Solution Manual For Managerial Economics 7th Edition Allen

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INSTRUCTORS MANUAL
Managerial Economics
SEVENTH EDITION
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INSTRUCTORS MANUAL
SEVENTH EDITION
Robert Brooker
GANNON UNIVERSITY
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W W NORTON & COMPANY NEW YORK LONDON
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[Copyright TK]
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Contents
Chapter 1
Introduction
Chapter 2
Demand Theory
12
Chapter 3
Consumer Behavior and Rational Choice
28
Chapter 4
Production Theory
45
Chapter 5
The Analysis of Costs
59
Chapter 6
Perfect Competition
73
Chapter 7
Monopoly and Monopolistic Competition
83
Chapter 8
Managerial Use of Price Discrimination
99
Chapter 9
Bundling and Intrafirm Pricing
117
Chapter 10
Oligopoly
132
Chapter 11
Game Theory
148
Chapter 12
Auctions
163
Chapter 13
Risk Analysis
173
Chapter 14
PrincipalAgent Issues and Managerial Compensation 189
Chapter 15
Adverse Selection
204
Chapter 16
Government and Business
214
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CHAPTER 1
Introduction
Lecture Notes
1. Introduction
Objectives
Provide a guide to making good managerial decisions.
Use formal models to analyze the effects of managerial decisions on
measures of a firms success.
Differs from microeconomics in that the former focuses on description and prediction while managerial economics is prescriptive
Is an integrative course that brings the various functional areas of
business together in a single analytical framework
Exhibits economies of scope by integrating material from other disciplines and thereby reinforcing and enhancing understanding of those
subjects
2. The Theory of the Firm
Managerial Objective
Make choices that will increase the value of the firm.
The value of the firm is defined as the present value of future profits:
pn
p1
p2
Present value of

2
expected future profits
1i
(1 i )
(1 i ) n
n
pt
Present value of

t
t1 (1 i )
n

TR
TC
Present value of
t
t

t

i
(
1
)
t1
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2 | Chapter 1
Notation
pt
Profit in time t total revenue in time t total cost in time t
i
Interest rate
n
Number of time periods
TRt Total revenue in time t
TCt Total cost in time t
Managerial Choices
Influence total revenue by managing demand
Influence total cost by managing production
Influence the relevant interest rate by managing finances and risk
Managerial Constraints
Available technologies
Resource scarcity
Legal or contractual limitations
STRATEGY SESSION:
Bono Sees Red and Corporate Participants See Black
Discussion Questions
1. How can a firm assess the benefits and costs of cause marketing?
2. What other examples of cause marketing can you identify?
3. What Is Profit?
Two Measures of Profit

Accounting profit
* Historical costs
* Legal compliance
* Reporting requirements
Economic profit
* Market value
* Opportunity, or implicit cost
* More useful measure for managerial decision making
4. Reasons for the Existence of Profit
Profit
Measures the quality of managers decision making skills
Encourages good management decisions by linkage with incentives
Sources of Profit
Innovation: Producing products that are better than existing products
in terms of functionality, technology, and style.
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Introduction | 3
Risk taking: Knowing that future outcomes and their likelihoods are
unknown, as are the reactions of rivals.
Exploiting market inefficiencies: Building barriers to entry, employing sophisticated pricing strategies, diversifying, and making good
strategic production decisions
5. Managerial Interests and the PrincipalAgent Problem
PrincipalAgent Problem
The interests of a firms owners and those of its managers may differ,
unless the manager is the owner.
Separation of ownership and control
* The principals are the owners. They want managers to maximize
the value of the firm.
* The agents are the managers. They want more compensation and
less accountability.
* The divergence in goals is the principalagent problem.
Example of moral hazard (Moral hazard is explained in Chapter 14.)
* Moral hazard exists when people behave differently when they are
not subject to the risks associated with their behavior.
* Managers who do not maximize the value of the firm may do so
because they do not suffer as a result of their behavior.
Solutions
* Devise methods that lead to convergence of the interests of the
firms owners and its managers.
* Examples: Stock option plans and bonuses linked to profits.
6. Demand and Supply: A First Look
Market
A group of firms and individuals that interact with each other to buy
or sell a good
Part of an economys infrastructure
A social institution that exists to facilitate economic exchange
Relies on binding, enforceable contracts
STRATEGY SESSION:
Baseball Discovers the Law of Supply and Demand
1. Do you see a relationship between variable pricing of baseball game tickets and odds making on horse races?
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4 | Chapter 1
2. How do you think real-time variable pricing would influence the practice
of ticket scalping?
7. The Demand Side of a Market
Demand Function
Quantity demanded relative to price, holding other possible influences
constant
Negative slope
Period of time
Shifts in demand
Other influences (held constant)
* Income
* Prices of substitutes and complements
* Advertising expenditures
* Product quality
* Government fiat
Total Revenue Function
A firms total revenue (TR) for a given time period is equal to the price
charged (P) times the quantity sold (Q) during that time period.
TR P Q
The demand function reflects the effect of changes in P on quantity
demanded (Q) per time period and, hence, the effect of changes in P
on TR.
8. The Supply Side of a Market
Supply Function
Quantity supplied relative to price, holding other possible influences
constant
Positive slope
Period of time
Shifts in supply
Other influences (held constant)
* Technology
* Cost of production inputs (land, labor, capital)
STRATEGY SESSION:
Demand and SupplyHow High Oil Prices Coax
High-Cost Suppliers into the Market
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1. During 2008, the price of a barrel of crude oil rose to above $130. In the
last quarter of 2008, financial crisis lead to a global economic slowdown.
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Introduction | 5
The price of oil promptly dropped by half. Were these price fluctuations
the result of changes in supply or demand?
2. Given the volatility of crude oil prices, do you think that private investors
will be likely to develop projects to extract oil from oil shale? How do you
think investment in alternative technologies like solar, geothermal, wind,
and biomass are likely to respond to oil price volatility?
3. Government can encourage the development of alternative sources of
energy such as extraction of oil from oil shale by offering incentives such as
tax credits or subsidies or by direct investment. Should it? What are the
pros and cons of government intervention in the development of energy
technologies?
9. Equilibrium Price
Disequilibrium Price
Price is too high.
* Excess supply
* Surplus
* Causes price to fall
Price is too low.
* Excess demand
* Shortage
* Causes price to rise
Equilibrium Price
Quantity demanded is equal to quantity supplied.
Price is stable.
The market is in balance because everyone who wants to purchase the
good can, and every seller who wants to sell the good can.
Actual Price
Invisible hand is the situation when no governmental agency is needed
to induce producers to drop or increase their prices.
If the actual price is above the equilibrium price, there will be a surplus that will put downward pressure on the actual price.
If the actual price is below the equilibrium price, there will be a shortage that will put downward pressure on the actual price.
If the actual price is equal to the equilibrium price, there will be neither a shortage nor a surplus and price will be stable.
10. What If the Demand Curve Shifts?
Increase in Demand
Represented by a rightward or upward shift in the demand curve
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6 | Chapter 1
Result of a change that makes buyers willing to purchase a larger quantity of a good at the current price and/or pay a higher price for the current quantity
Will create a shortage and cause the equilibrium price to increase
Decrease in Demand
Represented by a leftward or downward shift in the demand curve
Result of a change that makes buyers purchase a smaller quantity of a
good at the current price and/or continue to buy the current quantity
only if the price is reduced
Will create a surplus and cause the equilibrium price to decrease
11. What If the Supply Curve Shifts?
Increase in Supply
Represented by a rightward or downward shift in the supply curve
Result of a change that makes sellers willing to offer a larger quantity
of a good at the current price and/or offer the current quantity at a
lower price
Will create a surplus and cause the equilibrium price to decrease
Decrease in Supply
Represented by a leftward or upward shift in the supply curve
Result of a change that makes sellers willing to offer a smaller quantity of a good at the current price and/or offer the current quantity at a
higher price
Will create a shortage and cause the equilibrium price to increase
STRATEGY SESSION:
Life During a Market Movement
1. Several factors are mentioned as contributing to disequilibrium in global
food markets. Among them are emotions (panic), government restrictions
on trade, the Malthusian specter of population growth outpacing food production, slowing productivity growth in the agricultural sector, rising
incomes, and the production of ethanol. Which of these are supply factors,
and which are demand factors? How does each influence market price?
2. The market price for crude oil fluctuated widely during 2008. What supply and demand factors contributed to these fluctuations? Is the petroleum
market subject to any of the same factors cited as influencing agricultural
markets?
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Introduction | 7
Chapter 1: Problem Solutions
1. A book is to be written by Britney Spears. Batman Books agrees to pay Britney $6 million for the rights to this not-yet-written memoir. According to one
leading publisher, Batman Books could earn a profit of roughly $1.2 million
if it sold 625,000 copies in hardcover. On the other hand, if it sold 375,000
copies, managers would lose about $1.3 million. Publishing executives stated
that it was hard to sell more than 500,000 copies of a nonfiction hardcover
book, and very exceptional to sell 1 million copies. Were Batman managers
taking a substantial risk in publishing this book?
Solution:
There was a substantial risk of loss. On the other hand, there was substantial
opportunity for gain. Risk is unavoidable. The appropriate balance between
risk and return is what should determine managers decisions. Successful
decisions in circumstances of risk are a source of profit.
2. Some say that any self-respecting top manager joining a company does so
with a front-end signing bonus. In many cases this bonus is in the seven figures. At the same time the entering manager may be given a bonus guarantee. No matter what happens to firm profit, he or she gets at least a percentage
of that bonus. Do long-term bonus guarantees help to solve the principal
agent problem, or do they exacerbate it? Why?
Solution:
An executive who spends a lifetime working for a single company or in a single industry has a poorly diversified human capital portfolio. Such an executive also often has a significant, undiversified financial investment in the
form of stock options and pension plans that are used in partial substitution
for current salary to align the long-term wealth of the executive with that of
the shareholders. As an executive climbs the corporate ladder, the value
of his or her human capital becomes more closely tied to the fortunes of the
firm and industry. This lack of diversification requires a compensating risk
premium. A large signing bonus may allow a risk-averse executive to make
an investment that increases the value of the firm but that the executive
would otherwise avoid because of concern for his or her own personal wealth;
thus the bonus may reduce the principalagent conflict. Of course, the benefits of reduced risk to the executive come at the potential cost of indifference
to the wealth of the shareholders. Although a large signing bonus may help
solve the incentive alignment problem, compensation that is too great and too
insensitive to the fortunes of the shareholders makes the principalagent problem worse.
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8 | Chapter 1
3. If the interest rate is 10 percent, what is the present value of the Monroe
Corporations profit in the next 10 years?
Number of Years
in the Future
Profit
(millions of dollars)
1
2
3
4
5
6
7
8
9
10
8
10
12
14
15
16
17
15
13
10
Solution:
Number of Years
in the Future
Profit
(1 i)t
1
2
3
4
5
6
7
8
9
10
8
10
12
14
15
16
17
15
13
10
0.90909
0.82645
0.75131
0.68301
0.62092
0.56447
0.51316
0.46651
0.42410
0.38554
Present Value
Total
7.27272
8.26450
9.01572
9.56214
9.31380
9.03152
8.72372
6.99765
5.51330
3.85540
77.55047
The answer is $77.55047 million.

4. Managers at Du Pont de Nemours and Company expect a profit of $2.9 billion in 2008. Does this mean that Du Ponts expected economic profit will
equal $2.9 billion? Why or why not?
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Solution:
Economic profits differ from accounting profits because of differences in
the way depreciation is measured, differences in the way revenues and costs
are recognized in terms of timing, and the inclusion of the opportunity cost
of owner-supplied inputs in the calculation of economic profits. Du Ponts
economic profits might well be negative if accounting profits do not exceed
the risk-adjusted rate of return multiplied by the firms equity value.
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Introduction | 9
5. William Howe must decide whether to start a business renting beach umbrellas at an ocean resort during June, July, and August of next summer. He
believes he can rent each umbrella to vacationers at $5 a day, and he intends to
lease 50 umbrellas for the three-month period for $3,000. To operate this business, he does not have to hire anyone (but himself), and he has no expenses
other than the leasing costs and a fee of $3,000 per month to rent the business
location. Howe is a college student, and if he did not operate this business, he
could earn $4,000 for the three-month period doing construction work.
a. If there are 80 days during the summer when beach umbrellas are
demanded, and Howe rents all 50 of his umbrellas on each of these days,
what will be his accounting profit for the summer?
b. What will be his economic profit for the summer?
Solution:
a. TR (80 days) (50 umbrellas) ($5 per day) $20,000
TC (3 months) ($3,000 per month rent) ($3,000 umbrella lease)
$12,000
Accounting Profit TR TC $8,000
b. Economic profit accounting profit opportunity cost
Economic profit $8,000 $4,000 $4,000
6. On March 3, 2008, a revival of Gypsy, the Stephen Sondheim musical,
opened at the St. James Theater in New York. Ticket prices ranged from
$117 to $42 per seat. The shows weekly gross revenues, operating costs, and
profit were estimated as follows, depending on whether the average ticket
price was $75 or $65:
Gross revenues
Operating costs
Profit
Average Price
of $75
Average Price
of $65
$765,000
600,000
165,000
$680,000
600,000
80,000
a. With a cast of 71 people, a 30-piece orchestra, and more than 500 costumes, Gypsy cost more than $10 million to stage. This investment was in
addition to the operating costs (such as salaries and theater rent). How
many weeks would it take before the investors got their money back,
according to these estimates, if the average price was $65? If it was $75?
b. George Wachtel, director of research for the League of American Theaters and Producers, has said that about one in three shows opening on
Broadway in recent years has at least broken even. Were the investors in
Gypsy taking a substantial risk?
c. According to one Broadway producer, Broadway isnt where you make
the money any more. Its where you establish the project so you can make
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10 | Chapter 1
the money. When you mount a show now, you really have to think about
where its going to play later. If so, should the profit figures here be interpreted with caution?
d. If the investors in this revival of Gypsy make a profit, will this profit be,
at least in part, a reward for bearing risk?
Solution:
a. Given a price of $75, the weekly operating profit of $165,000 would pay
off the $10 million investment in 10,000/165 60.6 or 61 weeks. If the
price is $65, it would take 10,000/80 125 weeks to pay off the investment. This does not provide for any return on investment, however.
b. The investors in Gypsy were indeed taking a substantial risk. If only one
in three shows breaks even, two out of three make losses.
c. The profit figures should be interpreted with caution because they do not
take into account the likelihood of profits when, and if, the show goes on
the road.
d. Yes.
7. If the demand curve for wheat in the United States is
P 12.4 4QD
where P is the farm price of wheat (in dollars per bushel) and QD is the quantity of wheat demanded (in billions of bushels), and the supply curve for wheat
in the United States is
P 2.6 2QS
where QS is the quantity of wheat supplied (in billions of bushels), what is
the equilibrium price of wheat? What is the equilibrium quantity of wheat
sold? Must the actual price equal the equilibrium price? Why or why not?
Solution:
Setting demand equal to supply yields
12.4 4Q 2.6 2Q
Q 15/6 2.5
P 12.4 (4)(2.5) 2.6 (2)(2.5) $2.40
The actual price need not be equal to equilibrium price, although it will generally tend to move toward it because of the equilibrating effects of shortage
and surplus. Factors that might prevent the actual price from equaling the equilibrium price include the cost and availability of information, transportation
costs, and a lack of opportunities for price equalizing arbitrage.
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8. The lumber industry was hit hard by the subprime mortgage turmoil in
2008. Prices plunged from $290 per thousand board feet to less than $200
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Introduction | 11
per thousand board feet. Many observers believed this price decrease was
caused by the slowing of new home construction because of the glut of
unsold homes on the market. Was this price decrease caused by a shift in the
supply or demand curve?
Solution:
Because the demand for lumber is derived in large part from the demand for
new housing construction, a decline in construction would be likely to cause
the demand for lumber to fall, leading to lower lumber prices. Supply would
not be affected by changes in housing construction.
9. From November 2007 to March 2008, the price of gold increased from $865
per pound to over $1,000 per pound. Newspaper articles during this period
said there was little increased demand from the jewelry industry but significantly more demand from investors who were purchasing gold because of
the falling dollar.
a. Was this price increase due to a shift in the demand curve for gold, a shift
in the supply curve for gold, or both?
b. Did this price increase affect the supply curve for gold jewelry? If so,
how?
Solution:
a. A change in the value of the dollar causes the dollar price of globally
traded commodities to change. If the value of the dollar falls, the dollar
price of commodities will rise. In this case, a decline in the value of the
dollar can be expected to cause the market for gold (with price measured
in dollars) to experience an increase in demand and a decrease in supply,
and thus an increase in price. There may also have been an additional
increase in demand due to expectations by investors that the dollar price
of gold would continue to rise. Finally, there may have been a further
supply decrease if producers, speculating that prices would rise further,
withheld gold from the market.
b. Gold is an input to the production of jewelry. An increase in the price of
gold would therefore be expected to reduce the supply of jewelry, resulting in higher jewelry prices.
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CHAPTER 2
Demand Theory
Lecture Notes
1. Introduction
Objectives
Explain the importance of market demand in the determination of
profit.
Understand the many factors that influence demand.
* Elasticity: Measures the percentage change in one factor given a
small (marginal) percentage change in another factor.
* Demand elasticity: Measures the percentage change in quantity
demanded given a small (marginal) percentage change in another
factor that is related to demand.
Explain the role of managers in controlling and predicting market
demand.
* Managers can influence demand by controlling, among other things,
price, advertising, product quality, and distribution strategies.
Managers
cannot control, but need to understand, elements of the
*
competitive environment that influence demand, including the availability of substitute goods, their pricing, and the advertising strategies employed by their sellers.
* Managers cannot control, but need to understand how the macroeconomic environment influences demand, including interest rates,
taxes, and both local and global levels of economic activity.
2. The Market Demand Curve
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Market Demand Schedule

Table showing the total quantity of the good purchased at each price
12
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Demand Theory | 13
Market Demand Curve

Plot of the market demand schedule on a graph.
Price (the x variable) is on the vertical, and quantity demanded (the y
variable) is on the horizontal axis.
Example (Figure 2.1): Demand curve for laptops.
Characteristics of the Market Demand Curve
Quantity demanded is for output of the entire market, not of a single
firm.
For most products and services, the market demand curve slopes downward and to the right.
Quantity demanded is defined with regard to a particular time period.
* Determinants of the position and shape of the market demand
curve.
Consumer tastes
* Example (Figure 2.2): Increase in preference for laptop computers
causes an increase in demand for laptop computers.
Consumer income
* Normal and inferior goods.
* Example (Figure 2.3): Increase in income causes an increase in
demand for laptop computers.
Population size in the market
STRATEGY SESSION:
The Customer Is Always RightWrong!
1. Like retail technology stores, clothing stores have their angels and devils.
How do you think the devils prey on clothing stores, and how could their
behavior be discouraged? How do you think angels could be encouraged
to shop at a par ticular clothing store?
Answer: Devils buy clothes, wear them, and then return them for a refund.
Stores can refuse to provide refunds on returns and, instead, provide a credit
for future purchases or only allow exchanges. Angels buy lots of clothes on
impulse. Stores could offer quantity discounts or a shoppers club with
special notification of sales.
2. Some electronics stores refuse to allow customers to return or exchange
products, instead requiring them to deal directly with the manufacturer.
What are the pros and cons of this approach with regard to the stores
objective of encouraging angels and discouraging devils?
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14 | Chapter 2
3. Industry and Firm Demand Functions
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Market demand function: The relationship between the quantity demanded

and the various factors that influence this quantity
Quantity of X(Q) f (factors)
Factors include
* Price of X
* Incomes of consumers
* Tastes of consumers
* Prices of other goods
* Population
* Advertising expenditures
Example (equation 2.1): Q b1P b2 I b3S b4 A
* Assumes that population is constant and that the demand function
is linear
* P price of laptops
* I per capita disposable income
* S average price of software
* A amount spent on advertising
* b1, b2, b3, and b4 are parameters that are estimated using statistical
methods
Parameters: Constant or variable terms used in the function that helps
managers determine the specific form of the function but not its general nature.
* Example (equation 2.2): Q 700P 200I 500S 0.01A
Relationship between the market demand function and the market
demand curve
* Market demand curve shows the relationship between Q and P
when all other variables are held constant at specific values.
* Market demand function does not explicitly hold any values
constant.
Example (equation 2.3): Q 700P 200(13,000) 500(400)
0.01(50,000,000)
* Example (equation 2.4): Q 2,900,000 700P
* Example: P 4,143 0.001429Q (graphed in Figure 2.4)
Example: Q 700P 200(13,000) 500(200) 0.01(50,000,000)
* Shift in demand due to a change in the average price of software
from 400 to 200
* Example (equation 2.5): Q 3,000,000 700P
* Example (equation 2.6): P 4,286 0.001429P (graphed in Figure 2.4)
The Firms Demand Curve
Negative slope with regard to price
* Slope may not be the same as that of the market demand curve.
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Demand Theory | 15
Represents a portion of market demand

* Market share
* Responds to same market and macroeconomic factors as the market demand curve
Directly related to the prices of substitute goods provided by competitors
* Increase in competitors price will cause a decrease in a firms
demand.
* Decrease in competitors price will cause an increase in a firms
demand.
Inversely related to the prices of substitute goods provided by competitors
* Increase in competitors price will cause a decrease in a firms
demand.
* Decrease in competitors price will cause an increase in a firms
demand.
4. The Own-Price Elasticity of Demand
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Own-price elasticity of demand: More simply referred to as the price elasticity of demand, this is the concept that managers use to measure their
own percentage change in quantity demanded resulting from a 1 percent
change in their own price.
The elasticity of a function is the percentage change in the dependent
( y) variable in response to a 1 percent increase in the independent (x)
variable.
The price elasticity of a demand function is the percentage change in
quantity demanded in response to a 1 percent increase in price.
P Q
h
Q P
Price elasticity generally is different at different prices and on different markets.
Terminology
Price elasticity demand is symbolized by the Greek letter eta (h).
0 h
When
h
1, demand is elastic.
When
h
1, demand is inelastic.
When
h
1, demand is unitary.
When h 0, demand is perfectly inelastic, and the demand curve is
vertical.
* Quantity demanded is the same at all prices.
When h , demand is perfectly elastic, and the demand curve is
horizontal.
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16 | Chapter 2
* Price is the same for all quantities demanded.

* If price rises, quantity demanded falls to zero.
* If price falls, quantity demanded increases without limit.
Linear Demand Curves
The slope of a linear demand curve is constant.
If the demand curve is neither vertical nor horizontal, the price elasticity will differ depending on price.
* At the midpoint of a linear demand curve, h 1, with h approaching zero as price approaches the vertical intercept.
* At prices above the midpoint, demand is elastic, with h approaching negative infinity as price approaches zero.
* At prices below the midpoint, demand is inelastic.
Given a demand curve defined as P a bQ, the price elasticity of
1 a bQ
demand is h =
b Q
5. Point and Arc Elasticities
The point price elasticity formula should be used working with an estimated demand curve or when the change in price is very small.
Q P
h
P Q
Calculated value for small changes will differ depending on whether
P and Q are the starting values or the ending values after the price
change. The change will be small if the change is small.
* Example: P1 99.95, P2 100.00, Q1 20,002, and Q2
20,000
* h [(20002 20000)/(99.95 100)][99.95/20002] 0.1999
* h [(20000 20002)/(100 99.95][100/200000] 0.22
If the price change is large, then the direction of change will influence
the calculated elasticity.
* Example: P1 5, P2 4, Q1 3, and Q2 40
* h [(40 3)/(4 5)][5/3] 61.67
* h [(3 40)/(5 4)][4/40] 3.70
This problem is corrected by using the arc midpoints formula.
The midpoints arc elasticity formula should be used to estimate the price
elasticity of demand from a demand schedule where price differences are
not very small.
Q P1 P2
h
P Q1 Q2
Example: P1 5, P2 4, Q1 3, and Q2 40
h [(40 3)/(4 5)][(5 4)/(3 40)] 7.74
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Demand Theory | 17
6. Using the Demand Function to Calculate the Price Elasticity
of Demand
Given
Q 700P 200I 500S 0.01A
Q quantity demanded of computers
Price P 3,000
Income I 13,000
Software S 400
Advertising A 50,000,000
Derive the demand curve
Q 700P (200)(13000) (500)(400) (0.01)(50000000)
Q 2900000 700P
Determine Q
Q 2900000 (700)(3000) 800000
h (700)(3000/800000) 2.62
For P 2000, Q 2900000 (700)(2000) 1500000,
so h (700)(2000/1500000) 0.93
7. The Effect of Price Elasticity on the Firms Revenue
Derivation of relationship between marginal revenue (TR/Q or dTR/dQ)

and the price elasticity of demand:
TR PQ
dTR/dQ Q(dP/dP) P(dQ/dP)
(1/Q)(dTR/dQ) (dP/dP) (P/Q)(dQ/dP) 1 h
1/Q is positive. Implications:
If h 1, dTR/dQ 0, so total revenue is at a maximum and a change
in P will have no effect on total revenue.
If h 1 (inelastic), dTR/dQ 0, so an increase in P (and consequent decrease in Q) will increase total revenue.
If h 1 (elastic), dTR/dQ 0, so an increase in P (and consequent
decrease in Q) will decrease total revenue.
If the price elasticity is unitary, any price change will cause an equal and
opposite percentage change in quantity. Total revenue will remain constant.
If the price elasticity is in the inelastic range, then a 1 percent change in P
will cause less than a 1 percent change in quantity in the opposite direction. Therefore, total revenue will change in the same direction as price.
If the price elasticity is in the inelastic range, then a 1 percent change in P
will cause more than a 1 percent change in quantity in the opposite direction. Therefore, total revenue will change in the opposite direction from
price.
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18 | Chapter 2
PROBLEM SOLVED:
Price Elasticity of Demand: Philip Morris
1. The decline in total revenue from cigarette sales in 1993 is attributed to
Philip Morriss cut in the price of cigarettes. Are there other factors that
might have contributed to this decline in revenue?
Answer: The price elasticity of demand assumes that all other things
are held constant. Changes in taxes, consumer income, or attitudes toward
tobacco during this period might have reduced demand, while the price
cut increased quantity demanded. If this were the case, then the true price
elasticity would likely be closer to 1.
8. Funding Public Transit
Given
Price (fare) elasticity of demand for public transit in the United States
is about 0.3.
All public transit systems in the United States lose money.
Public transit systems are funded by federal, state, and local governments, all of which have budget issues.
Which transit systems have the most difficult time getting public funding?
Revenue from sales will increase if fares are increased, because demand
is inelastic.
Costs will likely decrease if fares are increased, because quantity
demanded (ridership) will fall.
Managers of public transit will therefore increase fares if they do not
receive enough public funds to balance their budgets.
9. Determinants of the Own-Price Elasticity of Demand
Number and similarity of available substitutes

Product price relative to a consumers total budget
Time period available for adjustment to a price change
10. The Strategic Use of the Price Elasticity of Demand
Example: Strategic pricing of first-class (h 0.45), regular economy

(h 1.30), and excursion (h 1.83) airline tickets between the United
States and Europe
First-class prices should be relatively high because demand is inelastic.
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Demand Theory | 19
Regular economy and excursion prices should be relatively low because

demand is elastic.
Example: Using differentiation strategies to change the price elasticity of
demand for a product
Differentiation strategies convince consumers that a product is unique
and therefore has fewer substitutes.
If consumers perceive that a product has fewer substitutes, then their
price elasticity of demand for the product will decrease (become less
elastic) in absolute value.
Differentiation strategies do not require actual differences in products, only a perceived difference.
STRATEGY SESSION:
Elasticity in Use
1. Suppose that a manufacturer sells a product through an upscale boutique
and, with a different brand name, through a discount retailer. The elasticity of demand at the boutique is 1.2 and at the discount retailer is 2.6.
If the optimal price at the boutique is $85, what price (PD) should be
charged at the discount retailer?
Answer: 85(1 1/1.2) PD (1 1/2.6), so PD $23.02.
2. A consulting firm charges $250 per hour to Fortune 500 companies. The
estimated elasticity of demand for consulting services is 3.1. The firm is
planning to spin off a subsidiary firm that will work with smaller businesses. The estimated elasticity of demand for these firms is 7.3. What
price per hour (PS), to the nearest dollar, should be charged by the
subsidiary?
Answer: 250(1 1/3.1) PS (1 1/7.3), so PS $200.
11. Total Revenue, Marginal Revenue, and Price Elasticity
577-41323_ch01_3P.indd 19
A firms total revenue (TR) is equal to the total amount of money consumers spend on the product in a given time period.
Linear demand curve: P a bQ
Corresponding total revenue curve: TR PQ aQ bQ2
Marginal revenue (MR) is the incremental revenue earned from selling
the nth unit of output.
MR TR/Q (aQ bQ2)/Q a 2bQ
* h (1/b)[(a bQ)/Q]
* If Q a/2b, then h 1.
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20 | Chapter 2
* If Q a/2b, then h is inelastic.
* If Q a/2b, then h is elastic.
M R T R /Q (PQ)/Q P(Q/Q) Q (P/Q)
P[1 (Q/P)(P/Q), so MR P(1 1/h).
*
h
1 (elastic) implies MR 0.
*
h
1 (inelastic) implies MR 0.
*
h
1 (unitary) implies MR 0.
STRATEGY SESSION:
Verizon and the Elasticity of Demand
1. What assumption was Verizon making about the elasticity of demand for
Internet services?
Answer: That it was inelastic
2. What assumption was Verizon making about its marginal revenue from
Internet services?
Answer: That it was negative
12. The Income Elasticity of Demand
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Income elasticity of demand (hI): The percentage change in quantity

demanded (Q) resulting from a 1 percent increase in consumers income (I)
Income can be defined as aggregate consumer income or as per capita
income, depending on circumstances.
Q I
hI
I Q
hI 0 for normal goods
* On average, goods are normal, since increases in aggregate income
are associated with increases in aggregate consumer spending.
hI 0 for inferior goods
* Examples: Hamburgers and public transportation
Strategic management and the income elasticity of demand
The demand for a product that has an income elasticity of demand
that is large in absolute value will vary widely with changes in income
caused by economic growth and recessions.
Managers can lessen the impact of economic changes on such products by limiting fixed costs so that changes in production capacity can
be made quickly.
Managers can forecast demand for products using the income elasticity of demand combined with forecasts of aggregate income.
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Demand Theory | 21
PROBLEM SOLVED:
Income Elasticity of Demand
1. Suppose that a market demand function is defined as Q 20,000 8P
0.1I, where P 2,000 and I 20,000. What is the income elasticity of
demand?
Answer: Q 6,000, so hI 0.1(20000/6000) 1 3
2. If the income elasticity of demand for a product is unitary, then a 1 percent change in income will change demand in the same direction by 1
percent. If price remains constant, then spending on the product will
change by 1 percent, and consequently, spending on the product will be
the same percentage of income after the income change as it was before.
If the income elasticity of demand is greater than 1, then spending will
increase as a percentage of income as income increases. If it is less than 1,
spending will decrease as a percentage of income as income increases.
How do you think the percentage of income spent on jewelry, food, clothing, housing, and automobiles responds to a 1 percent increase in income?
13. Cross-Price Elasticities of Demand
577-41323_ch01_3P.indd 21
Cross-price elasticity of demand (hXY): The percentage change in quantity

demanded of one good (QX) resulting from a 1 percent increase in the price
of a related good (PY)
Income can be defined as aggregate consumer income or as per capita
income, depending on circumstances.
QX PY
h XY
PY QX
hXY 0 if the two products are substitutes.
* Example: Wheat and corn
hXY 0 if the two products are complements.
* Example: Computers and computer software
hXY 0 if the two products are independent
* Example: Butter and airline tickets
Example Calculation
* Given: QX 1,000 0.2PX 0.5PY 0.04I, QX 2,000, and
PY 500
* hXY 0.5(500/2000) 0.125, so the two products are substitutes.
Strategic management and the cross-price elasticity of demand
Managers can use information about the cross-price elasticity of demand
to predict the effect of competitors pricing strategies on the demand for
their product.
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22 | Chapter 2
Antitrust authorities use the cross-price elasticity of demand to determine the likely effect of mergers on the degree of competition in an
industry.
* A high cross-price elasticity, indicating that two goods are strong
substitutes, suggests that a merger would significantly reduce competition in the industry.
A
low cross-price elasticity, indicating that two goods are strong
*
complements, suggests that a merger might give the merged firm
excessive control over the supply chain.
14. The Advertising Elasticity of Demand
Advertising elasticity of demand (hA): The percentage change in quantity

demanded (Q) resulting from a 1 percent increase in advertising expenditure (A).
Q A
hA

A Q
Example Calculation
* Given: Q 500 0.5P 0.01I 0.82A and A/Q 2
* hA 0.82(2) 1.64
15. The Constant-Elasticity and Unitary Demand Function
Constant-elasticity demand function: Mathematical form that always

yields that same elasticity, regardless of the products price and consumers income
Example: Q 200P0.3I 2
Price elasticity of demand 0.3
Income elasticity of demand 2.0
Unitary elastic demand function and total revenue (TR)
TR PQ, so if TR is constant, Q (TR)(P1)
Price elasticity of demand 1
Rectangular hyperbola
Chapter 2: Problem Solutions

1. The Dolan Corporation, a maker of small engines, determines that in 2008
the demand curve for its product is
P 2,000 50Q
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+1
where P is the price (in dollars) of an engine and Q is the number of engines
sold per month.
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Demand Theory | 23
a. To sell 20 engines per month, what price would Dolan have to charge?
b. If managers set a price of $500, how many engines will Dolan sell per
month?
c. What is the price elasticity of demand if price equals $500?
d. At what price, if any, will the demand for Dolans engines be of unitary
elasticity?
Solution:
a. For Q 20, P 2,000 50(20) $1,000
b. For P 500, Q 40 500/50 30
c. h (Q/P)(P/Q) (1/50)(500/30) 13
d. For P $1,000, h (Q/P)(P/Q) (1/50)(1,000/20) 1
2. The Johnson Robot Companys marketing managers estimate that the demand
curve for the companys robots in 2008 is
P 3,000 40Q
where P is the price of a robot and Q is the number sold per month.
a. Derive the marginal revenue curve for the firm.
b. At what prices is the demand for the firms product price elastic?
c. If the firm wants to maximize its dollar sales volume, what price should
it charge?
Solution:
a. MR TR/Q 3,000 80Q
b. P $1,500
c. P $1,500
3. After a careful statistical analysis, the Chidester Company concludes the
demand function for its product is
Q 500 3P 2Pr 0.1I
where Q is the quantity demanded of its product, P is the price of its product, Pr is the price of its rivals product, and I is per capita disposable income
(in dollars). At present, P $10, Pr $20, and I $6,000.
a. What is the price elasticity of demand for the firms product?
b. What is the income elasticity of demand for the firms product?
c. What is the cross-price elasticity of demand between its product and its
rivals product?
d. What is the implicit assumption regarding the population in the market?
Solution:
a. h (Q/P)(P/Q) (3)(10/1,110) 3/111
b. hI (Q/I)(I/Q) (0.1)(6,000/1,110) 60/111
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6/17/09 4:25:30 PM

24 | Chapter 2
c. hcross (Q/Pr)(Pr /Q) (2)(20/1,110) 4/111
d. The calculations assume that the population is constant.
4. The Haas Corporations executive vice president circulates a memo to the
firms top management in which he argues for a reduction in the price of the
firms product. He says such a price cut will increase the firms sales and
profits.
a. The firms marketing manager responds with a memo pointing out that
the price elasticity of demand for the firms product is about 20.5. Why is
this fact relevant?
b. The firms president concurs with the opinion of the executive vice president. Is she correct?
Solution:
a. Whether total revenue will go up or down when the product price is lowered and more units are sold depends on whether the quantity of units
sold increases by a greater percentage than the price is reduced by. That
is, it depends on whether the demand is elastic or inelastic.
b. Assuming that the marketing manager is correct that the demand elasticity is 0.5, than a price reduction will cause the number of units sold to
increase by a smaller percentage than the price has fallen, and both the
president and executive vice president will have egg on their faces when
total revenues decline after the price is reduced.
5. Managers of the Hanover Manufacturing Company believe the demand curve
for its product is
P5Q
where P is the price of its product (in dollars), and Q is the number of millions of units of its product sold per day. It is currently charging $1 per unit
for its product.
a. Evaluate the wisdom of the firms pricing policy.
b. A marketing specialist says that the price elasticity of demand for the
firms product is 1.0. Is this correct?
Solution:
a. At P 1, MR 3. The price is too low; increasing the price and selling fewer units would increase revenues.
b. No. While Q/P 1, (Q/P)(P/Q) 1/4 at P 1.
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6. On the basis of historical data, Richard Tennant has concluded, The consumption of cigarettes is . . . [relatively] insensitive to changes in price. . . .
In contrast, the demand for individual brands is highly elastic in its response
to price. . . . In 1918, for example, Lucky Strike was sold for a short time at
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Demand Theory | 25
a higher retail price than Camel or Chesterfield and rapidly lost half its
business.
a. Explain why the demand for a par ticular brand is more elastic than the
demand for all cigarettes. If Lucky Strike raised its price by 1 percent in
1918, was the price elasticity of demand for its product greater than 2?
b. Do you think that the demand curve for cigarettes is the same now as it
was in 1918? If not, describe in detail the factors that have shifted the
demand curve and whether each has shifted it to the left or right.
Solution:
a. As we define a product more narrowly, consumers have better substitutes
(whose prices are held constant) as the price of the good under consideration varies. This makes the demand for a good more elastic the more
narrowly the good is defined. We are not told how much Lucky Strike was
priced above Camel and Chesterfield, but assuming that the margin was less
than 25 percent, we can conclude that the cross-price elasticity was greater
than 2. This isnt exactly right; we must also assume that Lucky Strikes
fall in sales resulted from a reduction in the price of Camels and Chesterfields for the cross-price elasticities as explained to students.
b. Population, per capita income, and subsidized health care have all
increased; this probably caused the demand curve for cigarettes to shift
out, or to the right. Public health education and general education have
increased; this probably shifted the demand curve in, or to the left.
7. According to S. Sackrin of the U.S. Department of Agriculture, the price
elasticity of demand for cigarettes is between 0.3 and 0.4, and the income
elasticity of demand is about 0.5.
a. Suppose the federal government, influenced by findings that link cigarettes
and cancer, were to impose a tax on cigarettes that increased their price by
15 percent. What effect would this have on cigarette consumption?
b. Suppose a brokerage house advised you to buy cigarette stocks because if
incomes were to rise by 50 percent in the next decade, cigarette sales
would be bound to spurt enormously. What would be your reaction to
this advice?
Solution:
a. Cigarette consumption would fall by between 4.5 and 6.0 percent.
b. Assuming that the prices of cigarettes were to remain constant, a 50 percent increase in income would cause sales of cigarettes to increase 25
percent. The weighted average of all income elasticities equals 1, so consumption of noncigarette items would increase by more than 50 percent
and certainly more than the 25 percent performance of cigarettes. I would
not follow the brokers advice.
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26 | Chapter 2
8. Using the PIMS (Profit Impact of Market Strategies) survey of major U.S.
firms, Michael Hagerty, James Carman, and Gary Russell estimated that, on
average, the advertising elasticity of demand was only about 0.003. Doesnt
this indicate that firms spend too much on advertising?
Solution:
No. The fact that the elasticity of demand with respect to advertising is relatively small (0.003) does not necessarily mean that an additional dollar
spent on advertising would not be profitable or that the last dollar spent was
not profitable.
9. The McCauley Company hires a marketing consultant to estimate the
demand function for its product. The consultant concludes that this demand
function is
Q 100P3.1I 2.3A0.1
where Q is the quantity demanded per capita per month, P is the products
price (in dollars), I is per capita disposable income (in dollars), and A is the
firms advertising expenditures (in thousands of dollars).
a. What is the price elasticity of demand?
b. Will price increases result in increases or decreases in the amount spent
on McCauleys product?
c. What is the income elasticity of demand?
d. What is the advertising elasticity of demand?
e. If the population in the market increases by 10 percent, what is the effect
on the quantity demanded if P, I, and A are held constant?
Solution:
a. The price elasticity of demand is 3.1.
b. An increase in price will cause revenues to fall because the demand is
elastic.
c. The income elasticity of demand is 2.3.
d. The advertising elasticity of demand is 0.1.
e. If P, I, and A are held constant, per capita consumption is constant. Therefore, a 10 percent increase in population gives rise to a 10 percent increase
in the quantity demanded.
10. The Schmidt Corporation estimates that its demand function is
Q 400 3P 4I 0.6A
-1
0
+1
where Q is the quantity demanded per month, P is the products price (in
dollars), I is per capita disposable income (in thousands of dollars), and A is
the firms advertising expenditures (in thousands of dollars per month).
Population is assumed to be constant.
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Demand Theory | 27
a. During the next decade, per capita disposable income is expected to
increase by $5,000. What effect will this have on the firms sales?
b. If Schmidt wants to raise its price enough to offset the effect of the
increase in per capita disposable income, by how much must it raise its
price?
c. If Schmidt raises its price by this amount, will it increase or decrease the
price elasticity of demand? Explain. Make sure your answers reflect the
fact that elasticity is a negative number.
Solution:
a. Sales will increase by 20 units per month.
b. Price must be increased by $6.67 per unit.
c. Two possible interpretations, both lead to more elastic demand. You
could assume that the question is asking if demand is more elastic after
both the income and price have increased. Since Q/P is unchanged
and P/Q has increased, the demand will be more elastic. Alternatively,
you might assume that the question is asking, as we increase the price to
choke off the anticipated increase in the quantity demanded after income
has gone up, does the demand become more or less elastic? This is, of
course, just moving up a linear demand curve, which implies an increasingly elastic demand.
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6/17/09 4:25:30 PM

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W W NORTON & COMPANY NEW YORK LONDON

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Consumer Behavior and Rational Choice

The Analysis of Costs

Monopoly and Monopolistic Competition

Managerial Use of Price Discrimination

Bundling and Intrafirm Pricing

PrincipalAgent Issues and Managerial Compensation 189

Government and Business

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2. The Theory of the Firm

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Two Measures of Profit

4. Reasons for the Existence of Profit

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6. Demand and Supply: A First Look

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8. The Supply Side of a Market

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10. What If the Demand Curve Shifts?

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11. What If the Supply Curve Shifts?

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The answer is $77.55047 million.

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2. The Market Demand Curve

Market Demand Schedule

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Market Demand Curve

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Market demand function: The relationship between the quantity demanded

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Represents a portion of market demand

4. The Own-Price Elasticity of Demand

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* Price is the same for all quantities demanded.

5. Point and Arc Elasticities

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7. The Effect of Price Elasticity on the Firms Revenue

Derivation of relationship between marginal revenue (TR/Q or dTR/dQ)

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9. Determinants of the Own-Price Elasticity of Demand

Number and similarity of available substitutes

10. The Strategic Use of the Price Elasticity of Demand

Example: Strategic pricing of first-class (h 0.45), regular economy

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Regular economy and excursion prices should be relatively low because

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Income elasticity of demand (hI): The percentage change in quantity

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Derivation of relationship between marginal revenue (TR/Q or dTR/dQ)

Example: Strategic pricing of first-class (h 0.45), regular economy