0, which implies that 0.6A = 30 and A
= 50(00) or
$5,000. Given this value, P = A - 10 = 50 - 10 = $40.
Inserting these numbers for P and A into the CSI demand function results in a va
lue for
Q of 5,800. Therefore, the maximum value of Q is 5,800 reflects an optimal price
of $40 and
optimal advertising of $5,000.
The process of simultaneously determining optimal levels of price and advertisin
g can be
visualized by referring to Figure 2.A1, a three-dimensional graph of the CSI dem
and function.
For positive values of P and A, this demand function maps out a surface with a p
eak at point X*.
At the peak, the surface of the figure is level. Alternatively stated, a plane t
hat is tangent to the
surface at point X* is parallel to the PA plane. This means that the slope of th
e figure with
respect to either P or A is zero; as is required for locating the maximum of a m
ultivariate
function.
Unfortunately, on the basis of Figure 2.A1 it is not possible to conclusively de
termine
whether point X* locates an optimal point for price and advertising that will re
sult in maximum
profits or an inflection point that indicates only a local maximum for profits.
On the basis of
Figure 2.A1, it does not appear that point X* is a local or global point for min
imum profits, but
in the absence of further analysis, the process described above can lead to mist
akes in
identifying minimums versus maximums, and vice versa. Absent a check of second-o
rder
conditions, the possibility of misidentifying inflection points and points of ma
xima and minima is
always present.
One attractive use of computer spreadsheet analysis is to create simple numerica
l
examples that can be used to conclusively show the change in sales, profits and
other variables
that occur as one moves beyond points such as point X* identified for CSI Inc.
A.
Set up a table or spreadsheet for CSI, that illustrates the relationships among
quantity
(Q), price (P), the optimal level of advertising (A), the advertising-sales rati
o (A/S), and
sales revenue (S). In this spreadsheet, use the relations developed in the case
study to
define appropriate values for each of these items. Importantly,
Q =
5,000 -10P + 40A + PA- 0.8A2 - 0.5P2
A =
$25 +$0.625P
- 133 -
Chapter 5
A/S = (100.A)/S
S =P.Q
Establish a range for P from 0 to $125 in increments of $5 (i.e., $0, $5, $10, .
.., $125).
To test the sensitivity of all other variables to extreme bounds for the price v
ariable, also
set price equal to $1,000, $2,500, $10,000.
B.
Based on the CSI table or spreadsheet, determine the price-advertising combinati
on that
will maximize the number of units sold.
C.
Give an analytical explanation of the negative quantity and sales revenue levels
observed at very high price-advertising combinations. Do these negative values h
ave an
economic interpretation as well?
CASE STUDY SOLUTION
A.
The table or spreadsheet for CSI's unit sales quantity (Q), price (P), optimal a
dvertising
level (A), advertising intensity (A/S), and sales revenue (S) is:
Quantity Price Advertising Ad/Sales Sales Revenue
5,500 $0 $25.000 ----$
0.00
5,570 5 28.125 10.10% 27,851.56
5,631 10 31.250 5.55% 56,312.50
5,683 15 34.375 4.03% 85,242.19
5,725 20 37.500 3.28% 114,500.00
5,758 25 40.625 2.82% 143,945.31
5,781 30 43.750 2.52% 173,437.50
5,795 35 46.875 2.31% 202,835.94
5,800 40 50.000 2.16% 232,000.00
5,795 45 53.125 2.04% 260,789.06
5,781 50 56.250 1.95% 289,062.50
5,758 55 59.375 1.87% 316,679.69
5,725 60 62.500 1.82% 343,500.00
5,683 65 65.625 1.78% 369,382.81
5,631 70 68.750 1.74% 394,187.50
5,570 75 71.875 1.72% 417,773.44
5,500 80 75.000 1.70% 440,000.00
5,420 85 78.125 1.70% 460,726.56
5,331 90 81.250 1.69% 479,812.50
5,233 95 84.375 1.70% 497,117.19
- 134 -
Demand Analysis
5,125 100 87.500 1.71% 512,500.00
B.
Based on the CSI table or spreadsheet, the optimal price-advertising combination
that
will maximize the number of units sold is the analytical solution P = $40 and A
= $5,000.
Notice that quantity rises until this point is reached, but then falls as both p
rice and
advertising climb beyond this point.
C.
The negative quantities and sales revenues observed at very high price-advertisi
ng
combinations have a simple analytical interpretation. The quadratic expressions
for both
price and advertising are negative in the CSI demand function. At very high leve
ls for
price and advertising, the importance of these negative quadratic terms will out
weigh
positive first-order effects. Therefore, at very high levels for price and adver
tising, both
quantity and sales revenue turn negative. However, negative values for quantity
and
sales revenue have no economic interpretation. Remember that price-quantityadver
tising
relations are clearly sensitive to the price and advertising levels considered.
The nonlinear relation described in the CSI demand function would undoubtedly ch
ange
dramatically with dramatic changes in the price-advertising levels considered.
- 135 -

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Chapter 5

PROBLEMS & SOLUTIONS

C. What price-output combination will maximize total profits?

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