Chapter 5 DEMAND ANALYSIS AND ESTIMATION QUESTIONS & ANSWERS Q5.1 Q5.

1 "The utility derived from consumption is intangible and unobservable. Therefore, the utility concept has no practical value. Discuss this statement. ANSWER The utility derived from consumption is intangible, and therefore unobservable. However, when goods and services provide utility to consumers, there is a direct and measurable influence on their purchase decisions. Through their revealed preferences, consumers convey their evaluation of the value, or worth, of individual products. While the value derived through consumption is intangible, it leads to purchase decisions that can be monitored and responded to by firms. Q5.2 Q5.2 Is an increase in total utility or satisfaction following an increase in income consistent with the law of diminishing marginal utility? ANSWER Yes, the law of diminishing marginal utility states that the marginal utility derived from consumption will eventually diminish as consumption increases during a given time period. This means that the addition to total utility per dollar of income will tend to fall as total income rises. Despite the fact that total utility, or well-being, tends to rise with income, it is typical that the marginal utility derived per dollar of income tends to fall as income rises -- as is predicted by the law of diminishing marginal utility. Q5.3 Prospective car buyers are sometimes confronted by sales representatives who argue that they can offer a vehicle that is just as good as a BMW, but at one-half the price. Use the indifference concept to explain why the claims of the sales representative are not credible. ANSWER If two products provide the same amount of satisfaction or utility, the consumer is said to display indifference between the two. Indifference implies equivalence in the eyes of the consumer. A consumer can be indifferent between goods and services that are

Q5.3

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Chapter 5 distinct in a physical or material sense. Similarly, a consumer can display distinctly different preferences for goods and services that are similar in a physical or material sense. Whats important in the case of consumer indifference is that two products yield the same amount of satisfaction or well-being to the consumer. This should make consumers skeptical of sales representatives who argue that a cheaper product is just as good as a more expensive competitor. First of all, cheaper substitutes seldom perform at the same high level as competing products with a deservedly superior reputation. And second, it is important to remember that when consumers buy a product, they purchase a whole range of attributes associated with that product. For example, the BMW 760i four-door sedan is a $125,000 vehicle famous among car buffs for its awesome power, comfort, and styling. Buyers of a BMW 760i four-door sedan not only enjoy the creature comforts of a fine automobile, some also enjoy the snob appeal of owning a rare and exclusive automobile that tells all onlookers that they are successful. While you and I might think snob appeal is silly, some consumers have a different opinion, and who are we to argue with consumer preferences?

Q5.4 Q5.4

Following a price change for Diet Coke, explain how retailers use sales information to learn if Doritos snack chips represent a complement or substitute for Diet Coke. ANSWER Following a price change, companies use sales information to distinguish complements from substitutes by noting the size and direction of effects on demand for related products. Demand curves are downward sloping. As a result, when the price of a product is decreased, sales of that product rise. At the same time, sales of substitutes fall as customers switch to the now lower-priced alternative. When the price of a product rises, sales of that product fall but sales of substitute products rise as customers switch to the substitutes relative bargain price. There is a positive correlation between price changes and units sold when two products are substitutes. Sales of substitutes change in the same direction of the price change for substitute products. Conversely, when the price of a product is decreased, sales of that product and complements both rise. When the price of a product rises, sales of that product fall as do sales of complementary products. There is an inverse correlation between price changes and units sold when two products are complements.

Q5.5

During the past 40 years the average price of a new single-family home has risen by a factor of ten, making the cost of housing prohibitive for many Americans. Over the same time frame, however, the number of units sold per year has more than doubled. Are these data inconsistent with the idea of a downward-sloping demand curve for new housing? ANSWER

Q5.5

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105

No, these data are consistent with a downward-sloping demand curve for new housing. For most goods and services, the price charged is the most important determinant of sales. Quantity demanded falls with a price increase, and rises with a price decrease. In the case of housing, the quantity demanded would have fallen as prices rose except for the overwhelming influence of rising incomes over time. Housing is a normal good. Housing demand rises sharply during economic expansions and contracts during recessions. Over long periods of time, housing demand rises slowly and steadily as economic growth raises disposable income. It is vital that students separate out price and income effects when considering the demand for housing and other products. Q5.6 What would an upward-sloping demand curve imply about the marginal utility derived from consumption? Why aren't upward sloping demand curves observed in the real world? ANSWER The law of diminishing marginal utility states that the marginal utility derived will fall as the consumption of a given product increases during a given time interval. This gives rise to a downward sloping demand curve for all goods and services. For a given demand curve to be upward sloping, an increasing marginal utility of consumption would have to be operative. This is counter to human nature. Despite myths that sometimes arise concerning the pricing of some luxury goods, like perfume, there is no real-world evidence of upward sloping demand curves. In this regard, it is worth emphasizing the fact that an upward sloping demand curve implies that higher prices lead to an increase in quantity demanded. Under such a wonderful circumstance, firms would have an incentive to charge higher and higher prices (to infinity and beyond!). Nothing would limit the firms ability to gain revenues by raising prices. In the real world, higher prices eventually result in some buyers being priced out of the market and to an eventual downturn in revenues. Q5.7 Q5.7 How is a price-consumption curve related to a demand curve? ANSWER If income and the prices of other goods and services are held constant, a reduction in the price of a given consumption item causes consumers to choose different market baskets. The various market baskets that maximize utility at different prices for a given item trace out the consumers price-consumption curve. For example, the priceconsumption curve shows how the optimal consumption of both goods and services are affected by changing prices for services. A similar price-consumption curve could be used to illustrate how the optimal consumption of both goods and services are affected by changing prices for goods. On the other hand, the demand curve for services shows

Q5.6

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Chapter 5 how the quantity demanded of services rises in a response to a fall in the price for services. A similar individual demand curve could be used to illustrate how the quantity demanded of goods rises in a response to a fall in prices for goods.

Q5.8

An estimated 80% increase in the retail price of cigarettes is necessary to cause a 30% drop in the number of cigarettes sold. Would such a price increase help or hurt 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 taxes? ANSWER The price elasticity of demand for cigarettes is highly inelastic if an 80% increase in retail prices would cause only a 30% drop in the number of cigarettes sold. An arc 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. Since the variable costs of producing and selling cigarettes would fall with a 30% drop 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 on each pack of cigarettes sold. For example, a new $1.50 tax on a pack of cigarettes 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 fall 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

Q5.9

Individual consumer demand declines for inferior goods as personal income increases because consumers replace them with more desirable alternatives. Is an inverse relation between demand and national income likely for such products? ANSWER No, not usually. Theoretically, it is plausible that the aggregate demand for some goods and services might be counter-cyclical, actually rising during a business recession and falling during an economic boom. After all, if individual consumers shift from hamburger to steak as incomes rise, wouldn't it seem reasonable to expect hamburger demand to rise with a fall in income? The answer seems to be yes and no. Yes, as incomes rise, demand from high-income individuals declines for inferior goods like hamburger, bus rides, and blue jeans as these consumers switch to more desirable substitutes such as porterhouse steak, automobiles, and designer clothing.

Q5.9

Demand Analysis and Estimation

107

However, as incomes rise, other low-income consumers move up the economic ladder. Perhaps for the first time, they are now able to afford hamburger, bus rides, and blue jeans. As a result, economy wide demand for so-called inferior goods may actually rise as income levels increase, albeit at a much slower pace than demand for other, more desirable products. Despite a lack of empirical evidence, the possibility of an inverse relation between aggregate product demand and income has intrigued economists for a number of years. This interest was originally created by an anomaly called the potato paradox. As legend has it, a Victorian economist named Robert Giffen discovered that the potato crop failure of 1845 so depressed Irish incomes that the poor had to actually increase their consumption of the now higher-priced potatoes. Because they had to spend so much on potatoes, a necessary staple, the poor couldn't afford meat or other substitutes and became even more dependent than before on potatoes. Thus, potatoes became known as the classic case of the inferior or, Giffen, good. However, empirical evidence casts serious doubt on the credibility of such a chain of events. After studying the historical record, economists Gerald Dwyer and Cotton Lindsay found little support for the notion that the consumption of potatoes in Ireland increased during this period. So widespread were the effects of the fungus Phytophthora infestans that it destroyed roughly one-half of the 1845 potato crop in Ireland after inflicting serious damage in America, in England, and on the Continent. After September 1846 and until harvest time in August of the following year, few potatoes could be bought at any price. Without imports and with a decrease in domestic supply, how could potato consumption by the poor possibly have risen during the Irish potato famine? Moreover, there is no evidence that low potato prices during good years had a depressing effect on potato consumption by the poor, as would be necessary to classify potatoes as an inferior good. Therefore, it is only reasonable to conclude that the increase in potato prices and the decrease in income caused by the Irish potato famine resulted in a decline in the aggregate consumption of potatoes. As is typical for goods in general, a positive relation between potato demand and economy wide income seems to hold. Despite the legend of the potato paradox, concrete evidence of an inverse relation between aggregate demand and income remains elusive. (See: Gerald P. Dwyer, Jr. and Cotton M. Lindsay, Robert Giffen and the Irish Potato, American Economic Review, March 1984, 188-192.) Q5.10 In the United States, high-wage workers shun public transit and drive cars to work. These same high-income individuals often support massive subsidies for public transit. Use the concept of revealed preference to explain the public demand for transportation. Can you explain this consumer behavior by high-income individuals? ANSWER

Q5.10

108

Chapter 5 High-wage workers often shun public transit and drive their cars to work. This stems from the fact that time in transit is a compelling consideration for such workers. Getting where they need to go, and getting there on time, matter much more than the out-of-pocket costs associated with driving to work. For example, Kobe Bryants time is valuable, and he drives to work. His time is much too valuable to be spent waiting for the bus. At the same time, it is fascinating to note the almost universal political support for subsidized mass transit among high-income individuals. While high-income individuals have a documented revealed preference for driving to work, they prefer that others, including the less fortunate, take public transit. This makes economic sense from the standpoint that subsidized mass transit might reduce road and parking congestion, and thereby make driving to work easier for high-income individuals. These same high-income individuals often support massive subsidies for public transit. On the other hand, it is less obvious why high-income individuals might support woefully underutilized mass transit. Perhaps they view support for such mass transit as a type of income transfer to the poor and other beneficiaries of mass transit (government employees, equipment manufacturers, and so on).

SELF-TEST PROBLEMS AND SOLUTIONS ST5.1 Individual Demand Curve. Alex P. Keaton is an ardent baseball fan. The following table shows the relation between the number of games he attends per month during the season and the total utility he derives from baseball game consumption: Number of Baseball Games per Month 0 1 2 3 4 5 A. B. Total Utility 0 50 90 120 140 150

Construct a table showing Keaton's marginal utility derived from baseball game consumption. At an average ticket price of $25, Keaton can justify attending only one game per month. Calculate Keatons cost per unit of marginal utility derived from baseball game consumption at this activity level.

Demand Analysis and Estimation C.

109

If the cost/marginal utility trade-off found in part B represents the most Keaton is willing to pay for baseball game consumption, calculate the prices at which he would attend two, three, four, and five games per month. Plot Keaton's baseball game demand curve.

D. ST5.1 A.

SOLUTION

Number of Baseball Games Per Month 0 1 2 3 4 5 B.

Total Utility 0 50 90 120 140 150

Marginal Utility -50 40 30 20 10

At one baseball game per month, MU = 50. Thus, at a $25 price per baseball game, the cost per unit of marginal utility derived from baseball game consumption is P/MU = $25/50 = $0.50 or 50 per util. At a maximum acceptable price of 50 per util, Keaton's maximum acceptable price for baseball game tickets varies according to the following schedule: Maximum Acceptable price at 50 per MU -$25.00 20.00 15.00 10.00 5.00

C.

Number of Games Per Month 0 1 2 3 4 5

Total Utility 0 50 90 120 140 150

Marginal Utility MU = U/G -50 40 30 20 10

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D.

Keaton's baseball ticket demand curve is:

Keaton's Baseball Ticket Dem and Curve
$3 5

$3 0 Dem dcurve an $2 5

$2 0

$1 5

$1 0

$5

$0 0 1 2 Num ber of gam es 3 4 5

ST5.2

Elasticity Estimation. Distinctive Designs, Inc., imports and distributes dress and sports watches. At the end of the company's fiscal year, brand manager Charlie Pace has asked you to evaluate sales of the sports watch line using the following data: Number of Sports Watches Sold 4,500 5,500 4,500 3,500 5,000 15,000 5,000 4,000 5,500 6,000 4,000 5,000 Sports Watch Advertising Expenditures $10,000 10,000 9,200 9,200 9,750 9,750 8,350 7,850 9,500 8,500 8,500 8,500 Sports Watch Price, P 26 24 24 24 25 20 25 25 25 24 26 26 Dress Watch Price, PD 50 50 50 46 50 50 50 50 55 51 51 57

Month July August September October November December January February March April May June

In particular, Pace 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.

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111

Also note that by restricting your analysis to consecutive months, changes in any additional factors not explicitly included in the analysis are less likely 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 Expenditures, A ____________ ____________ ____________ ____________ ____________ ____________ ____________ ____________ ____________ ____________ ____________

Month-Pair July-August August-September September-October October-November November-December December-January January-February February-March March-April April-May May-June B. C. D. ST5.2 A.

Sports Watch Price, P ____________ ____________ ____________ ____________ ____________ ____________ ____________ ____________ ____________ ____________ ____________

Dress Watch Price, PD ____________ ____________ ____________ ____________ ____________ ____________ ____________ ____________ ____________ ____________ ____________

Calculate and interpret the average advertising arc elasticity of demand for sports watches. Calculate and interpret the average arc price elasticity of demand for sports watches. Calculate and interpret the average arc cross-price elasticity of demand between sports and dress watches.

SOLUTION

Month-Pair

Sports Watch Advertising Expenditures, A

Sports Watch Price, P

Dress Watch Price, PD

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Chapter 5

July-August August-September September-October October-November November-December December-January January-February February-March March-April April-May May-June B.

No change Change No change Change No change Change Change Change Change No change No change

Change No change No change Change Change Change No change No change Change Change No change

No change No change Change Change No change No change No change Change Change No change Change

In calculating the arc advertising elasticity of demand, only consider consecutive months when there was a change in advertising but no change in the prices of sports and dress watches: August-September

EA = =

Q A 2 + A1 A Q2 + Q1

4,500 - 5,500 $9,200 + $10,000 $9,200 - $10,000 4,500 + 5,500 = 2.4

January-February

EA = =

Q A 2 + A1 A Q2 + Q1

4,000 - 5,000 $7,850 + $8,350 $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.

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113

C.

In calculating the arc price elasticity of demand, only consider consecutive months when there was a change in the price of sports watches, but no change in advertising nor the price of dress watches: July-August

EP = =

Q P2 + P1 P Q2 + Q1

5,500 - 4,500 $24 + $26 $24 - $26 5,500 + 4,500 = - 2.5

November-December

EP = =

Q P 2 + P1 P Q2 + Q1

15,000 - 5,000 $20 + $25 $20 - $25 15,000 + 5,000 = - 4.5

April-May
EP = = Q P2 + P1 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 consecutive 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 May-June Q PX 2 + PX 1 E PX = P X Q 2 + Q1 3,500 - 4,500 $46 + $50 = $46 - $50 3,500 + 4,500 =3

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Q PX 2 + PX 1 P X Q 2 + Q1

Chapter 5

E PX = =

On average, EPX substitutes. PROBLEMS & SOLUTIONS P5.1

5,000 - 4,000 $57 + $51 $57 - $51 5,000 + 4,000 =2 = (3 + 2)/2 = 2.5. Since EPX > 0, sports and dress watches are

Utility Theory. Determine whether each of the following statements is true or false. Explain why. A. B. C. D. E. According to the theory of consumer behavior, more is always better. Consumers must understand how much one product is preferred over another in order to rank-order consumption alternatives. A market basket is a descriptive statement that relates satisfaction or well-being to the consumption of goods and services. The nonsatiation principle abstracts from time and place considerations. Marginal utility measures the consumer's overall level of satisfaction derived from consumption activities

P5.1 A.

SOLUTION True. Consumer behavior theory rests upon the more is better assumption regarding the utility tied to consumption. All goods and services are desirable in the sense of being able to satisfy consumer wants. As a result, consumers will always prefer more to less of any good or service. False. The consumers understanding of ordinal utility makes possible a rank ordering of preferred goods and services. Notice that knowledge concerning complete consumer preferences does not necessarily include understanding about how much one product is preferred over another. False. A utility function is a descriptive statement that relates satisfaction or well-being to the consumption of goods and services.

B.

C.

Demand Analysis and Estimation D.

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True. At any specific place and time, consumers do become sated. Therefore, the nonsatiation principle involves a certain amount of abstraction from time and place considerations. It is best considered within the context of money income where more money brings additional satisfaction or well-being. False. Whereas total utility measures the consumer's overall level of satisfaction derived from consumption activities, marginal utility measures the added satisfaction derived from a one-unit increase in consumption of a particular good or service, holding consumption of other goods and services constant. Law of Diminishing Marginal Utility. Indicate whether each of the following statements is true or false. Explain why. A. The law of diminishing marginal utility states that as an individual increases consumption of a given product within a set period of time, the utility gained from consumption eventually declines. When prices are held constant, a diminishing marginal utility for consumption decreases the cost of each marginal unit of satisfaction. Marginal utility measures the added satisfaction derived from a one-unit increase in consumption, holding consumption of other goods and services constant. When goods are relatively scarce, the law of diminishing marginal utility means that the added value of another unit of goods will be small in relation to the added value of another unit of services. The law of diminishing marginal utility gives rise to a downward-sloping demand curve for all goods and services.

E.

P5.2

B. C.

D.

E. P5.2 A.

SOLUTION False. In general, the law of diminishing marginal utility states that as an individual increases consumption of a given product within a set period of time, the marginal utility gained from consumption eventually declines. False. When prices are held constant, a diminishing marginal utility for consumption increases the cost of each marginal unit of satisfaction. True. Whereas total utility measures the consumer's overall level of satisfaction derived from consumption activities, marginal utility measures the added satisfaction

B. C.

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Chapter 5 derived from a one-unit increase in consumption of a particular good or service, holding consumption of other goods and services constant.

D.

False. When goods are relatively scarce, the law of diminishing marginal utility means that the added value of another unit of goods will be large in relation to the added value of another unit of services. True. This law gives rise to a downward-sloping demand curve for all goods and services. Indifference Curves. Suggest briefly whether each of the following statements about indifference curves that show preferences between goods and services is true or false and defend your answer. A. Consumers prefer higher indifference curves that represent greater combinations of goods and services to lower indifference curves that represent smaller combinations of goods and services. Indifference curves slope downward because if the quantity of one consumer product is reduced, the quantity of the other must also decrease to maintain the same degree of utility. The slope of an indifference curve shows the rate at which consumers are willing to tradeoff goods and services. The fact that indifference curves do not intersect stems from the more is better principle. Indifference curves bend inward (are convex to the origin) because if goods are relatively abundant, the added value of another unit of goods will be small in relation to the added value of another unit of services.

E. P5.3

B.

C. D. E.

P5.3 A.

SOLUTION True. Consumers prefer more to less, so they prefer higher indifference curves that represent greater combinations of goods and services to lower indifference curves that represent smaller combinations of goods and services. False. Indifference curves slope downward. This stems from the fact that the slope of an indifference curve shows the tradeoff involved between goods and services. Because consumers like both goods and services, if the quantity of one is reduced, the quantity of the other must increase to maintain the same degree of utility.

B.

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117

True. The slope of an indifference curve shows the rate at which consumers are willing to tradeoff goods and services. For example, when goods are relatively scarce, the law of diminishing marginal utility means that the added value of another unit of goods will be large in relation to the added value of another unit of services. Conversely, when goods are relatively abundant, the added value of another unit of goods will be small in relation to the added value of another unit of services. True. Indifference curves do not intersect. Holding goods constant, an indifference curve involving a greater amount of services must give greater satisfaction. Similarly, holding services constant, an indifference curve involving a greater amount of goods must give greater satisfaction. This stems from the fact that goods and services both provide consumer benefits, and reflects the more is better principle. True. Indifference curves bend inward (are convex to the origin). For example, when goods are relatively scarce, the law of diminishing marginal utility means that the added value of another unit of goods will be large in relation to the added value of another unit of services. Conversely, when goods are relatively abundant, the added value of another unit of goods will be small in relation to the added value of another unit of services. Budget Constraints. Holding all else equal, indicate how each of the following changes would affect a budget constraint that limits consumption of goods (Y) and services (X). Explain your answer. A. B. C. D. E. Deflation that uniformly drops the price of all goods and services. Inflation that consistently increases the price of all goods and services. Technical change that reduces the price of goods, but leaves the price of services unchanged. Economic growth that boosts the level of disposable income. Government-mandated health care coverage for workers that boosts the price of goods by 3% and increases the price of services by 5%.

D.

E.

P5.4

P5.4 A.

SOLUTION Deflation that drops the price of all goods and services results in a parallel rightward (outward) shift in the budget constraint. Holding income constant, lower prices make it possible for consumers to buy more goods and services with the same total amount of spending. This beneficial impact on consumption is similar to that following an increase in income.

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B.

Inflation that increases the price of all goods and services results in a parallel leftward (inward) shift in the budget constraint. Holding income constant, higher prices reduce the amount of goods and services that consumers can buy with a fixed amount of spending. This harmful impact on consumption is similar to that following a decrease in income.

C.

Technical change that reduces the price of goods, but leaves the price of services unchanged results in an outward rotation of the budget constraint along the goods (Y) axis. After such a change, the budget line intersects the Y axis at a higher point, indicating that a greater amount of goods can be purchased with a fixed budget. The amount of services that can be purchased for a fixed amount is unaffected by such a change, and the X intercept (services axis) of the budget constraint is unaffected by such a change. Economic growth that boosts the level of disposable income results in a parallel rightward (outward) shift in the budget constraint. Holding prices constant, growing income makes it possible for consumers to buy more goods and services with the same total amount of spending. This beneficial impact on consumption is similar to that following deflation that drops the price of all goods and services. Government-mandated health care coverage for workers that boosts the price of goods by 3% and increases the price of services by 5% will have a negative impact on consumption of both goods and services, but the negative impact will be worse in the case of services. Following such a change, the relative price of services will rise relative to the price of goods. The new budget line will move inward 3% along the X axis reflecting the fact that a fixed budget will only be able to buy 97% of the previously affordable goods. The new budget line will move inward 5% along the Y axis reflecting the fact that a fixed budget will only be able to buy 95% of the previously affordable services. The net effect is similar to a decrease in income followed by a unilateral increase in the price of services. 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. B. C. D. E. A price reduction for personal computers will increase both the number of units demanded and the total revenue of sellers. The cross-price elasticity indicates that a 5% reduction in the price of personal computers will cause a 20% increase in software demand. Demand for personal computers is price elastic and computers are cyclical normal goods. Falling software prices will increase revenues received by sellers of both computers and software. A 2% price reduction would be necessary to overcome the effects of a 1% decline in income.

D.

E.

P5.5

P5.5 A.

SOLUTION 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. 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%. 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. 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. 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. 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 GasElectric Hybrid SUVs sold during the month of August. Customer response was wildly enthusiastic, with unit sales rising by 10% over the previous month's level. A. B. Calculate the point price elasticity of demand for Harrison Ford 4WD Escape Limited SUVs sold during the month of August. Calculate the profit-maximizing price per unit if Harrison Ford has an average wholesale (invoice) cost of $23,500 and incurs marginal selling costs of $350 per unit.

B. C.

D.

E.

P5.6

P5.6

SOLUTION

VVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVV VVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVV VVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVV VVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVV VVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVV VVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVV VVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVV VVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVV VVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVV VVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVV VVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVV VVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVV VVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVV. P = Q/Q P/P = 10%/-1% = -10 (Highly elastic) WWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWW WWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWW WWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWW WWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWW WWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWW WWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWW WWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWW WWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWW WWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWW WWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWW WWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWW WWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWW WWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWW WWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWW WWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWW WWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWW WWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWW W. The profit-maximizing price can be found using the optimal price formula: P* = MC/(1 + 1/P)

= ($23,500 + $350)/[1 + 1/(-10)] = $26,500

P5.7

Cross-Price Elasticity. The South Beach Cafe recently reduced appetizer prices from $12 to $10 for afternoon early bird customers and enjoyed a resulting increase in sales from 90 to 150 orders per day. Beverage sales also increased from 300 to 600 units per day. A. B. A. Calculate the arc price elasticity of demand for appetizers. Calculate the arc cross-price elasticity of demand between beverage sales and appetizer prices. Holding all else equal, would you expect an additional appetizer price decrease to $8 to cause both appetizer and beverage revenues to rise? Explain

P5.7 A.

SOLUTION

EP =
B.
E PX =

Q P 2 + P1 (150 - 90) ($10 + $1 2) = = - 2.75 P Q 2 + Q1 ($10 - $12) (150 + 90)

Q P X 2 + P X 1 (600 - 30 0) ($10 + $1 2) = = - 3.67 PX ($10 - $1 2) (600 + 30 0) Q 2 + Q1

B.

Yes, the |EP| = 2.75 > 1 calculated in part A implies an elastic demand for appetizers and that an additional price reduction will increase appetizer revenues. EPX = -3.67 < 0 indicates that beverages and appetizers are complements. Therefore, a further decrease in appetizer prices will cause a continued growth in beverage unit sales and revenues. Alternatively, If P = a + bQ, then $12 = a + b(90) and $10 = a + b(150). Solving for the demand curve gives P = $15 - $0.033Q. At P = $12, total revenue is $1,080 (= $12 90). If P = $10, total revenue is $1,500 (= $10 150). At P = $8, total revenue is $1,680 (= $8 210). In any case, to determine the profit effects of appetizer price changes it is necessary to consider revenue and cost implications of both appetizer and beverage sales. Income Elasticity. Ironside Industries, Inc., is a leading manufacturer of tufted carpeting under the Ironside brand. Demand for Ironside's products is closely tied to the overall pace of building and remodeling activity and, therefore, is highly sensitive to changes in national income. The carpet manufacturing industry is highly 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

P5.8

expected to ssurge 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. 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.

B.

C. Holding all else equal, would a further increase in price result in higher or lower total revenue? P5.8 A. SOLUTION

EI = =

Q I 2 + I1 I Q 2 + Q1

50 - 30 $58,500 + $55,500 $58,500 - $55,500 50 + 30 = 9.5

B. Without a price increase, sales this year would total 50 million units. Therefore, it is appropriate to estimate the arc price elasticity from a before-price-increase base of 50 million units:
EP = Q P P 2 + P1 Q 2 + Q1 30 - 50 $16.50 + $15.50 30 + 50

$16.50 - $15.50 = - 8 (Elastic)

C.

Lower. Since carpet demand is in the elastic range, EP = -8, an increase (decrease) in price will result in lower (higher) total revenues. 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.

P5.9

A. B.

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

C.

P5.9 A.

SOLUTION EPX =

QY 2-QY1 P X 2-P X1

P X 2+P X1 QY 2+QY1

4,800 - 10,000 $85 - $137

$85 + $137 4,800 + 10,000

= 1.5 (Substitutes) B. EP =
Q 2 -Q1 P 2 -P1 P 2+P1 Q 2 + Q1

6,000 - 4,800 $130 - $140

$130 + $140 6,000 + 4,800

= -3 (Elastic) C. EP =

Q 2 -Q1

P 2 -P1 Q 2 +Q1
10,000 - 6,000 + $130 x P2 10,000 + 6,000 P2 - $130
P 2 + $130 4( P 2 - $130)

P 2 + P1

-3 =

-3 =

-12P2 + $1,560 = P2 + $130 13P2 = $1,430

P2 = $110 This implies a further price reduction of $20 because: P = $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. B. C. Calculate the arc price elasticity implied by the initial response to the Enchantment price increase. Calculate the effective price reduction resulting from the coupon promotion. 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. Why might the true arc advertising elasticity differ from that calculated in part C?

D. P5.10 A.

SOLUTION EP =

Q P 2 + P1 P Q 2 +Q1 9,000 - 16,200 $12 - $9 $12 + $9 9,000 + 16,200

= -2 B. The effective price reduction is $2 since 40% of sales are accompanied by a coupon: P = -$5(0.4) or P2 = $12 - $5(0.4)

= -$2

= $10 P = $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 =
Q* - Q 1 P 2-P1 P 2 + P1 Q* + Q 1

-2

Q* - 9,000 $10 - $12

$10 + $12 Q* + 9,000

-2 -2(Q* + 9,000) -2Q* - 18,000 9Q*

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

= -11(Q* - 9,000) = -11Q* + 99,000 = 117,000

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

Q 2 - Q* A 2 + A 1 = - A 1 Q 2 + Q* A2
=

15,000 - 13,000 $3,750 - $3,250

$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 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.

CASE STUDY FOR CHAPTER 5 Demand Estimation for Mrs. Smyths Pies Demand estimation for brand-name consumer products is made difficult by the fact that managers must rely on proprietary data. There simply is not any publicly available data which can be used to estimate demand elasticities for brand-name orange juice, frozen entrees, pies, and the like--and with good reason. Competitors would be delighted to know profit margins across a broad array of competing products so that advertising, pricing policy, and product development strategy could all be targeted for maximum benefit. Product demand information is valuable and jealously guarded. To see the process that might be undertaken to develop a better understanding of product demand conditions, consider the hypothetical example of Mrs. Smyth's Inc., a Chicago-based food company. In early 2008, Mrs. Smyth's initiated an empirical estimation of demand for its gourmet frozen fruit pies. The firm is formulating pricing and promotional plans for the coming year, and management is interested in learning how pricing and promotional decisions might affect sales. Mrs. Smyth's has been marketing frozen fruit pies for several years, and its market research department has collected quarterly data over two years for six important marketing areas, including sales quantity, the retail price charged for the pies, local advertising and promotional expenditures, and the price charged by a major competing brand of frozen pies. Statistical data published by the U.S. Census Bureau (http://www.census.gov) on population and disposable income in each of the six Metropolitan Statistical Areas were also available for analysis. It was therefore possible to include a wide range of hypothesized demand determinants in an empirical estimation of fruit pie demand. These data appear in Table 5.9. The following regression equation was fit to these data: Qit = b0 + b1Pit + b2Ait + b3PXit + b4Yit + b5Popit + b6Tit + uit Q is the quantity of pies sold during the tth quarter; P is the retail price in dollars of Mrs. Smyth's frozen pies; A represents the dollars spent for advertising; PX is the price, measured in dollars, charged for competing premium-quality frozen fruit pies; Y is the median dollars of disposable income per household; Pop is the population of the market area; T is the trend factor (2006-1 = 1, . . . , 2007-4 = 8); and uit is a residual (or disturbance) term. The subscript i indicates the regional market from which the observation was taken, whereas the subscript t represents the quarter during which the observation occurred. Least squares estimation of the regression equation on the basis of the 48 data observations (eight quarters of data for each of six areas) resulted in the estimated regression coefficients and other statistics given in Table 5.10.

A. B. C. D.

Describe the economic meaning and statistical significance of each individual independent variable included in the Mrs. Smyth's frozen fruit pie demand equation. Interpret the coefficient of determination (R2) for the Mrs. Smyth's frozen fruit pie demand equation. Use the regression model and 2007-4 data to estimate 2008-1 unit sales in the Washington-Arlington-Alexandria market. To illustrate use of the standard error of the estimate statistic, derive the 95 percent and 99 percent confidence intervals for 2008-1 unit sales in the WashingtonArlington-Alexandria market.

CASE STUDY SOLUTION A. The individual coefficients for the Mrs. Smyth's pie demand regression equation can be interpreted as follows. The intercept term, 529,774, has no economic meaning in this instance; it lies far outside the range of observed data and obviously cannot be interpreted as the demand for Mrs. Smyth's frozen fruit pies when all the independent variables take on zero values. The coefficient for each independent variable indicates the marginal relation between that variable and sales of pies, holding constant the effect of all the other variables in the demand function. For example, the -122,607 coefficient for P, the price charged for Mrs. Smyth's pies, indicates that when the effects of all other demand variables are held constant, each $1 increase in price causes quarterly sales to decline by roughly 122,607 pies. Similarly, the 5.838 coefficient for A, the advertising and promotion variable, indicates that for each $1 increase in advertising during the quarter, roughly 5.838 additional pies are sold. Demand for Mrs. Smyth's pies rises by roughly 29,867 pies with every $1 increase in competitor prices, and a $1 increase in the median disposable income per household leads to roughly a 2.043-unit increase in quarterly pie demand. Similarly, a one person increase in the population of a given market area leads to a small 0.030-unit increase in quarterly pie demand. Finally, the coefficient for the trend variable indicates that pie demand is growing in a typical market by roughly 2,815 units per quarter. Mrs. Smyth's is enjoying secular growth in pie demand. Individual coefficients provide useful estimates of the expected marginal influence on demand following a one-unit change in each respective variable. However, they are only estimates. For example, it would be very unusual for a $1 increase in price to cause exactly a -122,607-unit change in the quantity demanded. The actual effect could be more or less. For decision-making purposes, it would be helpful to know if the marginal influences suggested by the regression model are stable or instead tend to vary widely over the sample analyzed. In general, if it were known with certainty that Y = a + bX, then a one-unit change in X would always lead to a b-unit change in Y. If b > 0, X and Y are directly related; if b < 0, X and Y are inversely related. If no relation at all holds between X and Y, then b = 0. Although the true parameter b is unobservable, its value is projected by the coefficient estimate. To

be statistically reliable, the coefficient estimate must be large relative to its standard deviation over the sample. In Mrs. Smyth's frozen fruit pie demand equation, the coefficient estimates for price (P), advertising (A), competitor price (PX) and population (Pop) are all more than twice as large as their respective standard errors. Therefore, it is possible to reject the hypothesis that each of these independent variables is unrelated to pie demand with 95 percent confidence. These coefficient estimates suggest an especially strong relation between pie demand and the P, A, and Pop variables. Each of these coefficient estimates is over three times as large as its underlying standard error and therefore is statistically significant at the 99 percent confidence level. Once the effects of these independent variables have been constrained, there is no additional independent influence noted for income (Y) or the time trend variable (T). B. The coefficient of determination R2 = 0.871 or 87.1 percent indicates that the regression model has explained 87.1 per cent of the total variation in pie demand. This is a very satisfactory level of explanation for the model as a whole. The corrected coefficient of determination R 2 = 0.852 or 85.2 per cent is a relatively modest downward adjustment from R2; it suggests that the high level of explanatory power achieved by the regression model cannot be attributed to an overly small sample size. Finally, the F statistic is used to indicate whether a significant share of variation in the dependent variable has been explained by the regression model. The hypothesis actually tested is that the dependent Y variable is statistically unrelated to all the independent X variables included in the model. If this hypothesis cannot be rejected, variation explained by the regression is small. The critical value for F is denoted as F f 1, f 2 , where f1, the degrees of freedom for the numerator, equals k - 1, and f2, the degrees of freedom for the denominator, equals n - k. For example, the F statistic for this example involves f1 = k - 1 = 7 - 1 = 6, and f2 = n - k = 48 - 7 = 41 degrees of freedom. Also note that the calculated F6,41 = 45.16 > 3.29, the critical F6,40 value for the = 0.01 or 99% confidence level shown in Appendix B. This means there is less than a 1% chance of observing such a high F statistic when there is no link between the dependent Y variable and the entire group of X variables. Given the ability to reject the hypothesis of no relation at the 99% confidence level, it will always be possible to reject this hypothesis at the lower, 95% and 90%, confidence levels. To project the next quarter's sales of frozen fruit pies in the Washington, DC-ArlingtonAlexandria market, the company must simply enter expected values for each independent variable in the estimated demand equation. Mrs. Smyth's expects an average price for its pies of $7.95, advertising expenditures of $30,487. The prices of competing pies are expected to be $5.69; median disposable income per household is $53,235; population in the market area is 5,445,382 persons; and the quarter for which demand is being forecast is the ninth quarter in the model. Inserting the appropriate unit values into the demand equation results in an estimated demand of: Q = 529,774 122,607(7.95) + 5.838(30,487) + 29,867(5.69) + 2.043(53,235)

C.

+ 0.030(5,445,382) + 2,815(9) = 200,430 pies.

Mrs. Smyth's could forecast the total demand for its pies by forecasting sales in each of the six market areas, then summing these area forecasts to obtain an estimate of total pie demand. Using the results from the demand estimation model and data from each individual market, it would also be possible to construct a confidence interval for total pie demand based on the standard error of the estimate. (Note: Be sure to remember that 2008-1 is time period T = 9!) D. Although 200,430 is the best estimate of pie demand for the Washington, DC-ArlingtonAlexandria market during the 2008-1 period, it is highly unlikely that precisely this number of pies will be sold. Either more or less may be sold, depending on the effects of other factors not explicitly accounted for in our pie demand estimation model. The standard error of the estimate is a very useful statistic because it allows us to construct a range or confidence interval within which actual sales are likely to fall. For example, sales can be projected to fall within a range of 2 standard errors of the 200,430 expected sales level with a confidence level of 95 per cent. There is only a 5 per cent chance that actual sales in the Washington, DC-Arlington-Alexandria market during the coming period will fall outside this range. Similarly, there is a 99 per cent chance that actual sales will fall in the range of 200,430 3(67,584), and only a 1 per cent chance that actual sales will fall outside this range.