Instructor's Manual to Accompany

MANAGERIAL
ECONOMICS
IN A GLOBAL
ECONOMY
EIGHTH EDITION

DOMINICK SALVATORE
Professor of Economics and Business
Fordham University, New York

Oxford University Press

 PREFACE

The purpose of this manual is to facilitate the use of the text by the instructor. It contains the detailed
outline of each chapter and the answers to all the end-of-chapter discussion questions and problems.

The discussion questions at the end of each chapter of the text involve, for the most part, simple
applications or recall of what is clearly explained in the text. Their function is to emphasize those
concepts, theories, and tools that the student needs to learn and remember. I would encourage
students to go over them on their own and check the answers in the text. I would assign the non-
asterisked problems at the end of each chapter of the text to be done at home. These problems are
challenging but not tricky or very time consuming. They are intended to enlist the active
participation of students so as to make managerial economics truly come alive. The student can
solve the asterisked problems and check their answers at the end of the book.

The following ancillaries are available for this text (see the Preface to the text for the details of their
content:
Study Guide
Computerized Test Bank
Downloadable Power Point
Analytical Business Calculator (ABC)

I thank you for adopting this text and welcome any comment, suggestion, or opinion that you may
have on the use of the text. You can correspond directly with me or through Oxford University
Press, and I will personally acknowledge your letter and answer your questions.

D. S.

ii
 CONTENTS

PART ONE: INTRODUCTION

Ch. 1 The Nature and Scope of Managerial Economics 1

Ch. 2 The Basic Economic Model: Demand, Supply, and Equilibrium 12

Ch. 3 Optimization Techniques and New Management Tools 29

PART TWO: DEMAND ANALYSIS

Ch. 4 Demand Theory 54

Ch. 5 Demand Estimation 76

Ch. 6 Demand Forecasting 97

PART THREE: PRODUCTION AND COST ANALYSIS

Ch. 7 Production Theory and Estimation 122

Ch. 8 Cost Theory and Estimation 148

PART FOUR: MARKET STRUCTURE AND PRICING PRACTICES

Ch. 9 Market Structure: Perfect Competition, Monopoly, and Monopolistic Competition 173

Ch. 10 Oligopoly and Firm Architecture 194

Ch. 11 Game Theory and Strategic Behavior 215

Ch. 12 Pricing Practices 225

PART FIVE: REGULATION, RISK ANALYSIS, AND CAPITAL BUDGETING

Ch. 13 Regulation and Antitrust: The Role of Government in the Economy 252

Ch. 14 Risk Analysis 268

Ch. 15 Long-Run Investment Decisions: Capital Budgeting 294

iii
 CHAPTER 1

THE NATURE AND SCOPE OF MANAGERIAL ECONOMICS

1-1 THE SCOPE OF MANAGERIAL ECONOMICS

Definition of Managerial Economics
Relationship to Economic Theory
Relationship to Decision Sciences
Relationship to the Functional Areas of Business Administration Studies

1-2 THE BASIC PROCESS OF DECISION-MAKING

Case Study 1-1: Peter Drucker – The Man Who Invented Management
Case Study 1-2: The Management Revolution

1-3 THE THEORY OF THE FIRM

Reasons for the Existence of Firms and Their Functions
The Objective and Value of the Firm
Constraints on the Operation of the Firm
Limitations of the Theory of the Firm
Box 1 – Managerial Economics at Work: The Objective and Strategy of Firms in the
Cigarette Industry

1-4 THE NATURE AND FUNCTION OF PROFITS

Business versus Economic Profit
Theories of Profit
Function of Profit
Case Study 1-3: Profits in the Personal Computer Industry

1-5 BUSINESS ETHICS

Case Study 1-4: Business Ethics at Boeing
Case Study 1-5: Enron-Andersen and Other Financial Disasters
Case Study 1-6: The Global Financial Crisis

1-6 THE INTERNATIONAL FRAMEWORK OF MANAGERIAL ECONOMICS

Case Study 1-7: The Rise of the Global Corporation
Case Study 1-8: The Global Business Leader
Case Study 1-9: Global Most Admired Companies

1-7 MANAGERIAL ECONOMICS IN A MORE RISKY, CRISIS-PRONE, AND

SLUGGISH GLOBAL ECONOMY
Case Study 1-10: Terrorism, Cyber Espionage, Financial Crisis, and Globalization

1
PART ONE INTRODUCTION

1-8 MANAGERIAL ECONOMICS AND THE INTERNET

Case Study 1-11: The Most Important Internet Site Addresses for Managerial Economics

SUMMARY
DISCUSSION QUESTIONS
PROBLEMS
APPENDIX TO CHAPTER 1: SOLVING MANAGERIAL DECISION PROBLEMS USING
SPREADSHEETS
Microsoft Excel
Example
Solution
SPREADSHEET PROBLEM
SUPPLEMENTARY READINGS
KEY TERMS (in the order of their appearance)
______________________________________________________________________

Managerial economics Value of the firm

Economic theory Constrained optimization
Microeconomics Principal-agent problem
Macroeconomics Satisficing behavior
Model Business profit
Mathematical economics Explicit costs
Econometrics Economic profit
Functional areas of business Implicit costs
administration studies Business ethics
Firm Sarbanes-Oxley Act
Transaction costs Globalization of economic activity
Circular flow of economic activity Internet
Theory of the firm Information superhighway

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 CHAPTER 1 THE NATURE AND SCOPE OF MANAGERIAL ECONOMICS

ANSWERS TO DISCUSSION QUESTIONS

1. (a) Microeconomics and macroeconomics provide the theoretical framework for the study
of the decision-making process in any organization, which is the subject matter of
managerial economics.

(b) Mathematical economics is used in managerial economics to formalize (i.e., to express

in equational form) the economic models postulated by economic theory. On the other
hand, econometrics is used to estimate and test empirically economic relationships and
models.

(c) The fields of accounting, finance, marketing, personnel, and production are the
functional areas of business administration studies. These study the business
environment in which the firm operates, and, as such, they provide the background for
managerial decision-making.

2. Managerial economics utilizes the theoretical tools of microeconomics and macroeconomics,

the mathematical and econometric techniques of decision sciences, as well as knowledge of
accounting, finance, marketing, personnel, and production (the functional areas of business
administration studies) to examine how any organization can achieve its objectives most
efficiently. To that extent, managerial economics integrates all of those fields and illustrates to
the student the relationship among the various fields and how they interact in the decision-
making process.

3. In his Essays in Positive Economics, Milton Friedman (a Nobel Prize winner in economics)
postulated that a theory must be tested by its predictive ability and not by the realism of its
assumptions. The accepted methodology of economics (and science in general) today is to
accept a theory or model if it predicts accurately and if the prediction follows logically from
the assumptions.

4. The objective of a museum might be to maximize the number of visitors or the size of its
artwork collection, subject to its physical and financial limitations or constraints. On the other
hand, a firm might seek to maximize profits subject to the resource, legal, environmental, and
other constraints it faces. While the goals and constraints of a museum and a firm differ, the
decision-making process is basically the same. That is, both seek to maximize an objective in
the face of some constraints, in the same general way and by utilizing the same general
techniques.

5. Firms exist because of the economies that arise from the organization of production and
distribution that they make possible (i.e., to save on transaction costs). A great deal of
production and distribution would be too costly and, therefore, impossible without firms. Both
entrepreneurs and other resource owners benefit from the existence of firms. Entrepreneurs can
earn profits or higher profits, and workers and owners of capital, land, and raw materials
receive a higher income or price for the rental or sale of their resources.

3
PART ONE INTRODUCTION

6. The theory of the firm postulates that the primary goal of the firm is to maximize the wealth or
value of the firm. This is given by the present value of all expected future profits of the firm.
By introducing the time dimension, the theory of the firm is superior to the goal of short-term
profit maximization because it considers both short-term and long-term profits and also allows
for the consideration of uncertainty.

7. The theory of the firm postulates that the primary goal of the firm is to maximize the present
value of all expected future profits of the firm. Profits are the difference between revenues and
costs, and the time element is introduced by the discount rate. Revenues and sales are the
primary responsibility of the marketing department, costs are the responsibility of the
production and personnel departments, and financing is dealt with primarily by the finance
department. The accounting department, of course, deals with revenues, costs and financing
also.
There are many interactions among these departments and these also can be best evaluated
within the framework of the formula for the value of the firm. Thus, the theory of the firm
provides an integrated framework for the analysis of managerial decision making across the
functional areas of business.

8. (a) The increase in sales increases the value of the firm (see Equation 1-2A).

(b) The entrance of a new competitor in the market may reduce the sales of the firm,
thereby reducing the value of the firm.

(c) By reducing costs of production, a technological breakthrough increases the value of

the firm.

(d) The requirement to install pollution-control equipment increases the costs of the firm
and reduces its profitability and value.

(e) To the extent that a labor union is able to increase wages over and above what they
would be in the absence of the union, the labor costs of the firm rise and the
profitability and value of the firm declines.

(f) A rise in the interest rate increases the cost of capital. The firm will then require a
greater return on investment (a higher discount rate). This lowers the value of the
firm.

(g) A change in the rate of inflation will affect the revenues of the firm, its costs, and the
discount rate and, through them, the value of the firm.

9. The normal return on investment is included as part of profit by businessmen and accountants
but as part of costs (the implicit costs) by economists. Thus, business profit minus the normal
return on investment or implicit costs equals economic profit. It is economic profit that is
important in allocating society’s scarce resources among competing uses.

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 CHAPTER 1 THE NATURE AND SCOPE OF MANAGERIAL ECONOMICS

10. In determining whether profit levels are excessive in a particular industry we must consider the
level of risk in the industry, whether the industry is or is not in long-run equilibrium, the
existence of monopoly power in the industry, the rate at which new innovations are introduced,
and managerial efficiency.
Higher than average profits for the industry need not reflect excessive profits if they reflect
higher risk, long-term disequilibrium, the introduction of more significant innovations, or
managerial inefficiency. A more risky industry requires higher-than-average profits to attract
and retain investments in the industry. Higher-than-average short-term profits may be required
to attract more resources into the industry. They may also be the reward for successful
innovations and greater managerial efficiency. Profits are excessive only to the extent that they
are not required to perform the allocative function that profits are expected to perform in a
free-enterprise economy.

11. Unethical business behavior is behavior that the firm does not allow its personnel (managers
and workers) to engage in, even though such behavior may not be unlawful. Unlawful
behavior, on the other hand, is behavior that is not allowed by law and which would be
punished under the legal system if engaged in. Thus, ethics is a source of guidance beyond
enforceable law. Being based on values, however, it is often not clear what ethical behavior is
and what it is not since different people may have different values. An ethic officer helps to
draw up the company’s ethical code and is responsible for seeing it enforced.

12. The government often allows only one telephone and electric power company in each area to
allow economies of large scale in production and lower costs per unit. But then it regulates
these companies to allow just enough (i.e., normal) return on investment to attract and retain
investments in the industry. Regulation is required to prevent these companies from using the
monopoly power conferred on them by the government to charge higher prices to consumers
and earn above normal return on investment (i.e., economic profits).

13. It is important to introduce an international dimension into the study of managerial economics
because many of the commodities that we consume today are imported, and American firms
purchase many inputs abroad, sell an increasing share of their output to other nations, and face
increasing competition from foreign firms operating in the United States. International flows of
capital, technology, and skilled labor have also reached unprecedented dimensions.

14. The danger and fear of terrorism increases the cost of doing business in order to pay for the
cost of security measures. It also increases insurance costs. In addition, it may restrict some
international trade and financial dealings with some countries and some foreign firms, and it
makes it more difficult and costly for a firm to hire foreign workers on temporary work visas.

15. The Internet is extremely useful for the study of managerial economics because it can be used
to provide a wealth of macro and micro information.

5
PART ONE INTRODUCTION

ANSWERS TO PROBLEMS

1. At r = 5%, PV = $100 = $100 = $95.24

(1 + 0.5)1 1.05

At r = 8%, PV = $100 = $92.59

1.08

At r = 10%, PV = $100 = $90.91

1.10

At r = 15%, PV = $100 = $86.96

1.15

At r = 20%, PV = $100 = $83.33

1.20

At r = 25%, PV = $100 = $80.00

1.25

2. At r = 5%, PV = $100 = $100 = $100 = $90.70

(1 + 0.5)2 (1.05)2 1.1025

At r = 8%, PV = $100 = $100 = $85.73

(1.08)2 1.1664

At r = 10%, PV = $100 = $100 = $82.64

(1.10)2 1.21

At r = 15%, PV = $100 = $100 = $75.61

(1.15)2 1.3225

At r = 20%, PV = $100 = $100 = $69.44

(1.20)2 1.44

At r = 25fs%, PV = $100 = $100 = $64

(1.25)2 1.5625

6
 CHAPTER 1 THE NATURE AND SCOPE OF MANAGERIAL ECONOMICS

3. PV = $100 + $100 + $800

(1.15)1 (1.15)2 (1.15)2

= $100 + $100 + $800

1.15 1.3225 1.3225

= $86.96 + $75.61 + $604.91

= $767.48

4. At r = 15%, $120 = $104.35

1.15

At r = 20%, $120 = $100.00

1.20

At r = 25%, $120 = $96.00

1.25

At r = 20%, the firm is indifferent between undertaking the advertising campaign

or not because the present value of the return equals the cost. The firm should
undertake the campaign if its rate of discount (r) is lower than 20%, and it should
not if its rate of discount is higher than 20%.

5. Project 1: PV = $100,000 + $100,000 + $100,000 + $100,000

1.10 (1.10)2 (1.10)3 (1.10)4

= $100,000 + $100,000 + $100,000 + $100,000

1.10 1.21 1.331 1.4641

= $316,986.55

Project 2: PV = $75,000 + $75,000 + $75,000 + $75,000

1.10 (1.10)2 (1.10)3 (1.10)4

+ $75,000 + $75,000
(1.10)5 (1.10)6

= $326,644.55

The manager should choose project 2.

7
PART ONE INTRODUCTION

6. Project 1: PV = $100,000 + $100,000 + $100,000 + $100,000

1.20 (1.20)2 (1.20)3 (1.20)4

= $258,873.45

Project 2: PV = $249,413.26

Thus, with a discount rate of 20%, the firm should choose project 1.

7. The present value of two investment projects depends on the timing of the receipts and on the
discount rate. At the discount rate of 10%, project 2 has a higher present value. At the
discount rate of 20%, project 1 has a higher present value.
Thus, the decrease in the present value with a higher discount rate is greater for project 2 than
for project 1 because the expected profits from project 2 arise over a longer period of time
than for project 1. That is, the decrease in present value arising from the longer period of time
over which the profits are generated by project 2 is magnified by increasing the discount rate.

8. The explicit costs are $6,000 for tuition, plus $2,000 for the room, plus $1,500 for meals, plus
$500 for books and supplies, for a total of $10,000 per year. The implicit costs are given by
the sum of $15,000 which the student could have earned by getting a job instead of going to
college and the $1,000 of interest foregone on the $10,000 of expenses for one year, for a total
of $16,000.
The total economic cost of attending college for a year by this student equals the sum of its
explicit costs of $10,000 and the implicit costs of $16,000, or $26,000.

9. (a) The explicit costs are $81,000.

(b) The implicit costs are equal to $25,000 (i.e., the entrepreneur’s foregone salary).

(c) The business profit equals total revenue minus the explicit costs, or $120,000 -
$81,000 = $39,000.

(d) The economic profit equals total revenues minus the explicit and implicit costs, or
$120,000 - $106,000 = $14,000.

(e) The normal return on investment equals the implicit costs of the entrepreneur (i.e., her
salary foregone) of $25,000.

8
 CHAPTER 1 THE NATURE AND SCOPE OF MANAGERIAL ECONOMICS

10. The statement is generally true. In the course of seeking to maximize profits or the value of the
firm, business supplies the goods and services that society wants the most, provides
employment, and pays taxes. Trying to superimpose on business additional explicit social
responsibility goals on top of profit maximization will interfere with the allocative efficiency
of the free-enterprise system.
It is true that society often wants to modify the operation of the economic system so as to
achieve some explicit social goal (such as reducing the overall level of unemployment, hiring
the handicapped, controlling pollution, etc.). But this can best be achieved through government
regulations and incentives. Business can best contribute to the welfare of society if it is left to
do what it does best—that is, to maximize profits.
As Adam Smith pointed out more than two centuries ago with his celebrated discussion of the
invisible hand, when each individual (and manager) is left to pursue his own selfish aims, he
also, and at the same time, promotes the welfare of society much more than he believes he
does.

11. In attending college the student incurs explicit and implicit costs. The explicit costs include
tuition and the expenditures for room, meals, and books and supplies. The implicit costs
include the salary foregone by attending college rather than getting a job, plus the interest
foregone on the explicit costs for one-half a year (on the assumption that the explicit
expenditures for each semester are incurred at the beginning of the semester).
Aside from the psychic benefit of attending college, a college education will also result in a
larger expected future stream of income over the working life of the college graduate.
Thus, the decision to attend college can be evaluated as any other investment decision, in terms
of its benefits and costs. Using this method it was estimated that the return to a college
education was about 10 percent to 15 percent per year during the 1950s and 1960s.
Since the early 1970s and as a result of sharp increases in tuition and relatively lower starting
salaries, the return to a college education declined to about 7 to 8 percent per year. This is
lower than on similarly risky investments. It must be pointed out, however, that part of what
was considered the cost of attending college may in fact be regarded as consumption. When
this is considered, the return on attending college may still be higher than on similarly risky
ventures.

12. Computer firms remain in the industry even in the face of declining profits because they hope
that they can make more profits in the future (as Dell has done in previous years) and the
computer industry is the industry they know best. Over the years many computer companies
have, indeed exited the industry or have discontinued making some computers (such as IBM
dropping desktop computers in 2001).

13. See: http://www.fortune.com/companies, at the beginning of 2006 and 2007. The vast majority
of the most admired global companies are likely to be American (as in previous years).

9
PART ONE INTRODUCTION

14. See the website for this text for Chapter 1.

15. (a) The business profit resulting from purchasing the pharmacy equals $200,000 in revenue
minus the explicit costs of $80,000 for supplies, $40,000 for hired help, $10,000 for rent,
$5,000 for utilities, and $8,000 for the interest on the bank loan of $80,000 at the rate of
interest of 10 percent per year.
Thus, the business profit is $200,000 - $143,000 = $57,000.
The economic profit equals the revenue of $200,000 minus the explicit costs of $143,000
and the implicit costs of $40,000 (Semantha’s opportunity costs of managing another
pharmacy) and $2,000 (the opportunity cost of using $20,000 of her own funds in the
business). Thus, the economic profit is $15,000 and Semantha should purchase the
pharmacy.

(b) For the economic profit to be zero, the revenue of the pharmacy would have to be
$185,000 in four years. Then, revenue equals the total of explicit and implicit costs, and
(economic) profit would be zero.

(c) The economic profit earned during the first three years of operation can be explained by
the frictional theory of profit.

(d) Semantha should still purchase the pharmacy if the present value of the pharmacy
exceeds zero at the discount rate of 15 percent. The present value of the pharmacy is
calculated by considering the economic profit of $15,000 in each of the three years and the
loss of $50,000 on the sale of the pharmacy at the end of the third year.

PV = $15,000 + $15,000 + $15,000 - $50,000

1.15 (1.15)2 (1.15)3 (1.15)3

= $13,043.48 + $11,342.16 + $9,862.74 - $32,875.81

= $1,372.57

Since the present value of the pharmacy exceeds zero, Semantha should still purchase the
pharmacy.

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 CHAPTER 1 THE NATURE AND SCOPE OF MANAGERIAL ECONOMICS

ANSWER TO APPENDIX SPREASHEET PROBLEM

(a) For a line graph in Excel, first highlight columns B and C together including the column
headings. Then choose Insert-Line, and select the first picture in the menu that appears. A
graph will appear that looks like the following (the top line referring to age and the lower line
to time:

(b) For part b, the process is the same as the first problem.
All the calculations can be performed through Excel functions.

(c) For part C, use the covar function. In a cell, type “=covar(“. Once you type this, Excel will
prompt you to highlight the first column of data. Move your mouse to highlight only the data
in column B, then type a comma. Finally, highlight the data in column C and press “Enter.”
You should get a value of -2.356. The covariance is negative, so it indicates that as the time
to finish goes down, the age goes up.

11
 CHAPTER 2

THE BASIC ECONOMIC MODEL: DEMAND, SUPPLY, AND EQUILIBRIUM

2-1 Market Analysis

2-2 Market Demand

Demand Schedule and Demand Curve
Changes in Demand

2-3 Market Supply

Supply Schedule and Supply Curve
Changes in Supply

2-4 When Is a Market in Equilibrium?

Case Study 2-1: Equilibrium Price by Auction

2-5 Adjustment to Changes in Demand and Supply: Comparative Static Analysis

Adjustment to Changes in Demand
Adjustment to Changes in Supply
Case Study 2-2: Changes in Demand and Supply and Coffee Prices

2-6 Domestic Demand and Supply, Imports, and Prices

Case Study 2-3: The Large US Automotive Trade Deficit Keeps US Auto Prices Down

2-7 Interfering With Versus Working Through the Market

Case Study 2-4: Rent Control—The Best Way to Destroy New York City!
Case Study 2-5: Is the US Farm Support Program on the Way Out?
Case Study 2-6: Working Through the Market with an Excise Tax
Case Study 2-7: Fighting the Drug War by Reducing Demand and Supply
Box 2 – Managerial Economics at Work: Nonclearing Financial and Other Markets

SUMMARY
DISCUSSION QUESTIONS
PROBLEMS
SPREADSHEET PROBLEMS

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 CHAPTER 2 THE BASIC ECONOMIC MODEL: DEMAND, SUPPLY, AND EQUILIBRIUM

APPENDIX TO CHAPTER 2: THE ALGEBRA OF DEMAND, SUPPLY AND

EQUILIBRIUM
Marker Equilibrium Algebraically
Shifts in Demand and Supply, and Equilibrium
The Effect of an Excise Tax
APPENDIX PROBLEMS
SUPPLEMTARY READINGS
INTERNET SITE ADDRESSES
KEY TERMS (in the order of their appearance)
______________________________________________________________________

Market Auction
Perfectly competitive market Comparative static analysis
Market demand schedule Excess demand
Law of demand Excess supply
Market demand curve Price ceiling
Market supply schedule Price floor
Market supply curve Excise tax
Equilibrium price Incidence of a tax
Surplus Import tariff
Shortage Nonclearing market

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PART ONE INTRODUCTION

ANSWERS TO DISCUSSION QUESTIONS

1. The demand for a commodity increases (i.e., shifts to the right) with an increase in consumers’
incomes, with an increase in the price of substitute commodities, and with an increase in the
number of consumers in the market. An increase in the price of complementary commodities
will reduce the demand for the commodity.

2. A fall in the price of a commodity, holding everything else constant, results and is referred to
as an increase in the quantity demanded.

3. When an individual’s income rises, while holding everything else the same, that person’s
demand for a normal good increases or shifts to the right, so that the individual will demand
more of the good at each price of the good.

4. If the supply curve is positively sloped, a rise in the price of the commodity leads to an
increase in the quantity of the commodity.

5. (a) An improvement in technology shifts the supply curve to the right.

(b) An increase in input prices shifts the supply curve to the left.

(c) If both occur, the supply curve will shift to the right or to the left depending on the
relative strength of the two opposing forces.

6. At Q=4, the price of $1.50 that consumers are willing to pay for the commodity (point C on the
D curve) exceeds the price of $0.75 that producers require to supply 4 units of the commodity
(point N on the S curve). As a result, producers will expand output to the equilibrium level of
Q=6 (point E on the D and S curves), which is exactly equal to the quantity of the commodity
that consumers are willing to purchase at P=$1.00.

7. At Q=8, the price of $1.25 that producers require to supply 8 units of the commodity (point K
on the S curve) exceeds the price of $0.50 that consumers are willing to pay for the commodity
(point G on the D curve). As a result, producers will reduce output to the equilibrium level of
Q=6 (point E on the D and S curves), which is exactly equal to the quantity of the commodity
that consumers are willing to purchase at P=$1.00.

8. An increase in both demand and supply leads to an increase in quantity, but the price can rise,
fall, or remain unchanged depending on the size of the relative shift in the demand and supply
curves.

9. At PT=$1.50, the United States would want to import 450 million yards of textiles, while the
rest of the world would like to export 150 million yards (see Panel B of Figure 2-9). Thus, the
price of textiles increases. As it does, quantity of textile imports demanded by the United States
decreases while the quantity of textile exports supplied by the rest of the world increases until
the equilibrium price of $2 is reached at which QD= QS.

14
 CHAPTER 2 THE BASIC ECONOMIC MODEL: DEMAND, SUPPLY, AND EQUILIBRIUM

10. The price of textiles in the United States will exceed the price of textiles abroad by the cost of
transportation of $1 per yard. A smaller quantity of textiles will then be traded.

11. Even though trade restrictions lead to higher consumer prices, governments usually impose
trade restrictions to protect domestic jobs in sectors in which the country is less efficient than
foreign producers.

12. (a) A price ceiling is effective only if it is below the equilibrium price. On the other hand, a
price floor is effective only if it is above the equilibrium price.

(b) Rent control is an example of an effective price ceiling. Rent control laws resulted in a
shortage of apartments and many other distortions in the housing market.

13. (a) One example of an effective price floor was the price support program in US
agriculture. It resulted in huge farm surpluses and other distortions in US agriculture. The
same is true For most other advanced nations.

14. It does not make any difference whether the tax is collected from buyers or sellers. The net
after-tax price paid by buyers and the net after-tax price received by sellers are the same in either case.

15. The size of a prohibitive tariff in Figure 2-9 (in the absence of transportation costs) is $2 per
year of textile imported. The reason is that the tariff of $2 per yard of imported textile makes
the price of a year imported textile equal to the pretrade price of textiles in the United States, so
that there is no reason to import foreign textiles (assuming that they are not of better quality).

ANSWERS TO PROBLEMS

1. By substituting P=$6 into the demand equation or function, we get:

QD = 60 - 10(6) = 0.

By substituting P=$5 into the demand equation, we get:

QD = 60 - 10(5) = 10.

If P=$4, QD = 60 - 10(4) = 20.

If P=$3, QD = 60 - 10(3) = 30.
If P=$2, QD = 60 - 10(2) = 40.

If P=$1, QD = 60 - 10(1) = 50.

If P=$0, QD = 60 - 10(0) = 60.

The above values for the quantity demanded are those given by the demand schedule.

15
PART ONE INTRODUCTION

2.

P($) 8 7 6 5 4 3 2 1 0
QD’ 0 10 20 30 40 50 60 70 80
’

3. See Figure 1 on the next page.

D' represents an increase in demand because consumers demand more of the commodity at
each and every price.

4. (a)
P$ 6 5 4 3 2 1 0
QS 60 50 40 30 20 10 0

(b)
P$ 6 5 4 3 2 1 0
QS 80 70 60 50 40 30 20

(c) See Figure 2 on the next page.

(d) The shift from S to S' (an increase in supply) may result from an improvement in
technology, a reduction in the price of resources going into the production of the
commodity, or more favorable weather (for an agricultural commodity).

Figure 1 Figure 2

16
 CHAPTER 2 THE BASIC ECONOMIC MODEL: DEMAND, SUPPLY, AND EQUILIBRIUM

5. (a) Market Supply Schedule, Market Demand Schedule, and Equilibrium

Price Quantity Quantity Surplus (+) or Pressure on

Supplied Demanded Shortage (-) Price
$6 60 0 60 Down
5 50 10 40 Down
4 40 20 20 Down
3 30 30 0 Equilibrium
2 20 40 -20 Up
1 10 50 -40 Up
0 0 60 -60 Up

(b) See Figure 3 on the next page.

6. Setting QD equal to QS, we get the equilibrium price ( P )

60-10P = 10P
60 = 20P
P=3

Substituting P =3 into either the D or S function, we get the equilibrium quantity ( Q )

QD = 60-10 P = 60-10(3) = 30 = Q
or
QS = 10 P = 10(3) = 30 = Q

Figure 3 Figure 4

17
PART ONE INTRODUCTION

7. (a) Market Supply Schedule, Market Demand Schedule, and Equilibrium

Price Quantity Quantity Surplus (+) or Pressure on

Supplied Demanded Shortage (-) Price
$6 80 30 60 Down
5 70 30 40 Down
4 60 40 20 Down
3 50 50 0 Equilibrium
2 40 60 -20 Up
1 30 70 -40 Up
0 20 80 -60 Up

(b) See Figure 4 above.

8. (a) See Figure 5 on the next page.

An increase in both D and S will increase the equilibrium quantity but may increase,
decrease or leave the price unchanged. In Figure 5, the equilibrium price remained
unchanged because the demand curve and supply curve shifted by an equal amount.

9. (a) See Figure 6 on the next page.

(b) See Figure 7 on the next page.

(c) See Figures 8, 9, 10 on page 18.

Figure 5 Figure 6

18
CHAPTER 2 THE BASIC ECONOMIC MODEL: DEMAND, SUPPLY, AND EQUILIBRIUM

Figure 7

Figure 8 Figure 9

19
PART ONE INTRODUCTION

Figure 10

10. (a) See Figures 11, 12, and 13 below.

(b) See Figures 14, 15, and 16 on page 20.

(c) See Figures 17, 18, and 19 on page 21.

Figure 11 Figure 12

20
CHAPTER 2 THE BASIC ECONOMIC MODEL: DEMAND, SUPPLY, AND EQUILIBRIUM

Figure 13

Figure 14 Figure 15

21
PART ONE INTRODUCTION

Figure 16

Figure 17 Figure 18

22
 CHAPTER 2 THE BASIC ECONOMIC MODEL: DEMAND, SUPPLY, AND EQUILIBRIUM

Figure 19

11. (a) The demand for hamburgers increases, and this results in a higher price and quantity.

(b) The supply of hamburgers declines, and this results in an increase in the equilibrium
price and a reduction in the equilibrium quantity.

(c) The supply of hamburgers increases and this lowers the equilibrium price and
increases the quantity purchased.

(d) The demand for hamburgers increases and this has the same effect as in part (a).

(e) A per unit subsidy is the opposite of a per unit tax; the per unit subsidy increases the
supply of hamburgers and this has the same effect as in part (c).

23
PART ONE INTRODUCTION

12. If the cost of transporting of textiles is $1 per yard and the cost of transportation falls equally
on US consumers and foreign on producers of textiles, the US consumer would pay $2.50 per
yard of foreign textiles imported and foreign textile producers would receive $1.50 per yard of
textiles exported. From Figure 20 below, we can calculate that 150 million yards of textiles
will be traded instead of 300 million yards in the absence of transportation costs.

Figure 20A Figure 20B

13. (a) A price ceiling of P=$2 results in a shortage of the commodity of 20 units.

(b) A price ceiling of P=$3 has no effect.

(c) A price ceiling higher than P=$3 has no effect.

14. (a) A price floor of P=$5 leads to a surplus of the commodity of 40 units.

(b) A price floor of P=$4 leads to a surplus of 20 units.

(c) A price floor equal or smaller than P=$3 has no effect.

24
 CHAPTER 2 THE BASIC ECONOMIC MODEL: DEMAND, SUPPLY, AND EQUILIBRIUM

15. (a) See Figure 21.

(b) See Figure 22.

Figure 21 Figure 22

25
PART ONE INTRODUCTION

ANSWERS TO SPREADSHEET PROBLEMS

1. The spreadsheet should look like the following.

A B C D
1
2 P QD'
3 1 70.0
4 2 60.0
5 3 50.0
6 4 40.0
7 5 30.0
8 6 20.0
9 7 10.0
10 8 0.0
11

2. (a) The equilibrium price is 50.

(b) The equilibrium price is 70. The price went up because less was supplied at every price.

3. If there is a price ceiling of $50, then QD = 450, which is greater than the equilibrium quantity of
410. QS = 350, though, which is less than the amount demanded, so there is a shortage of 100.

A B C D E F
1
2 P QD QS Shortage
3 40 470 320 150
4 41 468 323
5 42 466 326
6 43 464 329
7 44 462 332
8 45 460 335
9 46 458 338
10 47 456 341
11 48 454 344
12 49 452 347
13 50 450 350 100
14 51 448 353
15 52 446 356
16 53 444 359
17 54 442 362
18 55 440 365
19 56 438 368
20 57 436 371
21 58 434 374
22 59 432 377
23 60 430 380
24

26
 CHAPTER 2 THE BASIC ECONOMIC MODEL: DEMAND, SUPPLY, AND EQUILIBRIUM

ANSWERS TO APPENDIX PROBLEMS

1. With QD' = 80 – 10P and QS = 10P,

we find the equilibrium price ( P ) and quantity Q , as follows:

80 – 10P = 10P
80 = 20 P
Thus, P = $4
and Q = 80 – 10 ($4) = 40
or Q = 10P = 10($4) = 40

as shown by point E in Figure 4 in the solution to Problem 7.

2. With QD = 60 – 10P and QS' = 20 + 10P,

we find the equilibrium price ( P ) and quantity Q , as follows:

60 – 10P = 20 + 10P
40 = 20 P
Thus, P = $2
and Q = 60 – 10 ($2) = 40
or Q = 20 + 10P = 20 + 10($2) = 40

3. With QD' = 80 – 10P and QS' = 20 + 10P,

we find the equilibrium price ( P ) and quantity Q , as follows:

80 – 10P = 20 + 10P
60 = 20 P
Thus, P = $3
and Q = 80 – 10 ($3) = 50
or Q = 20 + 10P = 20 + 10($3) = 50

as shown by point E' in Figure 5 in the solution to Problem 8.

27
PART ONE INTRODUCTION

4. (a) With the excise tax of $2 per unit, QS shifts up and to the left to
QS” = -20 +10P (see Figure 21) below.
With QD = 60 +10P and QS” = -20 +10P,
the new equilibrium price ( P ) and quantity Q are found algebraically, as follows:

60 – 10P = -20 + 10P

80 = 20 P
Thus, P = $4
and Q = 60 – 10 ($4) = 20
or Q = -20 + 10P = -20 + 10($4) = 20
as shown by point E” in Figure 23.

(b) From Figure 23, we see that consumers pay a price of $4 per unit and producers
receive $2 per unit net of the tax. Therefore, half of the excise tax will fall on
consumers and half on producers.

Figure 23

28
 CHAPTER 3

OPTIMIZATION TECHNIQUES AND NEW MANAGEMENT TOOLS

3-1 METHODS OF EXPRESSING ECONOMIC RELATIONSHIPS

3-2 TOTAL, AVERAGE, AND MARGINAL RELATIONSHIPS

Total, Average, and Marginal Cost
Geometric Derivation of the Average- and Marginal-Cost Curves
Case Study 3-1: Total, Average, and Marginal Cost in the US Steel Industry

3-3 OPTIMIZATION ANALYSIS

Profit Maximization by the Total-Revenue and Total-Cost Approach
Optimization by Marginal Analysis
Case Study 3-2: Optimal Pollution Control

3-4 CONSTRAINED OPTIMIZATION

Case Study 3-3: Pursuing Multiple Objectives under Constraints by Global Corporations

3-5 NEW MANAGEMENT TOOLS FOR OPTIMIZATION

Benchmarking
Case Study 3-4: Benchmarking at Xerox, Ford, and Mobil
Total Quality Management
Case Study 3-5: Total Quality Management at Johnson & Johnson, Motorola, GE, and
Ford
Reengineering
Case Study 3-6: Reengineering at GE
The Learning Organization
Case Study 3-7: Applying Learning-Organization Principles at Ford and Southwest
Airlines

3-6 OTHER MANAGEMENT TOOLS FOR OPTIMIZATION

3-7 NEW MANAGEMENT TOOLS AND FUNCTIONAL SPECIALIZATION

Case Study 3-8: The American Business Model
Case Study 3-9: When Governance Rules Fail, Public Trust Is Eroded
Box 3 – Managerial Economics at Work: Management Practices Across Countries

29
PART ONE INTRODUCTION

SUMMARY
DISCUSSION QUESTIONS
PROBLEMS
SPREADSHEETS PROBLEMS
APPENDIX 1 TO CHAPTER 3: OPTIMIZATION USING SPREADSHEETS
APPENDIX 1 PROBLEM
APPENDIX 2 TO CHAPTER 3: DIFFERENTIAL CALCULUS AND OPTIMIZATION
TECHNIQUES
The Derivative and Rules of Differentiations
Optimization with Calculus
Multivariate Optimization
Constrained Optimization
APPENDIX 2 PROBLEMS
SUPPLEMENTARY READINGS
INTERNET SITE ADDRESSES
INTEGRATING CASE STUDY 1: A Genius Departs: The Astonishing Career of the World’s
Most Revered Executive
KEY TERMS (in the order of their appearance)
___________________________________________________________________________

Marginal cost Networking

Marginal revenue Performance management
Marginal analysis Pricing power
Constrained optimization Process management
Benchmarking Small-world model
Total quality management (TQM) Strategic development
Reengineering SWOT analysis
Learning organization Virtual integration
Broadbanding Virtual management
Direct business model

30
 CHAPTER 3 OPTIMIZATION TECHNIQUES AND NEW MANAGEMENT TOOLS

ANSWERS TO DISCUSSION QUESTIONS

1. (a) Average revenue equals total revenue divided by the volume of sales. Marginal
revenue equals the change in total revenue per unit change in the volume of sales.

(b) Average product equals total product divided by output, while marginal product equals
the change in total product per unit change in output.

(c) Average cost equals total cost divided by output, while marginal cost equals the change
in total cost per unit change in output.

(d) Average profit equals total profit divided by sales, while marginal profit is the Change
in total profit per unit change in sales.

2. Marginal revenue (MR) is defined as the change in total revenue (TR) per unit change in
output or sales. Thus, MR is given by the slope of the TR curve. When the TR curve is
concave, its slope declines continuously. Therefore, the MR curve is negatively sloped (i.e., it
slopes down and to the right). See Figure 3-1 in the text.

3. When TR increases, MR is positive. When TR is maximum, the slope of the TR curve, or MR,
is zero. When TR declines, MR is negative (see Figure 3-4 in the text).

4. When the TR curve is a positively sloped straight line, its slope or MR is constant. Thus, the
MR curve is a horizontal straight line.

5. (a) Average product equals total product divided by quantity and is given by the slope of
a ray from the origin to the total product curve. Marginal product equals the change in
total product per unit change in quantity and is given by the slope of the total product
curve. With the total product curve first rising at an increasing rate and then rising at a
decreasing rate, the slope of a ray from the origin to the total product curve, or average
product, will first rise and then fall. Thus, the average product curve has an inverted
U shape.

(b) On the other hand, the slope of the total product curve, or marginal product, will rise
up to the point of inflection on the total product curve (i.e., the point where the total
product curve will change direction, from increasing at an increasing rate to increasing at
a decreasing rate) and declines thereafter (but remains positive as long as the total product
curve rises). Thus, the marginal product curve also has an inverted U shape, but reaches
its highest point at a smaller level of output than the corresponding average product
curve.

6. When the marginal product curve is above the average product curve, the average product
rises. When the marginal product curve is below the average product curve, the average
product falls. When the marginal product curve intercepts the average product curve, the
average product is highest and equals the marginal product.

31
PART ONE INTRODUCTION

7. When the total product curve first rises at an increasing rate and then rises at a decreasing rate,
the marginal product curve first rises and then falls. On the other hand, the total cost curve of
Figure 3-2 first rises at a decreasing rate (i.e., it faces down) and then rises at an increasing rate
(it faces up). Thus, the marginal cost curve first falls and then rises. More generally, we can say
that the total product curve is the mirror image of the total cost curve.

8. The profit-maximizing level of output of a firm is the one at which (1) the marginal revenue of
the firm equals its marginal cost and (2) the marginal revenue curve intersects the marginal
cost curve from below. At this level of output, the total revenue and total cost curves are
parallel and the vertical distance between them (with the total revenue curve above the total
cost curve) is maximum.

9. When sales or total revenue is maximum, marginal revenue is zero. Since marginal cost is
usually positive, marginal cost exceeds marginal revenue and the firm produces too much
output to maximize total profit. Therefore, the marketing program of the firm should be scaled
down until the marginal benefit of the program equals its marginal cost.

10. (a) The best level of advertising for a firm is the one at which the marginal benefit of
advertising (in the form of increased sales and revenue) is equal to the marginal cost of
advertising.

(b) A firm should use each input until the marginal revenue resulting from the sale of the
additional output generated by the last unit of input equals the marginal cost of hiring or
using the last unit of the input.

(c) A firm should continue to invest until the marginal return on the investment is equal to
the marginal cost of the investment (the extra interest that must be paid for the last dollar
invested).

11. The total cost of a business trip includes not only the transportation cost but also the imputed
cost of the businessman’s time. Often, the latter is greater than the former. The businessman
should fly or drive depending on which method of transportation will lead to a lower total cost
for the trip (which includes the imputed value of the businessman’s time).

12. A consumer should shop (search) for lower prices until the marginal benefit of the search (in
the form of the savings resulting from the lower prices) is equal to the marginal cost of the
search (i.e., the foregone earnings for the time of the search). The more valuable is a
consumer’s time, the smaller is his or her optimal search time.

13. Given the marginal cost of comparative shopping, or shopping for lower prices, of the
consumer, we would expect the consumer to spend more time searching for lower prices for
expensive than for cheap items. The reason is that the more expensive the item, the greater is
usually the potential benefit (saving) of the search.

32
 CHAPTER 3 OPTIMIZATION TECHNIQUES AND NEW MANAGEMENT TOOLS

14. The new management tools are: benchmarking, total quality management, reengineering, the
learning organization, broadbanding, direct business model, networking, performance
management, pricing power, process management, small-world model, strategic development,
SWOT analysis, virtual integration, virtual management.

15. The new management tools do not eliminate the need for the functional areas of managerial
economics (such as production, finance, marketing, and human resource development) because
most of the specific management tools often do not provide fully worked-out and cohesive set
of guidelines that most firm can easily implement and it is unlikely that we will get completely
horizontal and boundaryless corporations any time soon.

ANSWERS TO PROBLEMS

1. (a) The total, average, and marginal revenue schedules are derived in Table 1.

Table 1

Q 9Q - Q2 TR AR = TR/Q MR = ΔTR/ΔQ
0 9(0) - (0)2 $0 — —
1 9(1) - (1)2 8 $8 $8
2 9(2) - (2)2 14 7 6
3 9(3) - (3)2 18 6 4
4 9(4) - (4)2 20 5 2
5 9(5) - (5)2 20 4 0
6 9(6) - (6)2 18 3 -2

(b) The TR, AR, and MR schedules of Table 1 are plotted in Figure 1 on the next page. The
AR curve is the demand curve for the product that the firm faces. Note that the MR
values are plotted halfway between successive levels of output.

33
PART ONE INTRODUCTION

34
 CHAPTER 3 OPTIMIZATION TECHNIQUES AND NEW MANAGEMENT TOOLS

2. The slope of a ray from the origin to the TR curve, or AR, falls continuously and is positive as
long as TR is positive. From Figure 1 on the previous page, we see that since the TR curve is
concave, its slope of MR also falls continuously. MR is positive as long as TR increases, MR =
0 when TR is maximum, and MR is negative when TR declines. Since the AR or D curve falls
continuously, the MR curve is always below it.

3. The average and marginal product schedules are derived in Table 2.

Table 2

L TP AP = TP/L MP = ΔTP/ΔL
0 0 — —
1 2 2 2
2 5 2 1/2 3
3 9 3 4
4 12 3 3
5 14 2 4/5 2
6 15 2 1/2 1
7 15 2 1/7 0
8 14 1 3/4 -1

4. (a) The TP, AP, and MP schedules of Table 2 are plotted in Figure 2 on the previous page.
Note that the MP values are plotted halfway between successive levels of output.

(b) The slope of a ray from the origin to the TP curve, or AP, rises up to point B in Figure
2 and then falls, but it remains positive as long as TP is positive. Thus, the AP curve
rises up to point B' and then declines. On the other hand, the slope of the TP curve
rises up to point A (the point of inflection of the TP curve) and falls thereafter. Thus,
the MP curve rises up to point A' and then declines.
When TP is maximum, the slope of the TP curve is zero (point C), and so is MP (point
C'). Past point C, the TP curve declines and MP is negative. Note also that when the
AP is rising, the MP curve is above it, and when the AP curve declines, the MP curve
is below it.
The MP curve intersects the AP curve at the highest point e 2) of the latter (point B'),
so that AP = MP at that level of output (about 3.5 units in Figure 2).

35
PART ONE INTRODUCTION

5. (a) The average profit ( π ) and marginal profit ( π ) schedules are derived in Table 3.

36
 CHAPTER 3 OPTIMIZATION TECHNIQUES AND NEW MANAGEMENT TOOLS

Table 3

Q π π = π/Q π = Δπ/ΔQ

0 $-20 — —
1 -50 $-50 $-30
2 0 0 50
3 30 10 30
4 0 0 -30

6. (a) The π , π , and π schedules of Table 3 are plotted in Figure 3 on the next page.

(b) The slope of a ray from the origin to the π curve, or π , is negative at first but rises up
to almost Q = 3, after which it declines, becomes zero at Q = 4, and negative thereafter
(because π is once again negative).
On the other hand, the slope of the π curve, or π , is zero at Q = 1, but it rises up to
Q = 2 (the point of inflection) and declines thereafter, in such a way that π is zero at
Q = 1 and Q = 3 (where the π curve has zero slope). As the π curve rises, reaches its
highest point, and declines, the π curve is above it, intersects it, and is below it
respectively. Note that π is highest at a smaller level of output than the one (Q = 3) at
which π is maximum.

7. The average and marginal cost schedules are derived in Table 4.

Table 4

Q TC AC = TC/Q MC = ΔTC/ΔQ
0 $1 — —
1 12 $12 $11
2 14 7 2
3 15 5 1
4 20 5 5

37
PART ONE INTRODUCTION

8. (a) The TC, AC, and MC schedules of Table 4 are plotted in Figure 4 on the previous
page.

(b) The slope of a ray from the origin to the TC curve, or AC, falls up to Q = 3.5 in Figure
4 and rises thereafter. Thus, the AC curve declines up to Q = 3.5 and then rises. On
the other hand, the slope of the TC curve, or MC, falls up to the point of inflection on
the TC curve at Q = 2 and rises thereafter. Thus, the MC curve declines up to Q = 2
and then rises.
At Q = 3.5, a ray from the origin has the smallest slope (so that we are at the lowest
point on the AC curve) and equals the slope of the TC curve, or MC, at that point.
Thus, at Q = 3.5, AC = MC. As the AC curve declines, reaches its minimum point, and
then rises, the MC curve is below it, intersects it, and is above it, respectively.

9. In Figure 5 on page 39, the TR curve is that of Figure 1 and the TC curve is that of Figure 4.
The total profit (π) curve is derived from the vertical distance between the TR and TC curves.
The firm maximizes π at Q = 3, where the positive difference between TR and TC ($3) is
greatest.
At Q = 3, the TR and TC curves are parallel so that their vertical distance (with the TR
above the TC curve) is greatest, and the π curve lies above the horizontal axis and has zero
slope.
The π curve has zero slope also at Q = 1, where the TR and the TC curves are also parallel.
But at Q = 1, the TC curve is above the TR curve, so that the firm’s loss (of $4) is
maximum.
Thus, π = -$1 at Q = 0, π = -$4 at Q = 1 (the largest loss), and π = 0 at Q = 2 and Q = 4 (the
break-even point of the firm), and π = $3 (the largest profit) at Q = 3.

10. (a) A constrained optimization problem refers to the maximization or minimization of an

objective function subject to some constraint.

(b) Constrained optimization is very important to managerial economics because firms

often face constraints in their optimization decisions (such as profit maximization or
cost minimization).
For example, a firm may face a limit on its production capacity or on the availability of
skilled personnel and crucial raw materials. The firm may also face legal and
environmental constraints. A constrained optimization problem can be solved with the
Lagrangian multiplier method.

11. The American business model refers to the business practices used by American firms. It
preaches maximizing the value of the firm subjects to the constraints it faces and shareholder
supremacy.

12. The advantages of the American business model over its alternatives (state direction of the
economy under communism, the corporative state of Japan, and over-regulation in Europe) is
much greater firm and economy-wide efficiency.

38
 CHAPTER 3 OPTIMIZATION TECHNIQUES AND NEW MANAGEMENT TOOLS

13. Evidence that companies’ governance failed in the United Stated in the fall of 2001 and in
2002 is given by all the scandals that have come to the surface in the form of accounting
malpractices, conflicts of interests, excessive executive compensation, and poor board-room
scrutiny. These have resulted in American investors losing confidence in Wall Street’s ability
and willingness to act as an honest broker between them and the corporate world.

14. Public trust in the American financial markets was reestablished by the passage of the
Sarbanes-Oxeley Act in 2002, which greatly improved the quality of the financial information
provided by the companies, which depends on honest accounting and adequate firm
governance. Accounting standards need to be tightened and nonexecutive board of directors
must have much greater independence.

*15. (a) In Figure 6, the profit-maximizing output is Q = 3. This is the level of output at which
the MC curve intersects the MR curve from below. We can explain why the firm
maximizes total profits (π) at Q = 3 by showing that it pays for the firm to expand an
output smaller than 3 units and reduce a larger output.
For example, at Q = 2, MR > MC. Therefore, the firm is adding more to its TR than to
its TC, and so π increases by expanding output. On the other hand, at Q = 4, MR < MC.
Therefore, the firm is adding less to its TR than to its TC, and so π increases by
reducing output. AT Q = 3, MR = MC. Therefore, the firm is adding as much to TR as
to TC and is maximum.
Note, however, that MR = MC at Q = 1 also. But at Q = 1, the firm has produced all the
(fractional) units of the commodity for which MC > MR, and so the firm maximizes its
total loss.
To distinguish between the loss-maximizing and the profit-maximizing level of output
(since at both levels of output MR = MC), we seek the level of output at which MR =
MC and the MC curve intersects the MR curve from below.
This corresponds to looking for the level of output at which the π curve has zero slope
and faces down (i.e., its slope diminishes, from positive to zero, to negative).

39
PART ONE INTRODUCTION

40
 CHAPTER 3 OPTIMIZATION TECHNIQUES AND NEW MANAGEMENT TOOLS

(b) The answer to part (a) is an example of marginal analysis and optimization behavior in
general because it shows that an organization (say, a business firm) should pursue an
activity (say, expand output) as long as the marginal benefit (say, marginal revenue)
from the activity exceeds the marginal cost, and until the marginal benefit equals the
marginal cost. By doing so, the organization (firm) maximizes the benefit (total profit)
from the activity. Marginal analysis, therefore, is a most important tool of optimizing
behavior on the part of any organization, and especially of a business firm.

ANSWERS TO PROBLEMS USING SPREADSHEETS

1. The spreadsheet and graph should look like the following.

A B C D E F
1
2 Q TP AP MP
3 0 0 — —
4 1 2 2 2
5 2 5 2.5 3
6 3 9 3 4
7 4 12 3 3
8 5 14 2.8 2
9 6 15 2.5 1
10 7 15 2.142857 0
11 8 14 1.75 -1
12

41
PART ONE INTRODUCTION

16

14

12

10

8 TP 0
AP ---
6 MP ---

0
1 2 3 4 5 6 7 8
-2
Quantity

2. (a) The profit maximizing quantity is 8.

(b) Subtracting the TC function, the new profit maximizing quantity is 4.

3. You should get the same answer using the optimizer. Below is the output.

A B C D E
1
2 Q TR TR - TC
3 0 0 -30
4 1 30 0.5
5 2 56 26
6 3 78 43.5
7 4 96 50
8 5 110 42.5
9 6 120 18
10 7 126 -26.5
11 8 128 -94
12

42
 CHAPTER 3 OPTIMIZATION TECHNIQUES AND NEW MANAGEMENT TOOLS

ANSWER TO APPENDIX 1 PROBLEM

(OPTIMIZATION USING SPREADSHEETS)

Spreadsheets will differ according to each student. The relevant issue is to use solver, specifying
profit as the target cell, by changing the decision variable, the quantity.

43
PART ONE INTRODUCTION

ANSWERS APPENDIX 2 PROBLEMS

(DIFFERENTIAL CALCULUS AND OPTIMIZATION TECHNIQUES)

1. (a) For Y = a, dY/dX = 0

For TC = 182, d(TC)/dQ = 0

(b) For Y = 2X2, dY/dX = 4X

For Y = -1X3, dY/dX = -3X2

For Y = 1/2X-2, dY/dX = -X-1 = -1/X

For TR = 10Q, d(TR)/dQ = 10

For TR = -Q2, d(TR)/dQ = -2Q

2. (a) For Y = 45X - 0.5X2, dY/dX = 45 - X

For Y = X3 - 8X2 + 57X + 2, dY/dX = 3X2 - 16X + 57

For TR = 100Q - 10Q2, d(TR)/dQ = 100 - 20Q

For TC = 182 + 56Q, d(TC)/dQ = 56

(b) For Y = X3 - 2X2, dY/dX = 3X2 -4X (by the difference rule)

For Y = X2(X - 2), letting U = X2 and V = X - 2

dY/dX = X2(1) + (X - 2)2X = X2 + 2X2 - 4X

= 3X2 - 4X (the same as above by the quotient rule).

For Y = 8X4 - 20X3, dY/dX = 32X3 - 60X2

For Y = 4X3(2X - 5), letting U = 4X3 and V = 2X-5

dY/dX = 4X3(2) + (2X - 5)12X2 = 8X3 + 24X3 - 60X2

= 32X3 - 60X2 (the same as in the previous problem).

44
 CHAPTER 3 OPTIMIZATION TECHNIQUES AND NEW MANAGEMENT TOOLS

3. (a) For Y = 3X5/X2 = 3X3, dY/dX = 9X2

Using the quotient rule, we should get the same result. Specifically,

letting U = 3X5 and V = X2

dY = X2(15X4) - 3X5(2X) = 15X6 - 6x6 = 9X6 = 9X2

dX (X2)2 X4 X4

Note that exponents are added in multiplication.

For Y = 5X3
4X+3

letting U = 5X3 and V = 4X + 3

dY = (4X + 3)15X2 - 5X3(4) = 60X3 + 45X2 - 20X3 = 40X3 + 45X2

dX (4x + 3)2 (4X + 3)2 (4X + 3)2

(b) For Y = U5 and U = 2X3 + 3

dY/dU = 5U4 and dU/dX = 6X2

Therefore, dY/dX = (dY/dU)(dU/dX) = (5U4)6X2

Substituting the value of U (i.e., 2X3 + 3) into the above expression, we get

dY/dX = 5(2X3 + 3)6X = 60X4 + 90X

For Y = U3 + 3U and U = -X2 + 10X

dY/dU = 3U2 + 3 and dU/dX = -2X + 10

dY/dX = (3U2 + 3)(-2X + 10) = -6U2X - 6X + 30U2 + 30

45
PART ONE INTRODUCTION

Substituting the value of U (i.e., -X2 + 10X) into the above expression, we get

dY/dX = -6(-X2 + 10X)X - 6X + 30(-X2 + 10X)2 + 30

= 6X3 - 60X2 - 6X + 30(X4 - 20X3 + 100X2) + 30

= 30X4 - 594X3 + 2940X2 - 6X + 30

= 5X4 - 99X3 + 490X2 - X + 5

For Y = (2X3 + 5)2

Let U = 2X3 + 5 and V = U2

Then, dY/dX = (dY/dU)(dU/dX) = (2U)6X2

Substituting the value of U (i.e., U = 2X3 + 5) into the above expression, we get

dY/dX = 2(2X3 + 5)6X2 = 24X5 + 60X2

4. (a) π = TR - TC

= 22Q - 0.5Q2 - (1/3Q3 - 8.5Q2 + 50Q + 90)

= 22Q - 0.5Q2 - 1/3Q3 + 8.5Q2 - 50Q - 90

= -1/3Q3 + 8Q2 - 28Q - 90

To maximize π , we set dπ/dQ = 0 and show that d2π/dQ2 < 0, at Q where

dπ/dQ = 0

dπ/dQ = -Q2 + 16Q - 28 = 0

(Q - 2)(-Q + 14) = 0

Q = 2 and Q = 14

d2π/dQ2 = -2Q + 16

46
 CHAPTER 3 OPTIMIZATION TECHNIQUES AND NEW MANAGEMENT TOOLS

At Q = 2, d2π/dQ2 = -2(2) + 16 = 12 > 0, and π is minimum

At Q = 14, d2π/dQ2 - 2(14) + 16 = -12 < 0, and π is maximum

(b) To find the maximum profit that the firm could earn, we substitute Q = 14 into the π
function found in part (a). That is,

π = 1/3Q3 + 8Q2 - 28Q - 90

= -1/3(14)3 + 8(14)2 - 28(14) - 90

= -914.67 + 1,568 - 392 - 90

= $171.33

5. (a) π = TR - TC

= 4Q - (0.04Q3 - 0.9Q2 + 10Q + 5)

= 4Q - 0.04Q3 + 0.9Q2 -10Q - 5

= -0.04Q3 + 0.9Q2 - 6Q - 5

To maximize π , we find the derivative of π with respect to Q, set it equal to zero,

and then solve for Q. That is,

dπ/dQ = -0.12Q2 + 1.8Q - 6 = 0

Dividing both sides by -0.12 to eliminate decimals, we get

Q2 - 15Q + 50 = 0

(Q - 5)(Q - 10) = 0

Therefore, dπ/dQ = 0 at Q = 5 and Q = 10

For a maximum, d2π/dQ2 < 0

47
PART ONE INTRODUCTION

Starting with dπ/dQ, we get

d2π/dQ2 = -0.24Q + 1.8

At Q = 5, d2π/d2Q = -0.24(5) + 1.8 = -1.2 + 1.8 = 0.6

Since at Q = 5, d2π/dQ2 > 0, π is minimum at this output level.

At Q = 10, d2π/dQ2 = -0.24(10) + 1.8 = -2.4 + 1.8 = -0.6

Therefore, π is maximum at Q = 10.

(b) Substituting Q=10 into the π function, we get

π = -0.04(10)3 + 0.9(10)2 - 6(10) -5

= -40 + 90 -60 -5

= -$15

Therefore, the firm incurs a loss of $15 at the best level of output. Since this
loss exceeds the fixed costs of the firm of $5 which the firm incurs whether it
produces or not, it pays for the firm to stop production and incur a loss equal to
its fixed costs of $5 in the short run.

6. For AC = 200 - 24Q + Q2

d(AC)/dQ = -24 + 2Q = 0

Therefore, Q = 12

d2(AC)/dQ2 = 2

Since d2(AC)/dQ2 > 0, AC is minimum at Q = 12

At Q = 12,

48
 CHAPTER 3 OPTIMIZATION TECHNIQUES AND NEW MANAGEMENT TOOLS

AC = 200 - 24(12) + (12)2

= 200 - 288 + 144

= $56

7. For MC = 200 -48Q + 3Q2

d(MC)/dQ = -48 + 6Q = 0

Therefore, Q = 8

d2(MC)/dQ2 = 8

Since d2(MC)/dQ2 > 0, MC is minimum at Q = 8

At Q = 8,

AC = 200 - 48(8) + 3(8)2

= 200 - 384 + 192

= $8

8. (a) To determine the level of output of commodity X and commodity Y that will
maximize the total profit of the firm for the following function:

π = 144X - 3X2 - XY -2Y2 + 120Y - 35

we set the partial derivative of π with respect to X and Y equal to zero and solve.

That is,

∂π/∂X = 144 - 6X - Y = 0

∂π/∂Y = - X - 4Y + 120 = 0

49
PART ONE INTRODUCTION

Multiplying the first expression by -4, rearranging the second, and adding, we get

-576 + 24X + 4Y = 0
120 - X - 4Y = 0
-456 + 23X =0

Therefore, X = 19.83

Substituting X = 19.83 into the first expression of the partial derivative set equal to
zero, and solving for Y, we get

144 - 6(19.83) - Y = 0

Therefore, Y = 144 - 118.98 = 25.02

Thus, the firm maximizes π when it sells 19.83 units of commodity X and 25.02
units of commodity Y.

(b) To determine the maximum amount of the total profit of the firm, we substitute the
values of X = 19.83 and Y = 25.02 into the original function and obtain

π = 144(19.83) - 3(19.83)2 - 19.83(25.02) - 2(25.02)2 + 120(25.02) - 35

= $2895.09

9. (a) To minimize the following (unconstrained) average cost function

AC = X2 + 2Y2 - 2XY - 2X - 6Y + 20

we find the partial derivative of AC with respect to X and Y, set them equal to
zero, and solve. That is,

∂(AC)/∂X = 2X - 2Y - 2 = 0

∂(AC)/∂Y = 4Y - 2X - 6 = 0

Adding the two partial derivative expressions, we get

2X - 2Y - 2 = 0
-2X + 4Y - 6 = 0
2Y - 8 = 0

50
 CHAPTER 3 OPTIMIZATION TECHNIQUES AND NEW MANAGEMENT TOOLS

2Y = 8

Therefore, Y = 4.

Substituting Y = 4 into the first partial derivative function set equal to zero (i.e.,
into ∂(AC)/∂X = 0), we have

2X-2(4) - 2 = 0

2X = 10

Therefore, X = 5.

Thus, the firm minimizes average cost when it produces 5 units of zipper X and 4
units of zipper Y.

Substituting X = 5 and Y = 4 into the firm’s AC function, we get the minimum value
of the AC. That is,

AC = 25 + 32 - 40 - 10 -24 + 20 = $3

(b) The first researcher uses the substitution method to complete the assignment. To
minimize the AC function subject to the X + Y = 6 constraint by the substitution
method, he first solves the constraint function for X and gets

X=6-Y

Then, he substitutes the value of X into the original AC function and obtains

AC = (6 - Y)2 + 2Y2 - 2(6 - Y)Y - 2(6 - Y) - 6Y + 20

= 36 - 12Y + 2Y2 - 12Y + 2Y2 - 12 + 2Y - 6Y + 20

= 5Y2 - 28Y + 44 = 0

Finally, he finds the value of the AC function with respect to Y and solves.

51
PART ONE INTRODUCTION

That is,

d(AC)/dY = 10Y - 28 = 0

Therefore, Y = 2.8.

Substituting Y = 2.8 into the constraint equation, he gets

X + 2.8 = 6

Therefore, X = 3.2

That is, the firm maximizes AC when it produces 3.2 units of X and 2.8 units of Y
(as compared with X = 5 and Y = 4 found in part (a) in the absence of any constraint).

Substituting X = 3.2 and Y = 2.8 into the firm's AC function, he obtains the minimum
value of AC of

AC = 10.24 + 15.68 - 17.92 - 6.4 - 16.80 + 20 = $4.80

as compared with the minimum AC = $3 when the firm faced no output constraint.

Thus, the firm operates in the declining range of its AC curve.

The second researcher uses the Lagrangian multiplier method to complete the
assignment. To minimize AC by the Lagrangian method, he first sets the constraint
function equal to zero and gets

X+Y-6=0

He then forms the following Lagrangian function

LAC = X2 + 2Y2 - 2XY - 2X - 6Y + 20 + λ(X + Y - 6)

52
 CHAPTER 3 OPTIMIZATION TECHNIQUES AND NEW MANAGEMENT TOOLS

Finding the partial derivative of LAC with respect to X, Y, and λ , he gets

∂LAC/∂X = 2X - 2Y - 2 + λ = 0

∂LAC/∂Y = 4Y - 2X - 6 + λ = 0

∂LAC/∂λ = X + Y - 6 =0

Subtracting the second from the first partial derivative expression, we obtain

4X - 6Y + 4 = 0

Multiplying the last partial derivative expression (i.e., ∂LAC/∂λ) by 4 and

Subbtracting it from the expression he has just obtained above, he gets

4X - 6Y + 4 = 0
4X + 4Y - 24 = 0
-10Y + 28 = 0

Therefore, Y = 2.8 and X = 3.2 (the same answer found by the first researcher by
the substitution method).

(c) Since the value of λ measures the marginal effect on the objective function resulting
from a one-unit change in the constant of the constraint function, the answer to
this question is provided by the estimated value of λ in this problem. To find the
value of λ, we substitute X = 3.2 and Y = 2.8 into the first partial derivative found
above by method 2 (i.e., into ∂LAC/∂X = 0) and get

2(3.2) - 2(2.8) - 2 = -1.2

Therefore, λ = $1.20.

This means that if the 7 unit order were received (i.e., if the constraint faced by the
firm were increased by 1 unit from X + Y = 6 to X + Y = 7), the AC of the firm would
fall by about $1.20, from $4.80 to $3.60.

Conversely, with X + Y = 5, the firm's AC would rise by about $1.20, from $4.80 to
$6.00. Thus, the firm operates in the declining range of the AC curve when it faces
a constraint that limits its joint output of zippers X and Y to one that is below
the unconstrained output level (of X = 5 and Y = 4) at which the firm's AC curve
is minimum.

53
 CHAPTER 4

DEMAND THEORY

4-1 THE DEMAND FOR A COMMODITY

An Individual’s Demand for a Commodity
From Individual to Market Demand
Case Study 4-1: The Demand for Big Macs
The Demand Faced by a Firm
Case Study 4-2: The Demand for Sweet Potatoes in the United States

4-2 PRICE ELASTICITY OF DEMAND

Point Price Elasticity of Demand
Arc Price Elasticity of Demand
Price Elasticity, Total Revenue, and Marginal Revenue
Factors Affecting the Price Elasticity of Demand
Case Study 4-3: Price Elasticities of Demand in the Real World

4-3 INCOME ELASTICITY OF DEMAND

Case Study 4-4: Income Elasticities of Demand in the Real World

4-4 CROSS-PRICE ELASTICITY OF DEMAND

Case Study 4-5: Cross-Price Elasticities of Demand in the Real World
Case Study 4-6: Substitution between Domestic and Foreign Goods

4-5 USING ELASTICITIES IN MANAGERIAL DECISION MAKING

BOX 4 – Managerial Economics at Work: Decision Time at the Aromatic Coffee
Company
Case Study 4-7: Demand Elasticities for Alcoholic Beverages in the United States

4-6 INTERNATIONAL CONVERGENCE OF TASTES

Case Study 4-8: Gillette Introduces Space-Technology Global Razors
Case Study 4-9: Ford’s World Car(s)

4-7 ELECTRONIC COMMERCE

Case Study 4-10: E-Commerce at Amazon.com
Case Study 4-11: Amazon Puts to an End eBay Star Performance

SUMMARY
DISCUSSION QUESTIONS

54
 CHAPTER 4 DEMAND THEORY

PROBLEMS
SPREADSHEET PROBLEMS
APPENDIX TO CHAPTER 4: BEHIND THE MARKET DEMAND CURVE—THE THEORY
OF CONSUMER CHOICE
The Consumer’s Tastes: Indifference Curves
The Consumer’s Constraints: The Budget Line
The Consumer’s Equilibrium
Derivation of the Consumer’s Demand Curve
Income and Substitution Effects of a Price Change
The Theory of Consumer Choice Mathematically

APPENDIX PROBLEMS
SUPPLEMENTARY READINGS
INTERNET SITE ADDRESSES
KEY TERMS (in the order of their appearance)
____________________________________________________________________________

Consumer demand theory Monopolistic competition

Normal goods Durable goods
Inferior goods Demand function faced by a firm
Individual’s demand schedule Derived demand
Individual’s demand curve Producers’ goods
Law of demand Price elasticity of demand (Ep)
Substitution effect Point price elasticity of demand
Income effect Arc price elasticity of demand
Giffen good Total revenue (TR)
Change in the quantity demanded Marginal revenue (MR)
Change in demand Income elasticity of demand (EI)
Market demand curve Point elasticity of demand
Market demand function Arc income elasticity of demand
Bandwagon effect Cross-price elasticity of demand (Exy)
Snob effect Point cross-price elasticity of demand
Monopoly Arc cross-price elasticity of demand
Perfect competition E-commerce
Oligopoly

55
PART TWO DEMAND ANALYSIS

ANSWERS TO DISCUSSION QUESTIONS

1. (a) We are interested in studying consumer demand theory in managerial economics

because the market or industry demand for a commodity is obtained by the summation
of the individual consumer’s demand curves for the commodity, and it is on the market
or industry market or industry demand curve for the commodity that the demand curve
that a particular firm faces depends. Thus, we study consumer demand theory to learn
more about the market or industry demand of the commodity, on which the demand
that the firm faces depends.

(b) A normal good is a good of which the consumer purchases more with an increase in
income.
On the other hand, an inferior good is a good of which the consumer purchases less
with an increase in income.
The substitution effect refers to the change in the quantity demanded of a commodity
resulting only from the change in its price and independent of the change in real
income.
On the other hand, the income effect is the change in the quantity demanded of a
commodity resulting only from the change in the real income that accompanies a price
decline.
A change in the quantity demanded refers to a movement along a particular demand
curve resulting from a change in the price of the commodity, while holding everything
else constant. This is to be contrasted with a change in demand, which refers instead
to a shift in the entire functional relationship or demand curve as a result of a change in
the consumer’s income, in the price of related commodities, in consumers’ tastes, or in
any of the determinants of demand other than the price of the commodity.

2. (a) We can identify at least 4 different types of demands. These are: the individual’s
demand for a good or service, the market or industry demand for the good or service,
the demand curve faced by a firm for the good or service it sells, and the firm’s
derived demand for inputs or factors of production.

(b) In managerial economics we are primarily interested in the demand that the firm faces
for the product it sells. The reason is that our primary interest is in the firm and its
operation.

(c) We study the other types of demand because they are closely related to the demand
that the firm faces for the product it sells. Specifically, the demand that a firm faces
for the product it sells depends in a very crucial way on the market or industry demand
curve, which, in turn, depends on (is the aggregation of) the demand curves for the
product of the individual consumers in the market.
In managerial economics, we are also interested in the firm’s derived demand for the
inputs or factors of production because this depends on, or is determined by, the
demand that the firm faces for the goods and services it sells. The firm generates

56
 CHAPTER 4 DEMAND THEORY

revenue from the sale of the product and uses the revenue to purchase or hire the
inputs it requires in production.

3. (a) The most important determinants of the demand function that a firm faces for the
commodity it sells are: the price of the commodity, consumers’ income, the price of
related commodities, consumers’ tastes, and other determinants which are specific to
the particular industry and firm.
These other determinants of the demand faced by a firm might be price expectations,
the level of advertising by the firm, the pricing and promotional policies of other firms
in the industry, the availability of credit, the type of good that the firm sells, and so on.

(b) Producers’ goods refer to those goods (raw materials, semiprocessed materials, and
equipment) that are used by the firm to produce the goods and services demanded by
consumers (i.e., consumers’ goods). Thus, the demand for producers’ goods is a
derived demand—derived from the demand for the commodities that the inputs are
used in producing.

(c) The demand for durable goods (automobiles, washing machines, refrigerators, capital
equipment, storable commodities, etc.) is less stable or more volatile than the demand
for non-durable goods because the purchase of durable goods can be postponed by
spending more on repairs and maintenance, or by working off inventories until the
economy improves or in the expectation of lower prices in future time periods.

When the economy does improve, credit incentives are introduced, or the lower prices
materialize, consumers and producers would increase their demand for durable goods
very much.

4. (a) The advantage of the price elasticity of demand over the slope or its inverse to measure
the responsiveness in the quantity demanded of a commodity to a change in its price is
that the price elasticity of demand, being measured by the ratio of the percentage
change in quantity to the percentage change in price is a pure number (i.e., it has no
units attached to it).
Thus, the value of elasticity is independent of the units in which quantity and price are
measured. Elasticities also allow a meaningful comparison of the responsiveness in
the quantity demanded to a change in price among any number of commodities.
The slope of the demand curve or its inverse (i.e., ΔQ/ΔP), on the other hand, is
expressed in terms of the units of the problem and does not allow a meaningful
comparison of the responsiveness in the quantity demanded of a commodity to a
change in price among two or more commodities.

(b) If we used the formula for the point price elasticity to measure the price elasticity of
demand between two points on the demand curve, we would get different results
depending upon whether the price increased or fell. To avoid such a shortcoming, we
modify slightly the formula for the point price elasticity of demand to measure arc
price elasticity.

57
PART TWO DEMAND ANALYSIS

To measure arc price elasticity we use the average price and the average quantity
rather than the original price and quantity or the new price and quantity in the formula.
By doing so, we obtain the same arc price elasticity of demand whether the price
increases or falls.

5. (a) An increase in price will result in total revenue (TR) declining if demand is elastic
(i.e., if /Ep/ > 1), TR remaining unchanged if demand is unitary elastic, and TR
increasing if demand is inelastic.

(b) The reason for this is that if demand is elastic, a price increase leads to a
proportionately larger decrease in quantity, and so total revenue declines. When
demand is unitary elastic, an increase in price leads to an equal proportionate decrease
in quantity, and so total revenue remains unchanged. Finally, if demand is inelastic, an
increase in price leads to a smaller proportionate decline in quantity, and so the total
revenue of the firm rises.

6. (a) A firm facing a negatively sloped demand curve would never produce in the inelastic
portion of the demand curve because it could increase total revenue by increasing
price. With an increase in price, the firm would produce less of the commodity and
also save on production costs. Thus, the firm would face higher total revenues and
lower production costs by increasing prices until it operates in the elastic range of its
demand curve.

(b) The firm would want to operate at the point where its demand curve is unitary elastic
only in the unusual situation where production and selling costs are zero. Then the
firm would maximize profits by maximizing total revenue, and total revenue is
maximized at the point where the demand curve is unitary elastic.

7. (a) We would expect the price elasticity of demand for Chevrolets to be much higher than
the price elasticity of demand for automobiles in general because there are many good
substitutes for Chevrolets, while few good substitutes are available for automobiles in
general.

(b) We would expect the price elasticity of demand for electricity for residential use to be
much greater than for industrial use because industrial users, using large amounts of
electricity, could generate their own electricity. This is generally not feasible for
residential users of electricity.

(c) We would expect the price elasticity of demand for electricity to be larger in the long
run than in the short run because in the long run there is more time to learn about the
availability of substitutes (such as gas ovens, solar energy, etc.) and to switch over to
substitutes. This is confirmed in Table 4-3 in the text.

58
 CHAPTER 4 DEMAND THEORY

8. (a) Since the short-run Ep for household natural gas is 1.40 and the long-run Ep = 2.10,
the quantity demanded decreases by 14% in the short run and by 21% in the long run.

(b) Since Ep for household electricity is 0.13 in the short run and Ep = 1.89 in the long
run, the quantity demanded decreases by 1.3% in the short run and by 1.89% in long
run.

9. Since the income elasticity of demand is measured by the percentage change in quantity
divided by the percentage change in income, the percentage change in the demand for a
commodity is equal to the product of the percentage change in income times the income
elasticity of demand for the commodity.
With a 10 percent increase in consumers' income and the income elasticity of 3.09 for air
travel (see Table 4-4 in the text), the demand for air travel increased by (10%)(3.09) =
30.9%.
With income having increased by l0 percent and with EI = 0.86 for tobacco products, the
demand for tobacco products must have increased by 8.6 percent. Finally, with income
having increased by 10 percent and with EI = -0.36 for flour, the demand for flour must
have decreased by 3.6 percent.

10. (a) A good harvest increases the supply of agricultural commodities. Given the demand for
agricultural commodities, this results in lower prices for farm products. Since the
demand for agricultural commodities is price inelastic, the reduction in prices after a
good harvest leads to a decline in the total revenues (income) of farmers.

(b) Since agricultural commodities are necessities (i.e., their income elasticity of demand
is positive but has a value below one), the increase in consumers’ income in the
process of economic growth leads to a smaller than proportional increase in the
demand for agricultural commodities. As a result, farmers’ incomes rise less than
proportionately in comparison to the rise in income in other sectors of the economy.

11. Since the cross-price elasticity of demand between McIntosh and Golden-Delicious apples is
positive and very large (0.8) they are very close substitutes. Since the cross-price elasticity of
demand between apples and apple juice is positive but not very large (0.5), apples and apple
juice are substitutes but not very good substitutes.
Since the cross-price elasticity of demand between apples and cheese is negative and not
very large (-0.4), apples and cheese are complements, but not very good complements.
Finally, since the cross-price elasticity of demand between apples and beer is close to zero,
apples and beer are practically independent commodities.

12. (a) Since the cross-price elasticity of demand between pork and beef is 0.40, a 10%
increase in the price of pork increases the demand for beef by 4%.

(b) Since the cross-price elasticity of demand between clothing and food is –0.18, a 10%
increase in the price of clothing reduces the demand for food by 1.84%.

59
PART TWO DEMAND ANALYSIS

13. (a) An elasticity can be calculated for each of the variables in the demand function for the
commodity that the firm sells.

(b) The firm can use the elasticity of demand for each variable under its control to
determine the best policies that are open to the firm to maximize profits or the value of
the firm. Some of the variables usually under the control of the firm are price, the
level of advertising, product quality, customers’ service, and discounts or other
incentive schemes that the firm can offer.

(c) The firm can use the elasticity of demand for each variable that is included in the
demand function, but over which the firm has little or no control, to determine the
most effective way to respond to these other forces and in planning for the future
growth of the firm.
Some of the variables over which the firm has no control but which have an important
effect on sales, profitability, and future growth prospects of the firm are the level and
growth of consumers’ income, the price charged by competitors, and competitors’
expenditures on advertising, quality control, customers’ service, and discounts or other
incentive schemes.

(d) Only by utilizing the elasticity of all the variables included in the demand function and
examining their interaction, can the firm determine the best policies available to
manipulate demand, to effectively respond to competitors’ policies, and to plan for the
growth of the firm.

14. (a) Tastes are converging around the world because of the ongoing information revolution,
increased travel, and many people around the world watching the same movies and TV
shows. The middle classes around the world seem to want more and more the same
lifestyle enjoyed by the middle class in the United States and in other industrialized
countries.

(b) The pressure to go global and introduce global products arises from the need to
achieve the economies of large scale production and in order to spread the high cost of
research and product development by selling products globally.

15. Since the mid-1990s, the Internet has given rise to electronic commerce or business and this is
revolutionizing traditional business relationships. The biggest lure for consumers is the
convenience of having round-the-clock access to the virtual store and engage in comparative
shopping at minimal cost and effort. Sellers get even greater benefits by being able to sharply
reducing their cost of executing sales and procuring inputs, reformulating supply chains and
logistics, and redefining customer relationship management. E-commerce has been likened to
the industrial revolution of the nineteenth century and is leading to a huge reengineering of
business.

60
 CHAPTER 4 DEMAND THEORY

ANSWERS TO PROBLEMS

1. Pc (the price of Chevrolets) is expected to be inversely related to Qc (the quantity demand of

Chevrolets) because of the law of demand. N (the size of the population) is expected to be
directly related to Qc because a larger population usually means more purchases. I (disposable
income) is also expected to be directly related to Qc because Chevrolets are normal goods (for
most people).

Pf (the price of Fords) is expected to be directly related to Qc because Fords are substitutes
for Chevrolets. Pg (the price of gasoline) is expected to be inversely related to Qc because
gasoline is complementary to automobiles. A (the amount of advertising for Chevrolets) is
expected to be directly related to Qc because we would expect more advertising to lead to
larger sales of Chevrolets. Finally, Pi (credit incentives) are expected to be directly related
to Qc because they effectively reduce (temporarily) the price of purchasing Chevrolets.

2. (a) The number of Chevrolets purchased per year (Qc) declines by 100 units for each $1
increase in the price of Chevrolets (Pc), increases by 2,000 units for each 1 million
increase in population (N), increases by 50 units for each one dollar increase in per
capita disposable income (I), increases by 30 units for each dollar increase in the price
of Fords (Pf).
On the other hand, Qc declines by 1,000 for each one cent increase in the price of
gasoline (Pg), increases by 3 units for each one dollar increase in advertising
expenditures on Chevrolets (A), and increases by 40,000 units for each 1 percentage
point reduction in the rate of interest charged to borrow to purchase Chevrolets (Pi).

(b) To find the value of Qc, we substitute the average value of the independent or
explanatory variables into the estimated demand function. Thus, for Pc = $9,000, N =
200 million, I = $10,000, Pf = $8,000, Pg = 80¢, A = $200,000, and Pi = 1 percentage
point, we have:

Qc = 100,000 - 100(9,000) + 2,000(200) + 50(10,000) + 30(8,000)

- 1,000(80) + 3(200,000) + 40,000(1)

Qc = 100,000 - 900,000 + 400,000 + 500,000 + 240,000 -80,000

+ 600,000 + 40,000

Qc = 900,000.

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PART TWO DEMAND ANALYSIS

(c) To derive the equation for the demand curve for Chevrolets, we substitute into the
estimated demand equation the average value of all the independent or explanatory
variables given above, with the exception of Pc. Thus, the equation of the demand
curve for Chevrolets is

Qc = 100,000 - 100 Pc + 2,000(200) + 50(10,000) + 30(8,000) - 1,000(80) + 3(200,000) + 40,000(1)

Qc = 1,800,000 - 100 Pc

(d) To derive the demand curve for Chevrolets (Dc), we substitute the hypothetical values
of $12,000, $9,000, and $6,000 for Pc into the equation of the demand curve found in
part (c).
This gives, respectively, Qc = 600,000, Qc = 900,000 and Qc = 1,200,000. Plotting
these price-quantity values, we get the demand curve for Chevrolets, Dc, shown in
Figure 1.

3. (a) To derive the equation for the new demand curve for Chevrolets, we substitute the new
average values of the independent or explanatory variables given in this problem into
the estimated demand function given in Problem 4.2. When we do this, we get

Qc = 100,000 - 100Pc + 2,000N + 50I + 30Pf - 1,000Pg + 3A + 40,000Pi

Qc = 100,000 - 100Pc + 2,000(225) + 50(12,000) + 30(10,000) - 1,000(100)

+ 3(250,000) + 40,000(0)

Qc = 2,100,000 - 100Pc

(b) To derive the new demand curve for Chevrolets (D'c), we substitute the hypothetical
values of $12,000, $9,000, and $6,000 for Pc into the equation of the new demand
curve found in part (a). This gives, respectively, Q'c = 900,000, Q'c = 1,200,000 and
Q'c = 1,500,000. Plotting these price-quantity values, we get the new demand curve
for Chevrolets, D'c, shown in Figure 2. Figure 2 also shows Dc from Figure 1.

(c) Since the constant term in the equation of the new demand curve found in part (a) of
this problem (2,100,000) exceeds the constant term in the equation of the previous
demand curve (1,800,000) found in part (c) of Problem 4.2, D'c is to the right of Dc.
That is, at each level of Pc, D'c indicates a greater demand for Chevrolets than Dc.

This results because the effect of the change in all the forces that cause the demand
curve to shift to the right (the increase in N, I, Pf, and A) exceeds the effect of all the
forces that cause the demand curve to shift to the left (the increase in Pg and the fall in
Pi). Thus, D'c is to the right of Dc.

4. (a) By substituting various prices for ice cream into the estimated demand function,
Michael gets the demand schedule for ice cream shown in Table 1, which he plots as
Figure 3.

62
 CHAPTER 4 DEMAND THEORY

Figure 1

Figure 2

Table 1

Pi ($) 6 5 4 3 2 1 0
Qi 0 20 40 60 80 100 120

63
PART TWO DEMAND ANALYSIS

(b) Michael finds the point price elasticity of demand (Ep) at each price by applying the
following formula, where ΔQi / ΔPi = a1 = -20.

Ep = Δ Qi . Pi = a1 . Pi
Δ Pi Qi Qi

At Pi = $6, Ep = -20($6/0) = -oo

At Pi = $5, Ep = -20($5/20) = -5

At Pi = $4, Ep = -20($4/40) = -2

At Pi = $3, Ep = -20($3/60) = -1

At Pi = $2, Ep = -20($2/80) = -1/2

At Pi = $1, Ep = -20($1/100) = -1/5

At Pi = $0, Ep = -20($0/120) = -0

(c) Michael finds the arc price elasticity of demand (Ep) between each two consecutive
price levels by applying the following formula, where a1 = -20 (as in part b) and the
numbers 2 and 1 refer to the new and original price and quantity, respectively, or vice-
versa.

Ep = a1 . Pi2+Pi1
Qi2+Qi1

Between Pi = $6 and Pi = $5, Ep = -20($6 + $5) / (0 + 20) = -11.

Between Pi = $5 and Pi = $4, Ep = -20($5 + $4) / (20 + 40) = -3

Between Pi = $4 and Pi = $3, Ep = -20($4+$3) / (40 + 60) = -7/5 = -1.4.

Between Pi = $3 and Pi = $2, Ep = -20($3 + $2) /(60 + 80) = -5/7 = -0.71

Between Pi = $2 and Pi = $1, Ep = -20($2 + $1 / (80 + 100) = -1/3 = -0.33.

Between Pi = $1 and Pi = $0, Ep = -20($1 + $0) / (100 + 120) = -1/11 = -0.09.

5. Figure 4 shows how Michael could have found the price elasticity of demand for ice cream
graphically at Pi = $4. We can also use Figure 4 to show that the price elasticity of demand at
Pi = $4 would have been the same if the demand curve for ice cream had been curvilinear but
tangent to the linear demand curve given in Problem 4.4 at Pi = $4. For linear demand curve
Di, Ep at Pi = $4 is given by

64
 CHAPTER 4 DEMAND THEORY

Ep = P = $4 = $4 = -2
P-A $4-$6 -$2

65
PART TWO DEMAND ANALYSIS

where P is the price of the commodity at which we want to find Ep and A is the price
of the commodity at which Q = 0 (see footnote 10 in Section 4-2 in the text). The
value of Ep at other points on Di can be similarly obtained. If the demand curve were
curvilinear (D*i in Figure 4) and tangent to Di at Pi = $4, Ep = -2 at Pi = $4, as for Di.

6. (a) By substituting Pi = $6 to Pi = $0 in the demand function for ice cream that the Parlor
faces, we get its demand, total revenue, and marginal revenue schedules given in Table 2.

Table 2

P Q TR = P•Q MR = ΔTR/ΔQ
$6 0 $ 0 --
5 20 100 $5
4 40 160 3
3 60 180 1
2 80 160 -1
1 100 100 -3
0 120 0 -5

(b) The demand, total revenue, and marginal revenue schedules of Table 2 are plotted in
Figure 5 shown on the next page. Di is price elastic at Pi > $3, unitary elastic at Pi =
$3, and price inelastic at Pi < $3. TR increases and MR is positive when Di is price
elastic, TR is maximum and MR = 0 when Di is unitary price elastic, and TR declines
and MR is negative when Di is price inelastic.

(c) TR = PQ. Since Q = 120-20P, TR = (120-20P)P = 120P-20P2.

The MR curve in Figure 5 starts at the same point on the vertical or price axis and is
twice as steep as the D curve. Therefore, MR = 120 - 40P. This could have been
obtained with calculus by d(TR) / dQ = MR = 120 - 40P.

7. (a) Since the demand for public transportation is price inelastic, the public transportation
authority could increase revenues by increasing the price of a ride. The reason is that
with a demand that is price inelastic, the decline in quantity (the number of rides) will
decline proportionately less than the increase in price.

(b) Since the total revenues are $100 million and the price of a ride is $1, the number of
rides taken is originally 100 million. With a price elasticity of demand of -0.4, if the
public transportation authority increases the price of a ride from $1 to $1.50, or by 50
percent, the number of rides would decline by (Ep)(%ΔP) = (-0.4)(50%) = 20%. Thus,
the number of rides would decline from 100 million to 80 million. With 80 million
rides at the price of $1.50 per ride, total revenue would be $120 million. This equals
total costs, so that the deficit would be eliminated.

66
 CHAPTER 4 DEMAND THEORY

8. (a) The income elasticity of demand (EI) is given by ΔQ . I, where ΔQ is the change
ΔI Q
in quantity and ΔI is the change in income. The estimated coefficient of I in the
regression of Q on I and other explanatory variables is 10. That is, Δ Q = 10.
ΔI
Thus, with income of $10,000 and sales of 80,000 units, EI=10(10,000/80,000) =
1.25.

(b) For an increase in sales from 80,000 to 90,000 units and an increase in consumers’
income from $10,000 to $11,000,

EI = Q2-Q1 . I2+I1 = 90,000-80,000 . $11,000+$10,000 = 1.24.

I2-I1 Q2+Q1 $11,000-$10,000 90,000+80,000

Since EI is positive, the good is normal, and since EI exceeds one, the good is a luxury.

9. (a) Since Ep = -1.2, a 5 percent increase in the price of automobiles, by itself, would
result in a (-1.2)(5%) = -6 percent change in the auto sales. On the other hand, with
EI = 3.0, a 3 percent increase in consumers’ disposable income, by itself, would result
in a (3)(3%) = 9 percent increase in auto sales.

Therefore, the net effect of both a 5 percent increase in auto prices and a 3 percent
increase in consumers’ disposable income would be a 3 percent (9% - 6%) increase in
the sales of domestic automakers. Thus, the sales of domestic automakers would be
(8,000,000)(1.03) = 8,240,000 next year.

(b) If domestic automakers wanted to increase sales by 5 percent, in the face of a three
percent increase in consumers’ disposable income, they would have to raise prices by
only 3.33 percent. With an increase in price of only 3.33 percent, the reduction in
auto sales resulting exclusively from the increase in the price of automobiles would be
(-1.2)(3.33) = -4 percent.

This reduction in auto sales of 4 percent resulting exclusively from the increase in
the price of automobiles, together with the increase in auto sales of 9 percent resulting
from the increase in consumers’ disposable income would leave a net increase in the
sales of domestically produced automobiles of 5 percent, as desired.

67
PART TWO DEMAND ANALYSIS

68
 CHAPTER 4 DEMAND THEORY

10. (a) If we let commodity X be automobiles and commodity Y be gasoline, the cross-price
elasticity of demand between X and Y (Exy) is given by Exy = ΔQx . Py,
ΔPy Qx
where ΔQx is the change in the quantity of X and ΔPy is the change in the price ofY.

The estimated coefficient of Py in the regression of Qx on Py and other explanatory

variables is -14. That is, ΔQx = -14
ΔPy
Thus, with Py = $1 and Qx = 8, Exy = -14(1/8) = -1.75. That is, automobiles and
gasoline are fairly strong complements.

(b) For a reduction in auto sales from 8 to 6 (million units) with an increase in the price
of gasoline from $1 to $1.20 per gallon,

Exy = Qx2 - Qx1 . Py2 + Py1 = 6 - 8 . $1.20 + $1 = -2 . $2.20 = -1.57

Py2 - Py1 Qx2 + Qx1 $1.20 - $1 6+8 $0.20 14

11. (a) A 10% increase in the price of cigarettes will reduce the quantity demanded of
cigarettes by 4.6% in the short run and by 18.9% in the long run; a 10% increase in the
income of consumers will increase the demand for cigarettes by 5.0%, and a 10%
increase in the price of alcohol will reduce the demand for cigarettes by 7.0 percent.
Thus, in the short run the demand for cigarettes will decrease by 6.6% (from -4.6 + 5.0 -
7.0).

(b) In the long run, the demand for cigarettes will decrease by 20.9% (from -18.9 + 5.0 -
7.0).

12. (a) Since Ep = -2, if the firm increased the price of steel by 6 percent, its sales would
change by (-2)(6%) = -12 percent. With EI = 1, the forecasted increase in income of 4
percent, by itself, would result in a (1)(4%) = 4 percent increase in the steel sold by the
firm. Finally, since Exy = 1.5, a reduction in the price of aluminum of 2 percent, by
itself, will result in a (1.5)(-2) = -3 percent change in steel sales.
Therefore, the net effect of a 6 percent increase in the price of steel by the firm, a 4
percent increase in income, and a 2 percent reduction in the price of aluminum would
result in a net decline in the sales of the firm of -12% + 4% - 3% = -11%. Thus, the
steel sales of the firm next year would be 1,200 - (1,200)(-11%) = 1,200 - 132 = 1,068
tons.

(b) By themselves (i.e., without any increase in the price of steel), the increase in income
and the reduction in the price of aluminum would result in a 1 percent increase in the
steel sales of the firm.
Thus, in order to keep sales unchanged, the firm can only increase the price of steel so
that, by itself, it would reduce the demand for steel by 1 percent. Since the price
elasticity of demand of the steel is -2, the firm can only increase the price of the steel by
0.5 percent.

69
PART TWO DEMAND ANALYSIS

13. (a) Using formula 4-12, we get, MR = $10 (1 – ½) = $5.

(b) Using formula 4-12, we get

$12 = $16 (1 – 1/Ep),

$12 = $16 – $16/Ep

-$4 = -$16/Ep

Ep = 4

(c) From Fig. 4-4 in the text, we see that a firm maximizes its total profits when it
produces where

MR = MC. Since MR = $12 for the firm in part (b), MC = $12 also.

14. A firm maximizes its total profits at the output at which MR=MC (see Figure 4-4 in the text).

Thus, for this firm MR = MC = $8.

Substituting the value of $8 for MR and Ep = -3 in formula 4-12, we get

8 = P(1 – 1/3) or $8 = 2/3P

Thus P = $12.

15. (a) Substituting Px = $2, I = $4, Py = $2.50, Pm = $1, A = $2 into the following estimated
equation, we get

Qx = 1.0 - 2.0Px + 1.5I + 0.8Py -3.0Pm +1.0A

Qx = 1.0 - 2.0(2) + 1.5(4) + 0.8(2.50) - 3.0(1) + 1.0(2) = 4

Thus, the CFC would sell 4 million boxes of its corn flakes this year.

(b) The elasticity of demand for CFC cornflakes with respect to its price, personal
disposable income, the price of competitive cornflakes, the price of milk, and
advertising is

Ep = -2(2/4) = -1
EI = 1.5(4/4) = 1.5
Exy = 0.8(2.50/4) = 0.5
Exm = -3.0(1/4) = -0.75
EA = 1.0(2/4) = 0.5

70
 CHAPTER 4 DEMAND THEORY

(c) If next year the CFC increases PX by 10 percent and its advertising by 20 percent, and,
if, at the same time, I increases by 5 percent, Py is reduced by 10 percent, and Pm
remains unchanged, the sales of CFC cornflakes next year (Qx') would be

Qx' = Qx + Qx(ΔPx/Px)Ep + Qx(ΔI/I)EI + Qx(ΔPy/Py)Exy + Qx(ΔPm/Pm)Exm + Qx(ΔA/A)EA

= 4 + 4(-10%)(-1) + 4(5%)(1.5) + 4(-10%)(0.5) + 4(0%)(-0.75) + 4(20%)(0.5)

= 4 + 4(-0.1)(-1) + 4(0.05)(1.5) + 4(-0.1)(0.5) + 4(0.0)(-0.75) + 4(0.2)(0.5)

= 4 + 0.4 + 0.3 - 0.2 + 0.0 + 0.4

= 4.9.

Thus, the CFC would sell 4.9 million boxes of its cornflakes next year.

(d) In order for the sales of the CFC next year to be 30% higher than this year, it must sell
5.2 million boxes of cornflakes. This is 0.3 million greater than forecasted. To
determine the additional increase in advertising expenditures, we set up the following
equation 4(Z)(0.5) = 0.3, so that Z = 0.15 is the additional percentage increase in
advertising. The 0.15 percent additional increase in advertising expenditures over this
year’s level of $200,000 is $30,000.

71
PART TWO DEMAND ANALYSIS

ANSWERS TO SPREADSHEETS PROBLEMS

1. (a) With η = -6 and P rising by 10 percent, Q would decline by 60 percent.

(b) Since demand is elastic, total expenditures on Marlboro cigarettes would decline.

(c) The quantity demanded by consumers of Marlboro cigarettes would only decline by
20% (-60% + 40%) and their total expenditures on Marlboro cigarettes would decline
by less than before.

2. The spreadsheet and graph should look as follows.

A B C D E F G H I J
1
2 QC PC N I PF PG A PI
3 900000 9,000 200 10,000 8,000 80 200,000 1
4
5 QC PC
6 1200000 6,000
7 900000 9,000
8 600000 12,000
9

14,000

12,000

10,000

8,000
Price

6,000

4,000

2,000

0
600000 900000 1200000
Quantity

72
 CHAPTER 4 DEMAND THEORY

3. (a) The sale of potatoes is 132.3 pounds per capita per year.

(b) EX = -17.7(3/132.3) = -0.40 and EI = 9.3(2.344/132.3) = 0.165.

(c) Q’ = 132.3 + 132.3(-0.15)(-0.40) + 132.3(0.20)(0.165) = 144.60.

(d) You must have (Q – Q’) / Q = 0.165(ΔI/I), so ΔI/I = % change of I = -0.10/0.165 =

= -.61 = -61%.

A B C D E F
1
2 Px I Q
3 3.000 2.344 132.3
4
5 Ex EI Q' % Change in I
6 -0.4 0.2 144.6 -0.61
7

ANSWERS TO APPENDIX PROBLEMS

1. Given U = QxQy, M = $100, Px = $2, and Py = $5, we can derive dx and dy by first forming
the following Lagrangian function:

L = QxQy - λ(M - PxQx -PyQy)

Taking the partial derivative of L with respect to Qx, Qy, and λ, and setting them equal to
zero, we get

∂L/∂Qx = Qy - λPx = 0
∂L/∂Qy = Qx - λPy = 0
∂L/∂λ = M - PxQx - PyQy = 0

Solving the first two equations for Qy and Qx, respectively, we get

Qy = λPx
Qx = λPy

Dividing the second equation into the first and solving for Qy, we get

Qy = (Px/Py)Qx

73
PART TWO DEMAND ANALYSIS

Substituting this value of Qy into the third partial derivative equation found above, we have

M = PxQx + Py(Px/Py)Qx = 2PxQx

Therefore,

Qx = M/2Px

Substituting M=$100 and Px=$2 into Qx=M/2Px, we get

Qx = $100/$4 = 25

and

Qy = (Px/Py)Qx = ($2/$5)25 = 10

Thus, with M = $100, Px = $2 and Py = $5, the consumer is in equilibrium, or maximizes

utility by purchasing Qx = 25 and Qy =10. This gives one point on dx and dy.

On the other hand, with Px = $1.50 and Px = $1, the individual is in equilibrium when he or
she consumes, respectively:

Qx = M/2Px = $100/$3 = 33 1/3

Qx = M/2Px = $100/$2 = 50

Thus, with Px = $2, Qx = 25; with Px = $1.50, Qx = 33 1/3, and with Px = $1, Qx = 50. By
joining these points, we derive dx. Note that the amount of money that this individual spends
on commodity X is always $50. Therefore, dx is a rectangular hyperbola. This also means
that the individual always spends $50 on commodity Y. Thus,

Qy = $50/Py

With Py = $5, Qy = 10 (as found earlier); with Py = $10, Qy = 5, and with Py = 20, Qy = 2.5.
By joining these points we derive dy (which is also a rectangular hyperbola).

74
 CHAPTER 4 DEMAND THEORY

2. The Lagrangian function is now

L' = f(Qx, Qy) + λ(kM - kPxQx - KpyQy) (4-28)

To maximize L', we find the partial derivative of L' with respect to Qx, Qy, and λ, and
set them equal to zero. That is,

∂L'/∂Qx = ∂f/∂Qx - kλPx = 0 (4-29)

∂L'/∂Qy = ∂f/∂Qy - kλPy = 0 (4-30)
∂L'/∂λ = M - kPxQx - kPyQy = 0 (4-31)

Transposing the negative term to the right in Equations 4-29 and 4-30, we get

∂f/∂Qx = kλPx (4-32)

∂f/∂Qy = kλPy (4-33)

Dividing the first equation by the second, we have

∂f/∂Qx = Px (4-34)
∂f/∂Qy Py

Cross multiplying, we get

∂f/∂Qx = ∂f/∂Qy (4-35)

Px Py

MUx/Px = MUy/Py (4-36)

Thus, whether we have Px, Py, and M or kPx, kPy, and kM, the condition for consumer
equilibrium is the same, and so are the derived demand functions for commodities X and Y.
Therefore, demand function is said to be homogeneous of degree zero with respect to prices
and income.

75
 CHAPTER 5

DEMAND ESTIMATION

5-1 THE IDENTIFICATION PROBLEM

5-2 MARKETING RESEARCH APPROACHES TO DEMAND ESTIMATION

Consumer Surveys and Observational Research
Consumer Clinics
Market Experiments
Case Study 5-1: Micromarketing: Marketers Zero in on Their Customers
Virtual Shopping and Virtual Management
Case Study 5-2: Estimation of the Demand for Oranges by Market Experiment
Case Study 5-3: Reaching Consumers in the Vanishing Mass Market

5-3 INTRODUCTION TO REGRESSION ANALYSIS

5-4 SIMPLE REGRESSION ANALYSIS

The Ordinary Least Squares Method
Tests of Significance of Parameter Estimates
Other Aspects of Significance Tests and Confidence Intervals
Test of Goodness of Fit and Correlation

5-5 MULTIPLE REGRESSION ANALYSIS

The Multiple Regression Model
The Coefficient of Determination and Adjusted R2
Analysis of Variance
Point and Interval Estimates

5-6 PROBLEMS IN REGRESSION ANALYSIS

Multicollinearity
Heteroscedasticity
Autocorrelation

5-7 DEMAND ESTIMATION BY REGRESSION ANALYSIS

Model Specification
Collecting Data on the Variables
Specifying the Form of the Demand Equation
Testing the Econometric Results
Case Study 5-4: Estimation of the Demand for Air Travel over the North Atlantic

76
 CHAPTER 5 DEMAND ESTIMATION

5-8 ESTIMATING THE DEMAND FOR U.S. IMPORTS AND EXPORTS

Case Study 5-5: Price and Income Elasticities of Imports and Exports in the Real World
Case Study 5-6: The Major Commodity Exports and Imports of the United States
Case Study 5-7: The Major Trade Partners of the United States
Case Study 5-8: The Top US International Exporters
BOX 5 – Managerial Economics at Work: BlackBerry Crumbles

SUMMARY
DISCUSSION QUESTIONS
PROBLEMS
APPENDIX TO CHAPTER 5: REGRESSION ANALYSIS WITH EXCEL
APPENDIX PROBLEMS
SUPPLEMENTARY READINGS
INTERNET SITE ADDRESSES

KEY TERMS In the order of their appearance)

__________________________________________________________________________

Identification problem t test

Consumer surveys Confidence interval
Observational research Coefficient of determination (R2)
Micromarketing Total variation
Customer relationship management (CRM) Explained variation
Consumer clinics Unexplained variation
Market experiments Coefficient of correlation
Virtual shopping Multiple regression analysis
Virtual management Adjusted R2 ( R 2)
Scatter diagram Analysis of variance
Regression analysis F statistic
Regression line Standard error (SE) of the regression
Least-square method Multicollinearity
Degrees of freedom (df) Heteroscedasticity
Simple regression analysis Cross-sectional data
t statistic Autocorrelation
Significance test Time-series data
Critical value Durbin-Watson statistic (d)

77
PART TWO DEMAND ANALYSIS

ANSWERS TO DISCUSSION QUESTIONS

1. (a) The line connecting the observed price-quantity data points does not usually represent
the demand curve for the commodity because each observed price-quantity data point
is the joint result (intersection) of a different demand and a supply curve for the
commodity.

(b) To derive the demand curve for a commodity from the observed price-quantity data
points, we allow the forces that cause the supply curve to shift or be different to
operate unhampered, while identifying and correcting for the forces that cause the
demand curve to shift. This is accomplished by multiple regression analysis.

2. The major advantages of estimating demand by consumer surveys are:

They may provide the only information available;
They can be made as simple or as elaborate as desired;
The researcher can ask exactly the questions he or she wants.
The major disadvantages of consumer surveys are:
Consumers may be unable or unwilling to provide reliable answers.
Careful and extensive consumer surveys can be very expensive.

3. The major advantages of consumer surveys are:

They are more realist than consumer surveys.
They cannot be ruined by extraneous events as is the case for market experiments.
The major disadvantages of consumer surveys are:
Results are questionable because consumers know that they are in artificial situation.
The sample of participants must necessarily be small because of the high cost.

4. The major advantages of estimating demand by market experiments are:

Consumers in a real market situation do not know that they are being observed.
Market experiments can be conducted on a large scale and with controls so as to ensure the
validity of the results.
Sometimes they may provide the firm with the only market demand available for a
commodity.
The major disadvantages of market experiments to estimate demand are:
In order to keep costs down, the experiment is likely to be conducted on a too limited scale
and over too short a period of time, so that inferences about the entire market and over a
more extended period of time are questionable.
Extraneous occurrences, such as a strike or unusually bad weather, may seriously bias the
results in an uncontrolled experiment.
Competitors could try to sabotage the experiment by also changing prices and other
determinants of demand under their control.
Competitors can monitor the experiment and gain very useful information that the firm
would prefer not to disclose.

78
 CHAPTER 5 DEMAND ESTIMATION

The firm may permanently lose customers in the process of raising prices in the market
where it is experimenting with a high price.

5. (a) While consumer surveys, consumer clinics, market experiments, and other marketing
research approaches to demand estimation may be useful, by far the most useful and
used method of demand estimation by managers and economists is regression analysis.
Regression analysis is usually more objective, provides more complete information,
and is generally less expensive than properly conducted consumer surveys, consumer
clinics, market experiments, and other marketing research approaches to demand
estimation.

(b) Consumer surveys, consumer clinics, market experiments, and other marketing
research approaches to demand estimation may be useful to managers and economists
for:
verifying the results of demand analysis by the regression method;
gathering data about some of the variables for the regression analysis;
estimating demand when no statistical data are available (as in the case of a new
product) to conduct regression analysis.

6. (a) The steps that are usually involved in estimating a demand equation by regression
analysis are the following four: (1) the model must be specified (i.e., the variables to
include in the demand equation must be determined); (2) the data on each variable or
its proxy must be obtained; (3) the researcher must decide on the functional form (e.g.,
linear or power function formulations) of the demand equation, and (4) the regression
results must be evaluated.

(b) The researcher determines the demand model to estimate (i.e., the explanatory
variables to include in the model) from his or her knowledge of demand theory and the
market for the commodity.
Demand theory identifies the variables that are generally important in all demand
functions. These include the price of the commodity, consumers’ incomes, the number
of consumers in the market, the price of related (i.e., substitute and complementary)
commodities, and consumers’ tastes.
The demand for a commodity also depends on some specific variables that are
important for the particular commodity. These might include the level of advertising
by the firm and its competitors, the availability of credit incentives, consumers’
expectations about prices of the commodity and business conditions in the future, and
so on.
Often data are not available on all the variables that are thought to be important. In
those cases, the researcher can seek proxies for these variables or collect data on them
by consumer surveys. Omitting important variables will bias the results.
The number of variables included in a regression analysis must, however, be relatively
small (say, no more than 5 or 6) in order to have sufficient degrees of freedom and to
avoid problems of multicollinearity.

79
PART TWO DEMAND ANALYSIS

7. (a) A great deal of the data that a researcher is likely to require to estimate a demand
equation by regression analysis is likely to be published in some government
publication. This is especially true for such general variables as commodity prices,
consumers’ incomes, and size of the market, which are included in practically all
demand equations.
For data on specific variables included by the firm in the demand equation, the firm
may have to rely on its own internal records, publications of the business association in
the particular market (if it exists), consumer surveys conducted by the firm, or other
such direct methods.
Sometimes, a proxy may have to be used for a variable for which there are no data
and/or it is too difficult, time consuming, or expensive to obtain the data directly. Data
availability may also dictate whether the researcher utilizes time-series or cross section
data in estimation.

(b) Some of the most useful sources of published data on general economic variables that
a firm is likely to need in estimating demand are: the Survey of Current Business, the
Statistical Abstract of the United States, the Federal Reserve Bulletin, and the Annual
Economic Report of the President.

8. (a) There are only two ways to determine the form of the demand equation to be
estimated. The first is to plot on a graph (scatter diagram) the dependent variable
against each of the independent or explanatory variables included in the demand
equation and determine from the graph if the relationships are approximately linear or
not.
Another way to determine the form of the demand equation is from theory. If we
believe that the marginal effect of each explanatory variable on demand does not
depend on the level of the variables included in the demand equation, then the linear
form is appropriate.
On the other hand, if the marginal effect on demand of each explanatory variable is
believed to depend on the level of the explanatory variables, then the power function is
more likely to be the appropriate form of the demand equation.
In general, however, it is often difficult to determine by the two methods outlined
above the most appropriate form of the demand equation. Thus, both the linear and the
power function formulations of the demand equation are usually estimated and the
formulation that gives the better results (fit) is reported.
While other forms of the demand equation are sometimes estimated, the linear and the
power function formulations are by far the most common.

(b) In the linear function, the slope coefficient of each explanatory variable measures the
marginal effect of that explanatory variable on the demand for the commodity (the
dependent variable). By multiplying this coefficient by the ratio of the average value
of the explanatory variable to the average demand, we obtain the elasticity of demand
for the commodity with respect to that explanatory variable.

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 CHAPTER 5 DEMAND ESTIMATION

On the other hand, in the power formulation of the demand equation, the slope
coefficient of each explanatory variable is, itself, the elasticity of the demand for the
commodity with respect to that explanatory variable.

9. (a) The value of a parameter estimated by regression analysis varies with the sample data
used in the regression analysis. Thus, we do not know if the true but unknown
parameter is indeed different from zero, without conducting a test of the statistical
significance of the estimated parameter.

(b) A significance test is conducted by estimating the value of the t-statistic and
comparing its value to the critical value that we look up in the table of the
t-distribution for the specific level of significance (usually the 5 percent level) and
appropriate degrees of freedom.
The t-statistic is given by the ratio of the estimated coefficient to the standard error or
deviation of the estimated coefficient. The degrees of freedom is equal to the number
of observations or sample data used in the regression analysis minus the number of
estimated parameters in the regression.
The greater is the value of the ratio of the estimated parameter to its standard error, the
greater is the likelihood that there is indeed a statistically significant relationship
between the independent and the dependent variable in the regression analysis, and the
greater is, therefore, the confidence we have in the estimated parameter.

(c) A confidence interval gives the range of values within which we are confident (usually
at the 95 percent level) that the true value of the parameter lies.

(d) The confidence interval for a parameter is obtained by adding and subtracting from the
estimated value of the parameter, the standard error of the estimate times the critical t-
value (obtained from the table of the t-distribution, usually at the 5 percent level of
significance so as to have a 95 percent confidence interval).

10. (a) We can test for the overall explanatory power of the entire regression by calculating the
coefficient of determination. The coefficient of determination (R2) is defined as the
proportion of the total variation or dispersion in the dependent variable (about its mean)
that is explained by the independent or explanatory variable in the regression.
The closer the observed data points fall to the regression line, the greater is the
proportion of the total variation in the dependent variable (Y) that is explained by the
variation in the independent or explanatory variable (X), and the larger is the value of
the coefficient of determination or R2.
If all the data points were to fall on the regression line (a most unusual occurrence in
economics), all of the variation in the dependent variable (Y) would be explained by the
independent or explanatory variable (X), and R2 would be equal to 1 or 100 percent. At
the opposite extreme, if none of the variation in Y were explained by the variation in X,
R2 would be equal to zero. Thus, the value of R2 can assume any value from 0 to 1.

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PART TWO DEMAND ANALYSIS

(b) The total variation of the dependent variable (Y) is given by the sum of the squared
deviations of each observed value of Y (Y) from its mean (X). The explained
variation in Y is given by the sum of the squared deviations of each estimated value of
Y from its mean. The unexplained variation in Y is the sum of the squared deviations
of each observed value of Y from its corresponding estimated value.

(c) The coefficient of correlation (r) measures the degree of association or covariation
between two variables. The value of r can be obtained from the square root of the
coefficient of determination.

11. Regression analysis implies but does not prove causality (i.e., that the variation in X causes the
variation in Y). Only theory can tell us if we can expect the variation in X to result in variation
in Y. It is possible that a high coefficient of variation between X and Y may be due to some
other factor that affects both X and Y, which is not included in the regression analysis. In such
a case, we would simply say that there is correlation or covariation between X and Y without
identifying one variable (X) and the independent or explanatory variable.

12. (a) The analysis of variance is used to test the overall explanatory power of the entire
regression. This utilizes the value of the F statistic, or F ratio. Specifically, the F-
statistic is used to test the hypothesis that the independent variables (the Xs) explain a
significant proportion of the variation in the dependent variable (Y).
This is equivalent to the test of the null hypothesis that all of the regression coefficients
are equal to zero against the alternative hypothesis that they are not all equal to zero.

(b) The first step in the analysis of variance is to calculate the F statistic (this is routinely
given by most computer printouts). The F statistic is given by the ratio of the explained
variance divided by k - 1 degrees of freedom to the unexplained variance divided by n -
k degrees of freedom, where k is the number of estimated parameters in the regression
and n is the number of observations.
We then compare this calculated value of the F statistic with the critical F value from
the F distribution for the particular level of statistical significance chosen (usually the 5
percent level), and k - 1 and n - k degrees of freedom.
If the calculated value of the F statistic exceeds the critical F value from the F table, we
accept the hypothesis that the independent variables explain a significant proportion of
the variation in the dependent variable (i.e., we accept the alternative hypothesis at the
specified level of significance that not all coefficients are equal to zero).

(c) Both the adjusted R2 and the analysis of variance measure the overall explanatory
power of the entire regression analysis. However, whereas R 2 measures the proportion
of the explained to the total variation in the dependent variable, the analysis of variance
tests whether the regression has explained a statistically significant proportion of the
total variation in the dependent variable.

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13. (a) Multicollinearity arises when two or more explanatory variables are highly correlated in
regression analysis. Multicollinearity leads to exaggerated standard errors and biased
statistical tests.

(b) Multicollinearity can be easily detected when the estimated coefficients in the
regression are statistically insignificant even though the coefficient of determination
(R2) is very high.

(c) Multicollinearity could be overcome or reduced by increasing the sample size, utilizing
a priori information, using a different functional form, or dropping one of the highly
collinear variables. The latter method, however, can lead to mispecification of the
regression model, which is an even more serious problem than multicollinearity.

14. (a) Autocorrelation often arises in time series data when consecutive errors have the same
sign or change sign frequently. This leads to exaggerated t statistics, and unreliable R2
and F statistics.

(b) Autocorrelation can be detected by inspecting the plot of the errors or residuals against
time or, more usually and precisely, by the Durbin-Watson test.

(c) Autocorrelation may be corrected by including a time trend or an important missing

variable in the regression, using a nonlinear form, running the regression on first
differences in the variables, or with more complex techniques.

15. (a) The domestic-currency price of a nation’s imports depend on the foreign-currency price
of the nation's imports and on the exchange rate for the nation's currency.

(b) If the foreign-currency price of the nation’s imports increases and the nation’s currency
depreciates, the domestic-currency price of the nation's imports will increase for both
reasons.

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PART TWO DEMAND ANALYSIS

ANSWERS TO PROBLEMS

1. (a) In Figure 1, the observed price-quantity data points fall downward and to the right.
Each point is the result of the interaction of demand and supply forces (i.e., the result
of the intersection of a demand and a supply curve of the commodity).
Since the observed data points fall downward and to the right, shifts in the supply
curve are generally larger than shifts in the demand curve (for time-series data) or
differences in supply curves are greater than differences in the demand curves across
different individuals or areas.
By allowing the forces that cause the supply curve of the commodity to shift to operate
un-hampered, while correcting for the forces that cause the demand curve to shift, we
can derive the demand curve for the commodity (as, for example, the dashed demand
curve in Figure 1).
This is accomplished by running a regression of the observed quantities of the
commodity on the price of the commodity, consumers’ incomes, the price of related
(i.e., substitute and complementary) commodities, consumer tastes, and all the more
specific forces that affect the demand for the particular commodity.

(b) If the observed price-quantity data points are clustered or bunched together as in
Figure 2, this means that both the demand curve and supply curve of the commodity
do not shift very much (in time-series data), or different demand curves are very
similar to one another and different supply curves are also very similar to one another
(in cross-section data).
In such cases, correcting for the forces that cause the supply curve to shift will give or
define, more or less, a single point on the demand curve rather than the demand curve
itself.
On the other hand, correcting for the forces that cause the demand curve to shift would
give or define, more or less, a single point on the supply curve of the commodity.
Thus, when the observed price-quantity data points are clustered or bunched together
as in Figure 2, we can derive neither the demand curve nor the supply curve of the
commodity by regression analysis. In such cases, the demand curve for a commodity
may have to be derived by consumer surveys, consumer clinics, and market
experiments. Such methods can also be used to collect additional data to resolve the
identification problem.

2. (a) See Figure 3.

(b) See Figure 4.

(c) Because of changing and varying weather conditions, the supply curve of agricultural
commodities is likely to shift much more than the demand curve (since most foods are
necessities). Thus, it may be easier to derive or identify the demand curve than the
supply curve of agricultural commodities from the observed price-quantity data points.

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 CHAPTER 5 DEMAND ESTIMATION

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PART TWO DEMAND ANALYSIS

The same may be true in the markets for commodities, such as pocket calculators,
where very rapid technological change shifted the supply curve of pocket calculators
The same may be true in the market for commodities, such as calculators, where very
rapid technological change shifted the supply curve of pocket calculators in a very
short time during which demand conditions did not change much.
In the case of most industrial commodities, however, the demand curve is more likely
to shift than the supply curve because of business cycles. Thus, it may be easier to
derive or identify the supply curve than the demand curve from the observed price-
quantity data points.

3. (a) Since the price elasticity of demand for Florida Indian River oranges is -3.07, a 10
percent decrease in the price of these oranges would increase their quantity demanded
by (-10%)(-3.07) = 30.7 percent.
Since the price elasticity of demand for Florida interior oranges is -3.01, a 10 percent
decrease in the price of these oranges would increase their quantity demanded by
(-10%)(-3.01) = 30.1 percent.
Since the price elasticity of demand for California oranges is -2.76, a 10 percent
decrease in the price of these oranges would increase their quantity demanded by
(-10%)(-2.76) = 27.6 percent.

(b) Since the demand for all three types of oranges is price elastic, a decline in price will
increase the total revenue of the sellers of all three types of oranges because the
percentage increase in quantity sold exceeds the percentage decrease in their prices.
Specifically, for the sellers of Florida Indian River oranges, the 10 percent decrease in
price would result in an increase in the quantity sold of 30.7 percent, so that their total
revenue would increase by 30.7%-10% = 20.7%.
For the sellers of Florida interior oranges, the 10 percent decrease in price would result
in an increase in the quantity sold of 30.1 percent, so that their total revenue would
increase by 30.1%-10% = 20.1%.
For the sellers of California oranges, the 10 percent decrease in price would result in
an increase in the quantity sold of 27.6 percent, so that their total revenue would
increase by 27.6%-10% = 17.6%.

(c) Total profits are equal to the total revenue minus the total costs. We know from part
(b) that the sellers’ total revenue increases, but their total costs will also increase (to
grow, transport, and sell more oranges). Their profits will increase if the increase in
their total revenue exceeds the increase in their total costs. Since we do not know by
how much total costs increase by selling more oranges, we cannot answer this question
more precisely.

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4. Since the cross-price elasticity of demand between Florida Indian River oranges and Florida
interior oranges is 1.56 (the entry in the first row and second column of Table 5-1) a 10 percent
increase in the price of Florida interior oranges would lead to a (10%)(1.56) = 15.6 percent
increase in the demand for Florida Indian River oranges.
On the other hand, since the cross-price elasticity of demand between Florida interior
oranges and Florida Indian River oranges is 1.16 (the entry in the second row and first
column of Table 5-1), a 10 percent increase in the price of Florida Indian River oranges
would lead to a (10%)(1.16) = 11.6 percent increase in the demand for Florida interior
oranges.

5. (a) Table 1 shows the calculations to find a and b for the data in Table 5-6 in the text on
sales revenues of the firm (Y) and its expenditures on quality control (for simplicity
label this Z rather than X2 here).
By then using the value of b found below and the values of Y and Z found in Table 1,
we get the value of a of
a = Y - bX = 50 - 3.44(5) = 32.80
Thus, the equation of the regression line is
Yt = 32.80 + 3.344Zt

(b) With quality-control expenditures of $3 million as in the first observation year (i.e.,
with Z1 = $3 million), Y1 = 32.80 + $3.44(3) = $43.12 million. On the other hand, with
Z10 = $8 million, Y10 = $32.80 + 3.44(8) = $60.32 million. Plotting these two points (3,
43.12) and (8, 60.32) and joining them by a straight line, we have the regression line
plotted in Figure 5 on age 69.

n
Σ(Xt-X)(Yt-Y)
b= t=1 __ = 110 = 3.44
n 32
Σ(Xt - X)2
t=1

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PART TWO DEMAND ANALYSIS

Table 1
Calculations to Estimate Regression Line of Sales on Quality Control

Year Yt Zt Yt - Y Zt - Z (Zt - Z )(Yt - Y ) Σ(Zt - Z )2

1 44 3 -6 -2 12 4
2 40 4 -10 -1 10 1
3 42 3 -8 -2 16 4
4 46 3 -4 -2 8 4
5 48 4 -2 -1 2 1
6 52 5 2 0 0 0
7 54 6 4 1 4 1
8 58 7 8 2 16 4
9 56 7 6 2 12 4
10 60 8 10 3 30 9
n=10 ΣYt = 500 ΣZt = 50 Σ(Yt - Y ) =0 Σ(Zt - Z ) = 0 Σ(Zt - Z )(Yt - Y ) Σ(Zt - Z )2
Y = 50 Z =5 = 110 = 32

(c) If the firm’s expenditure on quality control was $2 million, its estimated sales revenue
would be

Ŷ t = 32.80 + 3.44(2) = $39.68 million

On the other hand, if the firm’s expenditure on quality control was $9 million, its
estimated sales revenue would be

Ŷ t = 32.80 + 3.44(9) = $63.76 million

These results are greatly biased because we have seen in the text that the sales
revenues of the firm also depend in an important way on its advertising expenditures.
By including only the firm's quality control expenditures in estimating the regression
line we obtain biased estimates for the a and b parameters and, therefore, biased values
for the forecast of the firm’s sales revenues.
The same, of course, is the case when sales revenues are regressed only on the firm’s
advertising expenditures (as was done in the text). The only reason for running these
simple regressions is to make it easier for the student to understand how regression
analysis is performed and how its results are interpreted.

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Figure 5

6. (a) Ŷ t = 114.074 - 9.470X1t + 0.029X2t

(-5.205) (4.506)

R2 = 0.96822 R 2 = 0.96448 F = 258.942

The value of b1 = -9.47 indicates that a $1 decline in the price of the commodity will
lead to a 9.47 unit increase in the quantity demanded of the commodity. On the other
hand, the value of b2 = 0.029, indicates that a $100 increase in consumers’ income will
increase the quantity demanded of the commodity by 2.9 units.

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PART TWO DEMAND ANALYSIS

(b) Since the t statistic for both b1 and b2 exceed the critical t value of 2.110 for 17 df, both
slope coefficients are statistically significant at the 5 percent level.

(c) The unadjusted and adjusted coefficients of determination are R2 = 0.96822 and R 2 =
0.96448, respectively. This means that the variation in price and income explains
96.82 percent of the variation in the quantity demanded of the commodity when no
adjustment is made for degrees of freedom, and 96.45 percent when such an
adjustment is made.

(d) Since the value of the F statistic exceeds the critical F value of 3.59 with k – 1 = 3 – 1
= 2 and n – k = 20 – 3 = 17 df, we accept the hypothesis that the regression explains a
significant proportion of the variation in the quantity demanded of the commodity (Y)
at the 5 percent level of significance.

7. The statistical significance of the estimated slope coefficients, R 2, and the F-statistic in the
demand equation estimated in double-log form are very similar to those obtained in Problem 6
in linear form. The only advantage that the double-log formulation might have over the linear
formulation of the demand function is that the estimated slope coefficients in the former
represent elasticities rather than marginal effects (as in the latter).
Specifically, b1 indicates that a one percent increase in the price of the commodity leads to a
0.39 percent decline in the quantity demanded of the commodity. Thus, the demand
function of the commodity is price inelastic. On the other hand, b2 gives an income
elasticity of 0.77. Thus, the commodity is a necessity.

8. (a) Since the price elasticity of demand is negative for all public goods, they all satisfy the
law of (negatively sloped) demand. The demand is price elastic (i.e., the price
elasticity of demand exceeds the value of one, when disregarding the sign) for
elementary school aid, parks and recreational areas, and highway construction and
maintenance.

(b) Since the income elasticity of demand is positive for all the public goods listed, all of
them are normal goods. Furthermore, since the income elasticities of demand are
smaller than one, they are all necessities, except for elementary school aid and parks
and recreational areas, which are luxuries.

(c) If the price or cost of college and university education increased by 10 percent, this, by
itself, would result in an 8.7% decline in the quantity demanded of college and
university education (from -0.87 times 10%). On the other hand, if incomes rose by 10
percent, this, by itself, would result in a 9.2 percent increase in the demand for college
and university education (from 0.92 times 10%).
Thus, the net effect of a 10 percent increase in the price or cost of college and
university education and a simultaneous 10 percent increase in incomes would be in a
0.5 percent increase in the demand for college and university education.

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9. (a) The result of the first regression clearly points to a multicollinearity problem in the
regression. Specifically, the t-statistic of both slope coefficients are statistically
insignificant at the 5 percent level, while the adjusted coefficient of determination is
very high ( R 2 = 98.94%).
The multicollinearity in regression 1 is also evident from the fact that when each
explanatory variable is used alone in a simple regression (regressions 2 and 3) each is
statistically highly significant (i.e., each has a very high t statistic).
Removing one of the explanatory variables in regression 1 (as done in regressions 2
and 3), however, leads to biased estimates since economic theory postulates that both
GNP and price are important determinants of imports.

(b) The fourth regression attempts to remove the multicollinearity between GNP and P by
dividing both M and GNP (Y) by P, and running the regression on the transformed
variables. Thus, regression 4 tests the hypothesis that real imports are a positive
function of real GNP. By doing so, regression 4 overcomes the multicollinearity
problem without resulting in a misspecified relationship (since P was implicitly
considered).

10. (a) All the estimated slope coefficients have the correct sign (i.e., the sign postulated by
demand theory). Specifically, a one unit increase in real per capita consumption
expenditures during a given year (Xt) results in a 0.0159 increase in the real per capita
consumption expenditures on bus transportation during the same year (Qt).
Similarly, a one unit increase in Pt results in a 0.1156 decrease in Qt, and a one unit
increase in St results in a 86.106 decrease in Qt. Thus, as expected, the stock of cars per
capita is a substitute for bus transportation. Finally, there has been a decline of 0.9841
in the value of the constant term in the regression during the post-war period.

(b) In view of the very high values of the t-statistics, all of the estimated coefficients are
statistically significant at better than the 1 percent level. The regression explains over
99 percent of the variation in Qt.

(c) Since all of the estimated slope coefficients are statistically significant at better than the
1 percent level, multicollinearity does not seem to be a problem. Finally, since the
value of the D-W statistic falls within the level of dL and dU, the test for evidence of
autocorrelation is indeterminate.

11. (a) The 4% increase in the price of TV sets in Japan and the 5% depreciation of the dollar
lead to a net increase of 9% in the dollar price of imported TV sets in the United States,
from $300 to $327.

(b) Since the price elasticity of demand for the TV sets in the United States is -1.5, the 9%
increase in price will lead to a (1.5)(0.09) = 0.135 or 13.5% reduction in the quantity
demanded of imported TV sets in the United States.

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PART TWO DEMAND ANALYSIS

(c) Since consumers’ income increases by 3% in the United States and the income elasticity
of demand for the imported TV sets is 2, the demand for the imported TV sets increases
by 6% as a result of the increase in consumers’ income alone.

(d) Since the price increase leads to a 13.5% decline in the quantity demanded, while the
3% increase in incomes leads to a 6% increase in demand, the net effect of both the
price and income increases is a 7.5% reduction in the demand for imported TV sets in
the United States.

12. (a) The 4% increase in the price of TV sets in Japan and the 5% appreciation of the dollar
lead to a net decrease of 1% in the dollar price of imported TV sets in the U.S., from
$300 to $297.

(b) Since the price elasticity of demand for the TV sets in the United States is -1.5, the 1%
decrease in price will lead to a (1.5)(0.01) = 0.015 or 1.5% increase in the quantity
demanded of imported TV sets in the United States.

(c) Since consumers’ income increases by 3% in the United States and the income elasticity
of demand for the imported TV sets is 2, the demand for the imported TV sets increases
by 6% as a result of the increase in consumers' income alone.

(d) Since the price decrease leads to a 1.5% increase in the quantity demanded and the 3%
increase in incomes leads to a 6% increase in demand, the net effect of both the price
and income changes is a 7.5% increase in the demand for imported TV sets in the
United States.

13. (a) By itself, the 10% increase in the price of household natural gas reduces the quantity
demanded by 14% in the short run; the 10% increase in consumers’ income increase
demand for natural gas by 12%, the 10% increase in the price of electricity increases the
demand for natural gas by 8%, and the 10% increase in population increases the
demand for natural gas by 10%. thus, the 10% increase in all variable increases the
demand for house-hold natural gas for the california power company by 16% (–14% +
12% + 8% + 10%).

(b) In the long run, the demand for household natural gas is expected to increase by 9%
(-21% + 12% + 8% + 10%).

14. The California Power Company management should ask its statistical department to provide it
with the t- values of the estimated parameters so as to be able to determine their statistical
significance. It should also ask for the coefficient of determination to see what percentage of
the variation in the demand for its household natural gas is in fact “explained” by the variation
in the variables included in the analysis. Finally, the management should ask for the D-W
statistics of the regression to determine if the assumption of regression analysis are satisfied (so
that the significance of the estimated parameters are not overestimated).

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15. (a) We have chosen to include the price of commodity Z into the regression equation
because economic theory postulates that the quantity demanded of a commodity per unit
of time is a function of or depends not only on the price of the commodity, the
consumers’ income, but also on the price of related commodities.

(b) From the t-test, we conclude that the estimated slope coefficient of Px and Y are
statistically significant at the 5 percent level (the critical value from the table of the t
distribution for n – k = 20 -4 = 16 df is 2.12), and the regression explains a very high
and significant proportion of the variation in Qx.

(c) Since the estimated slope coefficient of Pz is negative, commodity Z seems to be a

complement of commodity X. That is, when Pz rises, less of both commodities X and Z
are purchased. Thus, the relationship between X and Z seems to be one of
complementarity.

However, since the estimated slope coefficient of Pz is not statistically significant, we

cannot make much of the negative sign of Pz. Indeed, were we not to suspect
multicollinearity between Px and Pz, we would have to conclude that commodities X
and Z are unrelated.
There is however, strong collinearity between Pz and Px as indicated by the simple
correlation coefficient, r = 0.98. Therefore, we cannot be sure whether commodity Z is
a complement, a substitute, or is unrelated to commodity X.

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PART TWO DEMAND ANALYSIS

ANSWERS TO APPENDIX PROBLEMS

1. (a) The estimated regression gives you Ŷi = 59.13 – 2.60Xi.

(b) t0 ≈ 6.82, t1 ≈ -3.66 and both are significant at the 5% level. (c) R2 = 0.51.

2. The output of the regression gives you the equation Ŷt = 32.80 + 3.44Zt. Plugging this equation
in, your spreadsheet and graph output should look as follows. The forecast and actual data do
not differ much.

A B C D E F G H I J K L M
1
2 Quality Control (Z) 3 4 3 3 4 5 6 7 7 8
3 Sales Revenue (Y) 44 40 42 46 48 52 54 58 56 60
4
5 Z 2 3 4 5 6 7 8 9
6 Y Forecast 39.68 43.12 46.56 50.00 53.44 56.88 60.32 63.76
7

70

60

50

40
Sales (Y)

Actual
Forecast
30

20

10

0
0 1 2 3 4 5 6 7 8 9 10
Quality Control (Z)

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 CHAPTER 5 DEMAND ESTIMATION

3. (a) The estimated regression gives you Ŷi = 6.26 – 0.38X1i + 0.45X2i.

(b) The estimated OLS regression equation indicates that the level of real per capita
income Y is inversely related to the percentage of the labor force in agriculture X1 but
directly related to the years of schooling of the population over 25 years (as might
have been anticipated).
Specifically, the coefficient of X1i indicates that a 1 percentage point decline in the
labor force in agriculture is associated with an increase in per capita income of 380 US
dollars while holding X2 constant. However, an increase of 1 year of schooling for the
population over 25 years of age is associated with an increase in per capita income of
450 US dollars, while holding X1 constant. When X1i = X2i = 0, Ŷi = 6.26.

A B C D E F
1

2 n Y X1 X2
3 1 6 9 8
4 2 8 10 13
5 3 8 8 11
6 4 7 7 10
7 5 7 10 12
8 6 12 4 16
9 7 9 5 10
10 8 8 5 10
11 9 9 6 12
12 10 10 8 14
13 11 10 7 12
14 12 11 4 16
15 13 9 9 14
16 14 10 5 10
17 15 11 8 12
18

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PART TWO DEMAND ANALYSIS

G H I J K L M

SUMMARY OUTPUT

Regression Statistics
Multiple R 0.832588121
R Square 0.69320298
Adjusted R Square 0.642070143
Standard Error 1.011264918
Observations 15

ANOVA
df SS MS F Significance F
Regression 2 27.72811918 13.86405959 13.5569044 0.000833886
Residual 12 12.27188082 1.022656735
Total 14 40

Coefficients Standard Error t Stat P-value Lower 95% Upper 95%

Intercept 6.202979516 1.862253219 3.330900144 0.005988114 2.145478314 10.26048072
X Variable 1 -0.376163873 0.132723756 -2.834186459 0.0150583 -0.665344096 -0.08698365
X Variable 2 0.452513966 0.119511151 3.786374421 0.002593311 0.192121537 0.712906396

Lower 95.0% Upper 95.0%

2.145478314 10.26048072
-0.665344096 -0.08698365
0.192121537 0.712906396

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 CHAPTER 6

DEMAND FORECASTING

6-1 QUALITATIVE FORECASTS

Survey Techniques
Opinion Polls
Soliciting a Foreign Perspective
Case Study 6-1: Forecasting the Number of McDonald’s Restaurants Worldwide

6-2 TIME SERIES ANALYSIS

Reasons for Fluctuations in Time-Series Data
Trend Projection
Seasonal Variation
Case Study 6-2: Forecasting New-Housing Starts with Time-Series Analysis

6-3 SMOOTHING TECHNIQUES

Moving Averages
Exponential Smoothing
Case Study 6-3: Forecasting Lumber Sales with Smoothing Techniques

6-4 BAROMETRIC METHODS

Case Study 6-4: Forecasting the Level of Economic Activity with Composite and
Diffusion Indexes
Case Study 6-5: The Index of Leading Indicators Goes Global

6-5 ECONOMETRIC MODELS

Single-Equation Models
Case Study 6-6: Forecasting the Demand for Air Travel over the North Atlantic
Multiple-Equation Models
Case Study 6-7: Economic Forecasts with Large Econometric Models
BOX 6 – Managerial Economics at Work: Risks in Demand Forecasting

6-6 OUTPUT-OUTPUT FORECASTING

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PART TWO DEMAND ANALYSIS

SUMMARY
DISCUSSION QUESTIONS
PROBLEMS
APPENDIX TO CHAPTER 6:
CALCULATING FLUCTUATIONS IN TIME SERIES DATA WITH EXCEL
APPENDIX PROBLEMS
SUPPLEMENTARY READINGS
INTERNET SITE ADDRESSES
INTEGRATING CASE STUDY 2: Ford’s Bet: It’s a Small World After All
INTEGRATING CASE STUDY 3: Estimating and Forecasting the US Demand for Electricity
KEY TERMS (in the order of their appearance)
___________________________________________________________________________

Delphi method Barometric forecasting

Time-series data Leading economic indicators
Time-series analysis Coincident indicators
Secular trend Lagging indicators
Cyclical fluctuations Composite indices
Seasonal variation Diffusion index
Irregular or random influences Endogenous variables
Smoothing techniques Exogenous variables
Moving average Structural (behavioral) equations
Root-mean-square error (RMSE) Definitional equation
Exponential smoothing Reduced-form equation

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 CHAPTER 6 DEMAND FORECASTING

ANSWERS TO DISCUSSION QUESTIONS

1. (a) Forecasting refers to the estimation of a variable, such as the sales of the firm, at some
future time. Forecasting is important to business firms, government, and not-for-profit
organizations as a method of reducing the risk and uncertainty inherent in most
managerial decisions.

(b) There are many different types of forecasting. Macro forecasting estimates the future
level of general economic activity, while micro forecasting estimates future industry
and firm sales and other economic variables. We have short-term forecasting (i.e., for
a quarter or a year) and long-term forecasting (for periods longer than a year).
Forecasting can be qualitative or quantitative. Forecasting can be based on examining
only past values of the data series to forecast its future values or on the use of complex
models.
Some forecasts are performed by the firm itself, while others are purchased from consulting
firms.

(c) In order to determine the most suitable form of forecasting, the firm must consider the
cost of preparing the forecast and the benefit that results from its use, the lead time in
decision making, the time period of the forecast, the level of accuracy required, the
quality and availability of the data, and the level of complexity of the relationships to
be forecasted.
In general, the greater the level of accuracy required and the more complex the
relationships to be forecasted, the more sophisticated and expensive will be the
forecasting exercise.

2. (a) Qualitative forecasts are those that are based on surveys or opinions and without the
objective evaluation of market data. The most important qualitative forecasts are
surveys of business executives’ and consumers’ expenditure plans and those based on
opinion polls.

(b) The rationale for forecasting based on surveys of economic intentions is that many
economic decisions are made well in advance of actual expenditures. For example,
businesses usually plan to add to plant and equipment long before expenditures are
actually incurred.
Surveys and opinion polls are often used to make short-term forecasts when quantitative
data are not available. They can also be very useful to supplement quantitative forecasts,
to anticipate changes in consumer tastes or business expectations about future economic
conditions, and to forecast the demand for a new product.

(c) Some of the best known surveys are the ones conducted periodically on: business
executives’ plant and equipment expenditure plans, plans for inventory changes and
sales expectations, and consumer expenditure plans. In general, the record of these
surveys has been rather good in forecasting actual expenditures.

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PART TWO DEMAND ANALYSIS

(d) While the results of published surveys of expenditure plans of businesses, consumers,
and governments are useful, the firm usually needs specific forecasts of its sales.
The firm can forecast its sales based on polling its top executives or outside experts,
polling its sales force in the field, or polling a sample of consumers on their intentions
to purchase some particular durable good, such as a house, an automobile, or a major
appliance.

(d) It is important for firms to get a foreign perspective because they face increasing
competition from foreign firms both at home and abroad. US firms try to obtain a
foreign perspective on markets and products by forming advisory councils of foreign
dignitaries and businessmen.

3. (a) Time series data refer to the values of a variable arranged chronologically by days, weeks,
months, quarters, or years. The variation in time series data is usually caused by secular
trends, cyclical fluctuations, seasonal variations, and irregular or random influences.

(b) The assumption in time series analysis is that the time series will continue to move as
in the past (i.e., that past patterns will continue unchanged or will be very similar in the
future).

(c) The original time series data usually show the seasonal and irregular variations
superimposed on the cyclical fluctuations around the long-run trend.

(c) Cyclical fluctuations are often not included in time series analysis because they can be
of different duration and of irregular occurrence. This is even more so for random
forces. By their very nature, random forces cannot be examined systematically or
forecasted. Thus, time series analysis usually concentrates on the long-run trend and
seasonal variations only.

(e) Time series analysis is often referred to as naive forecasting because it forecasts future
values of the time series data based only on their past behavior. This, however, does
have its uses and sometimes it is the only form of forecasting possible.

4. (a) Trend projection refers to the extension of the past change in a time series data into the
future for the purpose of forecasting the time series.

(b) A linear trend measures constant absolute changes in the time series data over equal
time intervals. The other most common trend form used is the logarithmic trend. This
shows constant percentage changes over equal time intervals.
Some time series data are better approximated by a linear trend while others are better
approximated by a logarithmic trend. Both types of trends are usually estimated (with
regression analysis) and the one that best fits the data is utilized for forecasting.

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 CHAPTER 6 DEMAND FORECASTING

(c) Forecasting a time-series data by simply extending the past trend will give very poor
results even if past patterns remain unchanged if the time series data exhibit a strong
seasonal pattern. The latter is not captured in projecting the past trend into the future.

5. (a) Two methods of incorporating the past seasonal variation to improve the trend forecast
is by the ratio-to-trend method and by dummy variables.

(b) To adjust the trend forecast for the seasonal variation by the ratio-to-trend method, we
simply find the average ratio by which the actual value of the time series differs from
the corresponding estimated trend value during each quarter or month of the historical
period and then multiply the forecasted trend value by this ratio.

On the other hand, to adjust the trend forecast for the seasonal variation by using
dummy variables, we define one quarter or month as the base period and a dummy
variable for each remaining period (e.g., three dummies for quarterly data and 11
dummies for monthly data). The dummies assume the value of 1 for the period
(quarter or month) under consideration and zero in all other time periods.
A regression is run with the time series data as the dependent variable, and the trend
variable and the dummy variables as independent variables. In utilizing the regression
results for forecasting, we add to the constant of the regression the estimated
coefficient of the dummy that refers to the time period to be forecasted.

(c) It is difficult to determine which of the two methods of adjusting the trend forecast for
the seasonal variation in the data is better. Often, as in the example in the text, both
methods give very similar results.

6. (a) Smoothing techniques refer to the forecasting of future values of a time series on the
basis of some average of past values of the time series only. Since smoothing
techniques do not base the forecast on a model that seeks to explain the causes of the
variation, they are often referred to (together with time-series analysis) as naïve
forecasting.

(b) Smoothing techniques are useful in forecasting future values of a time series when the
time series data exhibit a great deal of irregular and random variation but little or no
secular trend or seasonal variation. The irregular or random variation in the time series
is then smoothed and future values are forecasted based on some average of past
observations.

(c) Two types of smoothing techniques are moving averages and exponential smoothing.
With a moving average, the forecasted value of a time series in a given period is equal
to the average value of the time series in a number of previous periods.
The greater the number of periods used in the moving average, the greater is the
smoothing effect because each new observation receives less weight. This is useful
the more erratic or random is the time-series data.

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PART TWO DEMAND ANALYSIS

With exponential smoothing, the forecast of a time series for a given time period is a
weighted average of the actual and forecasted values of the time series in the previous
period. The value of the time series at period t - 1 is assigned a weight (w) between 0
and 1 inclusive, and the forecast for the period t - 1 is assigned the weight 1 - w.
The greater the value of w, the greater is the weight given to the value of the time
series in period t - 1 as opposed to its values in previous time periods.

7. (a) Exponential smoothing is generally better (i.e., gives more accurate forecasts) than
moving averages. The reason is that with exponential smoothing the researcher can
assign a larger weight to more recent values of the time series than to previous ones.

(b) To determine which of two smoothing techniques is better, we measure the root-mean-
square error (RMSE) of each and choose the technique that minimizes the RMSE. The
RMSE is a weighted average of the forecast errors from the actual time series.

(d) If a time series contains not only a random variation but also a secular trend and a
seasonal variation, we must combine time series analysis and smoothing techniques.
One way of doing this is to perform the time series analysis first and then use a
smoothing technique.
A more complicated process that combines time series analysis and a smoothing
technique in a single operation is the double exponential technique. This, however, is
beyond the scope of the text. The interested reader can be directed to the two books on
this topic indicated in the supplementary readings at the end of Chapter 5.

8. (a) By examining the top panel of Figure 6-4 we see that the composite index of the 10
leading indicators anticipated or led the troughs of 1980, 1982, 1991, 2001, and 2008
by about 3 months, 2 months, 6 months, 8 months, and 6 months, respectively.

(b) From the bottom panel of Figure 6-4 in the text we see that the diffusion index of the
10 leading indicators fell below 50 percent from about ½ year to 2 years before every
recession.

9. Though unlikely, it is possible for the composite index of the twelve leading indicators to rise
at the same time that the diffusion index of the same eleven leading indicators is below 50
percent.
For example, when more than six of the eleven leading indicators fall, the diffusion index
will be below 50. However, if the rising indicators are better predictors of turning points
and are assigned sufficiently higher weights than the falling indicators, the composite index
will rise.
The two indexes will then give conflicting signals. We would forecast an expanding level
of economic activity according to the composite index and a decline in the level of
economic activity with the diffusion index.

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 CHAPTER 6 DEMAND FORECASTING

10. (a) Econometric forecasting seeks to explain the relationship(s) to be forecasted and to
determine the relative importance (elasticities) of its determinants.
Forecasting with single-equation models involves substituting into the estimated
equation the predicted values of the independent or explanatory variables for the period
of the forecast and solving for the forecasted values of the dependent variable.
In multiple-equation models the estimated values of the exogenous variables (i.e., those
determined outside the system) must be substituted into the estimated model to obtain
forecasts of the endogenous variables.

(b) The major advantage of econometric forecasting over other forecasting techniques is
that the former tries to explain the relationship(s) to be forecasted. That is, econometric
forecasting begins by identifying the determinants of the economic variable(s) to be
forecasted and estimating the relative importance (elasticities) of its determinants.
These are essential for the firm or organization to devise optimal policies for its
operation.

Other forecasting techniques either base the forecasts on the basis of the past patterns of
the relationship (as in time series analysis and smoothing techniques) or provide only a
qualitative forecast (as in survey techniques, opinion polls, and barometric forecasting).

11. While econometric forecasting is becoming more and more important, other forecasting
techniques still have much to contribute to the forecasting process.
When no quantitative data are available (as in the case of a new product), the firm may have
to rely on survey techniques and opinion polls to forecast demand or sales. Other
forecasting techniques can be used as a check on econometric forecasting. In fact, firms
seldom use only one forecasting technique.
Econometric forecasting is beginning to incorporate the best features of the other
forecasting techniques. For example, some exogenous variables of the model may have to
be predicted by trend projection and others facing strong random variation by a smoothing
technique.
Seasonal variation can be incorporated into econometric models by the use of dummy
variables and survey techniques, and opinion polls may be used to generate data on some
important variables for which no other data available.

12. (a) The endogenous variables are those variables whose values are determined by the
solution of a multiple-equation model. Exogenous variables, on the other hand, are
those variables determined outside the model and whose values are required to solve a
multiple-equation model.

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PART TWO DEMAND ANALYSIS

(b) Structural equations are those equations of a multiple-equation model which seek to
explain (i.e., to identify the determinants of) the relationships in the model. For this
reason they are also called behavioral equations. There is a structural or behavioral
equation for each endogenous variable of the model.
Definitional equations are those that are always true by definition. They are also called
identities. For example, GNP is defined as equal to consumption expenditures,
investments, and government expenditures. Thus, the GNP equation is a definitional
equation or identity in a macro model of the entire economy.
Reduced-form equations are those equations that represent the solution of a multiple-
equation model and express the endogenous variables of the model in terms of the
exogenous variables only. There is a reduced-form equation for each endogenous
variable in a multiple-equation model.

(c) The reason for using estimated or predicted values of the exogenous variables to
forecast the endogenous variables of the model is that the exogenous variables are often
policy variables (under the control of the government or the firm) and are easier to
predict than the endogenous variables.
For example, assuming different levels of government expenditures for next year we
can use a macro model of the economy to forecast GNP in the next year. Similarly,
assuming a particular level of expenditures on advertising for next year, a firm can
forecast its sales.

13. (a) An input-output table examines the interdependence among the various industries and
sectors of the economy.

(b) An input-output table can be used to forecasts the change in the direct and indirect
demand for inputs required to produce a good or service which has experienced a
change in demand and the effect that these have on the demand for the good or service
itself.

14. Forecasts of economic activity and other economic variables are often far off the mark. For
example, no one saw the 2001 recession coming even a few months after it officially started.
Similarly, almost everyone grossly underestimated the growth of the US economy in the first
quarter of 2002 as late as December 2001.

15. There are two reasons for still being useful to pursue forecasting even though it is often off the
mark by wide margins. The first is that even if off the mark (often by wide margins) it is still
better to forecast than not to forecast. Firms need to have forecast of future sales to be able to
forecast the need for all types of inputs. Without forecasts they would simply have to guess.
The second reason for forecasting is that by examining and trying to improve on the forecasts
firms learns more about their operation and the market.

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 CHAPTER 6 DEMAND FORECASTING

ANSWERS TO PROBLEMS

1. (a) Regressing gasoline sales (St) on time, from t = 1 from the first quarter of 1995
to t = 16 for the last quarter of 1998, we get

St = 22,902.05 + 117.06t R2 = 0.42

(36.83)

Using these regression results to forecast gasoline sales (in thousands of gallons)
for each quarter of 1999, we get

S17 = 22,902.05 + 117.06(17) = 24,892.07 in the first quarter of 1999

S18 = 22,902.05 + 117.06(18) = 25,009.13 in the second quarter of 1999

S19 = 22,902.05 + 117.06(19) = 25,126.19 in the third quarter of 1999

S20 = 22,902.05 + 117.06(20) = 25,243.25 in the fourth quarter of 1999

(b) Regressing the logarithm of gasoline sales (ln St) on time, from t = 1 for the first
quarter 1995 to t = 16 for the last quarter of 1998, we get

ln St = 10.04 + 0.0049t R2 = 0.41

( 3.15)

Since the estimated parameters are based on the logarithms of the data, however,
they must be converted into their antilogs to be interpreted in terms of the
original data. The antilog of ln S0 = 10.04 is S0 = 22,925.38 and the antilog of
ln (1 + g) = 0.0049 gives (1 + g) = 1.0049. Substituting these values back into the
equation, we get

St = 22,925.38(1.0049)t

where S0 = 22,925.38 in thousands gallons is the estimated sales of petroleum in

the United States in the fourth quarter of 1994 (i.e., at t = 0) and the estimated
growth rate is 1.0049, or 0.49 percent per quarter.

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PART TWO DEMAND ANALYSIS

To estimate sales (in thousands of gallons) in any future quarter, we substitute into the above
equation the value of t for the quarter for which we are seeking to forecast S and solve for St.
Thus,

S17 = 22,925.38(1.0049)17 = 24,910.72

S18 = 22,925.38(1.0049)18 = 25,034.51

S19 = 22,925.38(1.0049)19 = 25,156.02

S20 = 22,925.38(1.0049)20 = 25,279.82

(c) Since the value of the t statistic is higher for the linear trend than for the constant
logarithmic trend, the former seems to fit the data marginally better. However, both
fits are very poor (i.e., they “explain” less than 50 percent of the variation in the
quarterly sales of gasoline).
If we used either trend projection to forecast gasoline sales for 1999, they would be
very poor because they do not take into consideration the strong seasonal factor in the
data.

2. (a) Substituting the value of t for each quarter in the 1995–1998 period into the regression
equation estimated in problem 5.1a and solving for St we get the forecasted value of
gasoline sales for each quarter from 1995 to 1998. These can also be obtained directly
from the regression printout. Using these forecasted values, we can calculate the
seasonal adjustment factor, as indicated in Table 1.

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 CHAPTER 6 DEMAND FORECASTING

Table 1
Calculation of the Seasonal Adjustment to the
Trend Forecast by the Ratio-to-Trend Method

Year Forecast Actual Actual/Forecast

1995.1 23019.11 22434 0.975
1996.1 23487.35 22662 0.965
1997.1 23955.59 22766 0.950
1998.1 24423.83 23302 0.954
Average 0.961
1995.2 23136.17 23766 1.027
1996.2 23604.41 24032 1.018
1997.2 24072.65 24491 1.017
1998.2 24540.89 24045 0.980
Average 1.011
1995.3 23253.23 23860 1.026
1996.3 23721.47 24171 1.019
1997.3 24189.71 24751 1.023
1998.3 24657.95 25437 1.032
Average 1.025
1995.4 23370.29 23391 1.001
1996.4 23838.53 23803 0.999
1997.4 24306.77 24170 0.994
1998.4 24775.01 25272 1.020
Average 1.004

Multiplying the amount of gasoline sales forecasted in Problem 5.1a from the simple
extension of the linear trend by the seasonal factors found above, we get the following new
forecasts (in thousands of barrel) based on both the linear trend and the seasonal adjustment:

S17 = 24,892.07 (0.961) = 23,921.28 in the first quarter of 1999

S18 = 25,009.13 (1.011) = 25,284.23 in the second quarter of 1999

S19 = 25,126.19 (1.025) = 25,754.35 in the third quarter of 1999

S20 = 25,243.25 (1.004) = 25,344.22 in the fourth quarter of 1999

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PART TWO DEMAND ANALYSIS

(b) Taking the last quarter as the base-period quarter and defining dummy variable D1
by a time series with ones in the first quarter of each year and zero in other quarters,
D2 by a time series with ones in the second quarter of each year and zero in other
quarters, and D3 by ones in the third quarter and zero in other quarters, we obtain
the following results by running a regression of gasoline sales on seasonal dummy
variables and the linear time trend:

St = 23,201.19 - 1,080.66D1t + 116.06D2t + 491.53D3t +95.78t R2 = 0.90

(-4.61) (0.50) (2.15) (5.31)

Note that the estimated coefficients for the dummy variables and the trend variable
are all statistically significant at better that the 5 percent level except for D2, and
that the regression "explains" 90 percent of the variation in gasoline sales (as
compared with only 41 percent for the regression in Problem 5.1a).

Utilizing the above regression equation to forecast gasoline sales (in thousands of
barrels) for each quarter of 1999, we get:

S17 = 23,201.19 - 1,080.66 + 95.78(17) = 23,748.79 in the first quarter of 1999

S18 = 23,201.19 + 116.06 + 95.78(18) = 25,041.29 in the second quarter of 1999

S19 = 23,201.19 + 491.53 + 95.78(19) = 25,512.54 in the third quarter of 1999

S20 = 23,201.19 + 95.78(20) = 25,116.79 in the fourth quarter of 1999

These forecasted values differ somewhat from those obtained by the ratio-to-trend
method.

(c) See Fig. 1, where the trend forecasts adjusted by the ratio-to-trend method are given
by the dots off the extended trend line, while the trend forecasts adjusted by the
dummy variable method are marked by a "+" sign.

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 CHAPTER 6 DEMAND FORECASTING

Figure 1

3. Taking the last quarter as the base-period quarter and defining dummy variable D1 by a time
series with ones in the first quarter of each year and zero in other quarters, D2 by a time
series with ones in the second quarter of each year and zero in other quarters, and D3 by
ones in the third quarter and zero in other quarters, we obtain the following results by
running a regression of housing starts on the seasonal dummy variables and the linear time
trend:

St = 381.53 + 8.51D1t – 7.98D2t – 4.71D3t + 4.11t R2 = 0.78

(0.57) (-0.54) (-0.32) (+5.39)

None of the estimated coefficients for the dummy variables are statistically significant
at the 5 percent level and the regression “explains” 78 percent of the variation in new
housing starts (more than for regression 6-8).

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PART TWO DEMAND ANALYSIS

With none of the estimated coefficients for the dummy variables statistically significant
at the 5% level, we would not be justified in using this method for introducing the seasonal
variation into the forecasts. If we did, however, we would get the following forecasts for
housing starts in each quarter of 2005:

S25 = 381.53 + 8.51 + (25) 4.11 = 492.79 in 2005.1

S26 = 381.53 - 7.98 + (26) 4.11 = 480.41 in 2005.2

S27 = 381.53 - 4.71 + (27) 4.11 = 487.79 in 2005.3

S28 = 381.53 + (28) 4.11 = 496.61 in 2005.4

These forecasted values are very similar to those obtained by the ratio-to-trend
method shown in Case Study 6-2.

4. (a) From the Economic Report of the President of 2010, we find that number of new-
housing starts in the United States were as follows in Table 2 on the next page.

(b) The number of new-housing starts in the United States collapsed between 2005 and
2009 as a result of the burst in the housing bubble and deep recession (the deepest
since the end of World War II). In fact, the recession was triggered by the bursting of
the housing bubble, which then spread to other financial markets and subsequently to
the real economy.

If we tried to forecast new-housing starts in each year based only on the previous
years’ numbers, the forecast would almost certainly grossly overestimated the number
of new-housing starts in subsequent years.

Table 2
Number of New-Housing Starts in the
United States in Each Year, 2005-2009
(in thousands of units)

New Housing Starts

Year
2005 2,068.3
2006 1,800.9
2007 1,355.0
2008 905.5
2009 553.8

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 CHAPTER 6 DEMAND FORECASTING

5. Since the problem asks to forecast the index of new housing starts for 1998 and compare it to
the index of 163 already known, we only forecast the index for 1998 without the need to
forecast the index for all previous years.

The only reason for forecasting all previous years would be to calculate the root mean
square error (RMSE) of the forecast obtained with different moving averages so as to be
able to choose the forecast of the moving average with the smallest RMSE. Since we know
here the actual value of the index for 1998, we can compare our results directly with the
actual index rather than using RMSE.

The three-year moving average index of new housing starts in the United States for 1998 is
obtained by summing the indexes from 1995, 1996, and 1997 and dividing by 3. This is
(142 + 156 + 162)/3 = 460/3 = 153.3 or 153.

On the other hand, the five-year moving average is obtained by summing the indexes for the
five years from 1993 to 1997 and dividing by 5. This is (125 + 146 + 142 + 156 + 162)/5 =
731/5 = 146.2 or 146.

Neither the three-year nor the five-year moving average provides a good forecast for the
actual index of 163 for 1998, but the three-year moving average is somewhat better. In fact,
the RMSE for the three-year moving average is 17 while the RMSE for the five-year
moving average is 24.

6. (a) The exponential forecasts (F) of new housing starts (A) in the United States for the
years 1986 to 1998 with w = .3 and w = .7 are given in Table 3. They are obtained by
using Equation 6-12 in the text. To get the analysis started, we let F1986 = 128 (the
average of the actual index of housing starts between 1986 and 1997).

(b) From Table 3 we see that F1998 = 145 with w = .3 and 159 with = .7. Since A1998 =
163, the exponential forecast with w = .7 is better.

With w=.3, RMSE = 3,369 / 12 = 17 and with w=.7, RMSE = 1,834 / 12 = 12 .

Since the RMSE with w = .7 is smaller than the RMSE with w = .3, the former gives,
on the average, a better forecast.

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PART TWO DEMAND ANALYSIS

Table 3
Exponential Forecasts of Index of New Housing Starts in the United States for 1986–1997

(1) (2) (3) (4) (5) (6) F (7) (8)

Year A F with w = .3 A-F (A - F)2 with w = .7 A-F (A - F)2
1986 116 128 -12 144 128 -12 144
1987 122 124 -2 4 120 2 4
1988 121 123 -2 4 121 0 0
1989 121 122 -1 1 121 0 0
1990 111 122 -11 121 121 -10 100
1991 97 119 -22 484 114 -17 281
1992 113 112 1 1 102 11 121
1993 125 112 13 169 110 15 225
1994 146 116 30 900 121 25 625
1995 142 125 17 289 139 3 9
1996 156 130 26 676 141 15 225
1997 162 138 24 576 152 10 100
3,369 1,834
1998 145 159

7. The composite index is obtained by calculating the percentage change for each series relative
to the base month and then averaging these percentage changes. The percentage change from
the first to the second month is 10 for indicator A, 15 for indicator B, and -10 for indicator C.
Their simple average (since each indicator is given equal weight) is 5 percent. Taking the first
month as the base period with a composite index of 100, we obtain the composite index 105
for the second month.

For the third month, the change of each indicator from the base period is 20 percent, 10
percent, and 10 percent, respectively, with an average of 13.3 percent. Adding this value to
100 (the base-period value of the composite index), we get the composite index of 113.33
for the third month. These composite indexes are shown in the second column of Table 4.

Since two indicators rise and one falls from the first to the second period, the diffusion
index for the second period is 66.7 percent. On the other hand, since all three indicators rise
from the second to the third month, the diffusion index for the third month is 100 percent.
These diffusion indexes are shown in the third column of Table 4.

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 CHAPTER 6 DEMAND FORECASTING

Thus, according to the composite and diffusion indexes, the level of economic activity
should improve in future months.

Table 4

Month Composite Diffusion

Index Index
1 100.00 —
2 105.00 66.70
3 113.33 100.00

8. (a) Time series A is a coincident indicator of the index series of cereal sales of the Tasty
Food Company. The reason for this is that series A moves in step or coincidentally
with the time series of the sales index. When the time series of the sales index rises,
series A rises, and when the sales index falls, series A also falls in the same month.

(b) Time series B is a leading indicator of the index of cereal sales. That is, series B
anticipates or leads changes in the direction of the sales index and can, therefore, be
used to forecast changes in the firm's sales index. The lead time is two months.

For example, the decline in the sales index between the third and fourth month is
anticipated and can be forecasted from the decline in the value of time series B from the
first to the second month. Similarly, the rise in the index of cereal sales in the fifth
month can be forecasted by the rise in the value of series B in the third month, and so on.

(c) Time series C is a lagging indicator of the index of cereal sales. That is, series C
follows or lags the changes in the direction of the sales index. The lag time is one
month.

For example, the increase in the sales index between the first and the second month is
followed by the increase in series C from the second to the third month. Similarly, the
decline in the sales index in the third month is followed by the decline in series C in
the fourth month, and so on.

9. (a) By substituting the given values of the independent or explanatory variables and t = 24
for 1972 in the estimated demand equation, we get the quantity demanded (sales) of
sweet potatoes in the United States in 1972 of

QDs = 7,609 - 1,606(4.10) + 59(208.78) + 947(3.19) + 479(2.41) - 271(24)

= 11,013.74 in thousands (11.01 millions) hundredweight.

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PART TWO DEMAND ANALYSIS

(b) By substituting the given values of the independent or explanatory variables and t=25
for 1973 in the estimated demand equation, we get the quantity demanded (sales) of
sweet potatoes in the United States in 1973 of

QDs = 7,609 - 1,606(4.00) + 59(210.90) + 947(3.55) + 479(2.40) - 271(25)

= 11,364.55 in thousands (11.36 millions) hundredweight.

Of course, the accuracy of these results depends on the accuracy of the forecasted
values of the independent or explanatory variables. The greater the errors in
forecasting the latter, the greater will be the forecasting error in the former.

10. (a) By substituting the given values of the independent or explanatory variables and D = 1
(a post-war year) for 1962 in the estimated demand equation, we get the per capita
personal consumption expenditures on shoes of

Dt = 19.575 - 0.0923(20) + 0.0289(1,646) - 99.569(0.4) - 4.06(1)

= $21.41 at 1954 prices.

(b) By substituting the given values of the independent or explanatory variables and D=1 (a
post-war year) for 1972 in the estimated demand equation, we get the per capita
personal consumption expenditures on shoes of

Dt = 19.575 - 0.0923(30) + 0.0289(2,236) - 99.568(0.6) - 4.06(1) = $17.63

at 1954 prices.

It seems that real per capita personal consumption expenditures declined over time as
people used automobiles more and walked less (a change in taste).

(c) We would expect the error for the 1972 forecast to be larger than for the 1962 forecast.
The reason is that the further into the future the dependent variable is forecasted, the
more the estimated regression equation is likely to lead to error because it does not
reflect the structural changes (i.e., changes in the values of the estimated coefficients)
that usually occur over time.

11. (a) The reduced-form equation for Ct is obtained by substituting Equation 6-23 for GNPt
into Equation 6-21 for Ct. That is,

Substituting Equation 6-23 for GNPt into Equation 6-21 for Ct (and omitting u1t because
its expected value is zero), we get

Ct = a1 + b1(Ct + It + Gt) (6-24')

Ct = a1 + b1Ct + b1It + b1Gt (6-24")

By then substituting Equation 6-22 for It into Equation 6-24" (and omitting u2t), we have

Ct = a1 + b1Ct + b1(a2 + b2FS) + b1Gt (6-25')

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 CHAPTER 6 DEMAND FORECASTING

Ct = a1 + b1Ct + b1a2 + b1b2πt-1 + b1Gt (6-25")

Collecting the Ct terms to the left in Equation 6-25" and isolating Ct, we have

Ct(1 - b1) = a1 + b1a2 + b1b2πt-1 + b1Gt (6-26')

Dividing both sides of Equation 6-26' by 1-b1, we finally obtain

Ct = a1 + b1a2 + b1b2πt-1 + b1Gt (6-27')

1 - b1 1 - b1 1 - b1 1 - b1

Equation 6-27' is the reduced-form equation for Ct. It is expressed only in terms of πt - 1
and Gt (the exogenous variables of the model) and can be used in forecasting Ct + 1 by
substituting the known value of πt and the predicted value of Gt+1 into Equation 6-27'
and solving for Ct + 1.

(b) Equation 6-22 is already in reduced form because πt - 1 is exogenous (i.e., it is known in
period t). The lagged (and therefore known) value of a variable is sometimes known as
a predetermined variable.

12. Wait for June 2011 when the 2011/1 issue of OECD Economic Outlook will be out and
compare the forecasts presented in Table 6-10 in the text with the actual results reported for
2010 in June 2011.

13. Prepare a table similar to Table 6-10 in the text of the macroforecasts in the 2011/2 issue of
OECD Economic Outlook.

14. (a) Wait for June 2012 when the 2012/1 issue of OECD Economic Outlook is out and
compare the forecast presented in the table that you prepared for problem 13 with the
actual results reported in the 2012/1issue of OECD Economic Outlook.

(b) Compare the accuracy of the forecasts in your answer to problem 12 with your answer
to part (a) of this problem. The accuracy of the forecasts for 2011 will be better than for
those for 2010 if economic conditions were more stable in 2011 than in 2010. It is
easier to fore-cast the level of economic activity when economic conditions are stable
than when they are less stable or unsettled.

15. (a) For ease of reference, the estimated regression and the meaning of the variables are
repeated below:

ln Qt = 1.2789 - 0.1647 ln Pt + 0.5115 ln Yt + 0.1483 ln P't - 0.0089t

(-2.14) (1.23) (0.55) (-3.36)

- 0.0961 D1t - 0.1570 D2t - 0.0097 D3t

(-3.74) (-6.03) (-0.37)

R2 = 0.80 D-W = 2.08

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PART TWO DEMAND ANALYSIS

where

Qt = quantity (in pounds) of coffee consumed per capita (for population over 16) in quarter t

Pt = relative price of coffee per pound in quarter t, at 1967 prices

Yt = per capita disposable personal income in quarter t, in thousands of 1967 dollars

P't = relative price of tea per quarter pound in quarter t, at 1967 prices

t = time trend; t = 1 for first quarter of 1963 to t = 58 for second quarter of 1977

D1t = dummy variable equal to 1 for first quarter (spring) and 0 otherwise

D2t = dummy variable equal to 1 for second quarter (summer) and 0 otherwise

D3t = dummy variable equal to 1 for third quarter (fall) and 0 otherwise

and the numbers in parentheses below the estimated coefficients are values of the t statistic.

Since the above equation is expressed in terms of logarithms, the first step in the solution
is to change all the predicted values of the independent or explanatory variables (except
the dummy variables and t) into their natural logs. These are shown in Table 5.

Table 5

Quarter ln P Ln Y ln P'
1977.3 0.62 1.27 0.10
1977.4 0.55 1.28 0.08
1978.1 0.47 1.29 0.07
1978.2 0.38 1.30 0.05

By substituting the given values of the independent or explanatory variables, t = 59, and
D3 = 1 and D1 = D2 = 0 for the third quarter of 1977 in the estimated demand equation,
we get the third quarter 1977 forecast of the demand for coffee of

ln Q59 = 1.2789 - 0.1647(0.62) + 0.5115(1.27) + 0.1483(0.10) - 0.0089(59)

- 0.0961(0) - 0.1570(0) - 0.0097(1)

ln Q59 = 1.3064. The antilog of 1.3064 is 3.69 lb.

This is the forecasted number of pounds of coffee consumed per capita for the
population of over age 16 in the third quarter of 1977.

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 CHAPTER 6 DEMAND FORECASTING

(b) By substituting the given values of the independent or explanatory variables, t = 60 and
D1 = D2 = D3 = 0 for the fourth quarter of 1977 in the estimated demand equation, we
get the fourth quarter 1977 forecast of the demand for coffee of

ln Q60 = 1.2789 - 0.1647(0.55) + 0.5115(1.28) + 0.1483(0.08) - 0.0089(60)

- 0.0961(0) - 0.1570(0) - 0.0097(0)

ln Q60 = 1.3209. The antilog of 1.3209 is 3.75 lb.

This is the forecasted pounds of coffee consumed per capita for the population over age
16 in the fourth quarter of 1977.

(c) By substituting the given values of the independent or explanatory variables, t = 61, D1
= 1 and D2 = D3 = 0 for the first quarter of 1978 in the estimated demand equation, we
get the first quarter 1978 forecast of the demand for coffee of ln Q61 = 1.2789 -
0.1647(0.47) + 0.5115(1.29) + 0.1483(0.07) - 0.0089(61)

- 0.0961(1) - 0.1570(0) - 0.0097(0)

ln Q61 = 1.2327. The antilog of 1.2312 is 3.43 lb.

This is the forecasted number of pounds of coffee consumed per capita for the
population over age 16 in the first quarter of 1978.

(d) By substituting the given values of the independent or explanatory variables, t = 62, D1
= D3 = 0 and D2 = 1 for the second quarter of 1978 in the estimated demand equation,
we get the second quarter 1978 forecast of the demand for coffee ln Q62 = 1.2789 -
0.1647(0.38) + 0.5115(1.30) + 0.1483(0.05) - 0.0089(62)

- 0.0961(0) - 0.1570(1) - 0.0097(0)

ln Q62 = 1.1799. The antilog of 1.1799 is 3.25 lb.

This is the forecasted number of pounds of coffee consumed per capita for the
population over age 16 in the second quarter of 1978.

(e) Since the estimated regression equation seems to fit the data reasonably well (it explains
80 percent of the variation in Qt) and we are using it to forecast Qt for the next four
quarters only, we can be reasonably confident in our forecast.

A sudden and unforseen change in tastes (due, for example, to the finding that coffee
causes heart ailments) could cause the forecasted error to become very large. In that
case, the regression equation would have to be reestimated to reflect this structural
change before we could use it to generate forecasts in which we could have a great deal
of confidence.

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PART TWO DEMAND ANALYSIS

ANSWERS TO APPENDIX PROBLEMS

1. Calculating the values in Excel gives you the following:

A B C D E F G H I
1
3-month 6-month Moving
Moving Average Average
2 Date CPI Forecast (F) A-F (A-F)2 Forecast (F) A-F (A-F)2
3 Jan-98 161.0
4 Feb-98 161.1
5 Mar-98 161.4
6 Apr-98 161.8 161.2 0.6 0.40
7 May-98 162.3 161.4 0.9 0.75
8 Jun-98 162.2 161.8 0.4 0.13
9 Jul-98 162.1 162.1 0.0 0.00 161.6 0.5 0.22
10 Aug-98 162.6 162.2 0.4 0.16 161.8 0.8 0.61
11 Sep-98 162.6 162.3 0.3 0.09 162.1 0.5 0.28
12 Oct-98 163.2 162.4 0.8 0.59 162.3 0.9 0.87
13 Nov-98 163.4 162.8 0.6 0.36 162.5 0.9 0.81
14 Dec-98 163.5 163.1 0.4 0.19 162.7 0.8 0.67
15 Jan-99 164.2 163.4 0.8 0.69 162.9 1.3 1.69
16 Feb-99 164.6 163.7 0.9 0.81 163.3 1.3 1.82
17 Mar-99 165.0 164.1 0.9 0.81 163.6 1.4 2.01
18 Apr-99 166.6 164.6 2.0 4.00 164.0 2.6 6.85
19 May-99 166.2 165.4 0.8 0.64 164.6 1.7 2.72
20 Jun-99 165.4 165.9 -0.5 0.28 165.0 0.4 0.15
21 Jul-99 165.8 166.1 -0.3 0.07 165.3 0.5 0.22
22 Aug-99 166.3 165.8 0.5 0.25 165.6 0.7 0.49
23 Sep-99 167.2 165.8 1.4 1.87 165.9 1.3 1.73
24 Oct-99 167.2 166.4 0.8 0.59 166.3 0.9 0.90
25 Nov-99 167.1 166.9 0.2 0.04 166.4 0.7 0.56
26 Dec-99 167.3 167.2 0.1 0.02 166.5 0.8 0.64
27 Jan-00 167.9 167.2 0.7 0.49 166.8 1.1 1.17
28 Feb-00 169.3 167.4 1.9 3.48 167.2 2.1 4.55
29 Mar-00 170.7 168.2 2.5 6.42 167.7 3.0 9.20
30 Apr-00 170.6 169.3 1.3 1.69 168.3 2.3 5.52
31 May-00 171.1 170.2 0.9 0.81 168.8 2.3 5.21
32 Jun-00 171.0 170.8 0.2 0.04 169.5 1.5 2.30
33 Jul-00 171.7 170.9 0.8 0.64 170.1 1.6 2.56
34 Aug-00 172.2 171.3 0.9 0.87 170.7 1.5 2.15
35 Sep-00 173.3 171.6 1.7 2.78 171.2 2.1 4.34
36 Oct-00 173.8 172.4 1.4 1.96 171.7 2.2 4.62

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 CHAPTER 6 DEMAND FORECASTING

37 Nov-00 173.5 173.1 0.4 0.16 172.2 1.3 1.73

38 Dec-00 173.5 173.5 0.0 0.00 172.6 0.9 0.84

Total (A-F)2 32.09 Total (A-F)2 67.46

RMSE 0.172 RMSE 0.2738

Since the 3-month moving average RMSE = 0.172 and the 6-month moving average RMSE =
0.2738, the 3-month moving average is a better forecaster.

2. The output of the regressions give you

St = 22,902.05 + 117.06t
(3.18)

for gasoline sales and

ln St = 10.04 + 0.0049t
(3.15)

for the logarithms of gasoline sales. Since the estimated parameters are based on the logarithms
of the data, however, they must be converted into their antilogs to be interpreted in terms of the
original data. The antilog of ln S0 = 10.04 is S0 = 22,925.38 and the antilog of ln(1 + g) = 0.0049
gives (1 + g) = 1.0049. Substituting these values back into the equation, we get:

St = 22,925.38(1.0049)t

where S0 = 22,925.38 in thousands of gallons is the estimated sales of petroleum in the United
States in the fourth quarter of 1994 (i.e. at t=0) and the estimated growth rate is 1.0049, or 0.49
percent per quarter.

Plugging these equations into the spreadsheet, you get

19
20 Forecast 1 Forecast 2
21 1999.1 17 24892.07 24911.79
22 1999.2 18 25009.13 25033.86
23 1999.3 19 25126.19 25156.52
24 1999.4 20 25243.25 25279.79
25

Since the values of the t statistic is higher for the linear trend than for the constant logarithmic
trend, the former seems to fit the data marginally better. However, both fits are very poor (i.e.,
they “explain” less than 50 percent of the variation in the quarterly sales of gasoline). If we used
either trend projection to forecast gasoline sales for 1999, they would be very poor because they
do not take into consideration the strong seasonal factor in the data.

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PART TWO DEMAND ANALYSIS

3. Calculating the values in Excel give you the following:

J K L M N O

Forecast Forecast
with with
w=0.3 A-F (A-F)2 w=0.7 A-F (A-F)2
166.6 -5.6 31.70 166.6 -5.6 31.70
164.9714 -3.9 14.99 163.8653 -2.8 7.65
163.9 -2.5 6.25 162.6326 -1.2 1.52
163.27 -1.5 2.16 162.2163 -0.4 0.17
162.979 -0.7 0.46 162.2582 0.0 0.00
162.7453 -0.5 0.30 162.2291 0.0 0.00
162.5517 -0.5 0.20 162.1645 -0.1 0.00
162.5662 0.0 0.00 162.3823 0.2 0.05
162.5763 0.0 0.00 162.4911 0.1 0.01
162.7634 0.4 0.19 162.8456 0.4 0.13
162.9544 0.4 0.20 163.1228 0.3 0.08
163.1181 0.4 0.15 163.3114 0.2 0.04
163.4427 0.8 0.57 163.7557 0.4 0.20
163.7899 0.8 0.66 164.1778 0.4 0.18
164.1529 0.8 0.72 164.5889 0.4 0.17
164.887 1.7 2.93 165.5945 1.0 1.01
165.2809 0.9 0.84 165.8972 0.3 0.09
165.3166 0.1 0.01 165.6486 -0.2 0.06
165.4617 0.3 0.11 165.7243 0.1 0.01
165.7132 0.6 0.34 166.0122 0.3 0.08
166.1592 1.0 1.08 166.6061 0.6 0.35
166.4714 0.7 0.53 166.903 0.3 0.09
166.66 0.4 0.19 167.0015 0.1 0.01
166.852 0.4 0.20 167.1508 0.1 0.02
167.1664 0.7 0.54 167.5254 0.4 0.14
167.8065 1.5 2.23 168.4127 0.9 0.79
168.6745 2.0 4.10 169.5563 1.1 1.31
169.2522 1.3 1.82 170.0782 0.5 0.27
169.8065 1.3 1.67 170.5891 0.5 0.26
170.1646 0.8 0.70 170.7945 0.2 0.04
170.6252 1.1 1.16 171.2473 0.5 0.20
171.0976 1.1 1.22 171.7236 0.5 0.23
171.7583 1.5 2.38 172.5118 0.8 0.62
172.3708 1.4 2.04 173.1559 0.6 0.41

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 CHAPTER 6 DEMAND FORECASTING

172.7096 0.8 0.62 173.328 0.2 0.03

172.9467 0.6 0.31 173.414 0.1 0.01

Total (A-F)2 83.58 Total (A-F)2 47.93

RMSE 0.254 RMSE 0.192

Since the RMSE for the forecast with w = 0.7 is less than that for the forecast with w = 0.3,
the w = 0.7 forecast is better. Between 1. and 2., the best forecast is the 3-month moving
average.

121
 CHAPTER 7

PRODUCTION THEORY AND ESTIMATION

7-1 THE ORGANIZATION OF PRODUCTION AND THE PRODUCTION FUNCTION

The Organization of Production
The Production Function

7-2 THE PRODUCTION FUNCTION WITH ONE VARIABLE INPUT

Total, Average, and Marginal Product
The Law of Diminishing Returns and Stages of Production

7-3 OPTIMAL USE OF THE VARIABLE INPUT

Case Study 7-1: Labor Productivity and Total Compensation in the United States and
Abroad

7-4 THE PRODUCTION FUNCTION WITH TWO VARIABLE INPUTS

Production Isoquants
Economic Region of Production
Marginal Rate of Technical Substitution
Perfect Substitutes and Complementary Inputs

7-5 OPTIMAL COMBINATION OF INPUTS

Isocost Lines
Optimal Input Combination for Minimizing Costs or Maximizing Output
Profit Maximization
Effect of Change in Input Prices
Case Study 7-2: Substitutability Between Gasoline Consumption and Driving Time

7-6 RETURNS TO SCALE

Case Study 7-3: Returns to Scale in US Manufacturing Industries
Case Study 7-4: General Motors Decides Smaller Is Better

7-7 EMPIRICAL PRODUCTION FUNCTIONS

Case Study 7-5: Output Elasticities in US Manufacturing Industries

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 CHAPTER 7 PRODUCTION THEORY AND ESTIMATION

7-8 THE INNOVATION PROCESS

Meaning and Importance of Innovations
Case Study 7-6: How Do Firms Get New Technology?
How Innovating Is Your Company’s Culture?
The Open Innovation Model
Case Study 7-7: Open Innovation at Procter & Gamble
The Next Step in Open Innovation

7-9 INNOVATIONS AND INTERNATIONAL COMPETITIVENESS

Innovations and the International Competitiveness of US Firms
Box 7 – Managerial Economics at Work: How Xerox Lost and Regained International
Competitiveness and Became a Leader in Information Technology
The New Computer-Aided Production Revolution, 3-D Printing, and the International
Competitiveness of US Firms
Case Study 7-8: The New US Digital Factory
Case Study 7-9: The Euro and the International Competitiveness of European Firms

SUMMARY
DISCUSSION QUESTIONS
PROBLEMS
SPREADSHEET PROBLEMS
APPENDIX: PRODUCTION ANALYSIS WITH CALCULUS
Constrained Output Maximization
Constrained Cost Minimization
Profit Maximization
Appendix Problems
SUPPLEMENTARY READINGS
INTERNET SITE ADDRESSES
KEY TERMS (in the order of their appearance)
Production Marginal rate of technical
Inputs substitution (MRTS)
Fixed inputs Isocost line
Variable inputs Expansion path
Short run Constant returns to scale
Long run Increasing returns to scale
Production function Decreasing returns to scale
Total product (TP) Cobb-Douglas production function
Marginal product (MP) Product innovation
Average product (AP) Process innovation
Output elasticity Closed innovation model
Law of diminishing returns Open innovation model
Stage I of production Product cycle model

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PART THREE PRODUCTION AND COST ANALYSIS

Stage II of production Just-in-time production system

Stage III of production Competitive benchmarking
Marginal revenue product Computer-aided design (CAD)
Marginal resource cost Computer-aided manufacturing (CAM)
Isoquant 3-D printing
Rudge lines Disruptive innovation

ANSWERS TO DISCUSSION QUESTIONS

1. (a) Production refers to the physical transformation of resources into output of goods and
services. Inputs are the resources that the firm transforms into outputs of goods and
services. The broad categories of inputs are labor (including entrepreneurship),
capital, and land or raw materials.
Fixed inputs are those that cannot be changed readily during the period of the analysis
except, perhaps, at such a great expense to the firm as to make their change
impractical. Variable inputs, on the other hand, are those that can be changed readily
by the firm and on a short notice. The short run is the time period when at least one
input is fixed. The long run is the period long enough to allow the firm to change all
the inputs.

(b) The period of time of the long run differs in different industries. In some, such as in
setting up or expanding a photocopying business, the long run may be only a few
weeks or months. For others, such as in building a new steel plant, it may be several
years. It all depends on the time period required by the firm to conveniently change all
inputs.

(c) A production function is a table, graph, or equation showing the maximum output of a
commodity that a firm can produce per period of time with each set of inputs. Thus, a
production function provides the framework for the analysis of production by the firm.
It summarizes the technological production possibilities available to the firm and
provides the basis for the determination of the most efficient combination of inputs in
production.

2. The MPL curve reaches its maximum point before the APL curve. As long as the APL curve is
rising, the MPL curve is above it. When the APL curve is falling, the MPL curve is below it, and
when the APL curve is highest, the MPL curve intersects the APL curve.
The reason for this is that for the APL to rise, the MPL must be greater than the average to
“pull” the average up. For the APL to fall, the MPL must be lower than the average to pull
the average down. For the average to be maximum (i.e., neither rising nor falling), the
marginal must be equal to the average (the slope of line OH in Figure 7-4 in the text).
For example, for a student to increase his or her cumulative average test score, he or she
must receive a grade on the next (marginal) test that exceeds his or her average. With a

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 CHAPTER 7 PRODUCTION THEORY AND ESTIMATION

lower grade on the next test, the student’s cumulative average will fall. If the grade on the
next test equals the previous average, the cumulative average will remain unchanged.

3. (a) The law of diminishing returns refers to the range over which the marginal product of
the variable input declines. This corresponds to the portion of the total product curve
from the point of inflection onward (i.e., from the point where the total product curve
begins to increase at a decreasing rate).
Diminishing returns continues to operate as the total product curve reaches its
maximum point (so that the marginal product of the variable input is zero) and when
the total product curve declines (so that the marginal product curve of the variable
input is negative).

(b) Diminishing returns operates over part of stage I for the variable input and in all of
stage II (where the marginal product of the variable input is declining but positive) and
stage III (where the marginal product of the variable input is declining but negative).
While not shown in Figure 7-3 in the text, stage I of the variable input corresponds to
stage III of the fixed input (where the marginal product resulting from using fractional
units of the variable input together with the constant quantity of the fixed input leads
to declining and negative marginal product for the fixed input).
Since in stage III for the variable input the MP of the variable input is negative and in
stage I of the variable input (which corresponds to stage III of the fixed input) the MP
of the fixed input is negative, the rational producer would only produce in stage II,
where the marginal products of both inputs are positive but declining.

4. If the total product curve increases at a decreasing rate from the very beginning (i.e., from the
origin), its slope or the marginal product of the variable input would decline from the very
beginning. That is, there would be no range of increasing marginal product.
Similarly, the average product curve of the variable input would also lack a rising portion,
and it would decline from the very beginning.
The slope of a ray from the origin to any point on the total product curve or average product
is also larger than the slope of the total product curve at that point. Thus, the average
product curve of the variable input is not only declining over its entire range but is also
above the marginal product curve for each quantity of the variable input used. The student
can be asked to draw such curves.

5. (a) The marginal revenue product of an input is equal to the marginal product of the input
times the marginal revenue generated from the sale of the extra output produced.

(b) The marginal revenue product of a variable input declines because the rational
producer always produces in stage II of production, where the marginal product of the
input declines.

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PART THREE PRODUCTION AND COST ANALYSIS

If the marginal revenue from the sale of the extra product also declines (this occurs if
the firm must lower the price on all units of the commodity to sell the extra output
produced), then the marginal revenue product of the input will decline even more
rapidly.

6. (a) The marginal resource cost of a variable input refers to the increase in the total costs of
the firm resulting from hiring an additional unit of the variable input.

(b) Only if the firm is small and can hire an additional unit of the variable input at a given
(constant) market price for the input will the marginal resource cost remain constant
and be equal to the market price of the input.
If in order to hire more units of the variable input the firm must pay higher prices for
the input, the marginal resource cost of the input will differ from (i.e., it is higher than)
the input price.

7. The optimal use of the variable input is (i.e., the firm maximizes profits) where MRP = MRC
for the input. As long as MRP exceeds MRC, it pays for the firm to expand the use of the
variable input, because by doing so it adds more to its total revenue than to its total costs (so
that the firm's total profits rise). On the other hand, the firm should not hire any units of the
variable inputs for which the MRP falls short of the MRC.

8. (a) Isoquants can refer to the short run or to the long run. If the two inputs measured on
on the axes of an isoquant diagram are the only inputs used in production, then the
isoquant refers to the long run since both inputs are variable. On the other hand, if the
two variable inputs used in drawing an isoquant are used with other fixed inputs, then
we are still in the short run.

(b) Both indifference curves and isoquants are negatively sloped (in their relevant ranges),
convex to the origin, and do not intersect.

(c) While an indifference curve shows the various combinations of two commodities that
provide the consumer with equal satisfaction (measured ordinally), an isoquant shows
the various combinations of two inputs that give the same level of output (measured
cardinally, or in actual units of the commodity).

(d) Intersecting isoquants would mean that two different levels of output of the same
commodity could be produced with the identical input combination (i.e., at the point
where the two isoquants intersect). This is impossible under our assumption that the
most efficient production techniques are used at all times.

9. (a) The shape of an isoquant shows the degree or ease with which one input can be
substituted for another in production. The smaller the curvature of the isoquant, the
greater is the degree or ease with which one input can be substituted for the other in
production. On the other hand, the greater is the curvature of the isoquant, the smaller
is the ability to substitute one input for the other in production.

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 CHAPTER 7 PRODUCTION THEORY AND ESTIMATION

The degree by which one input can be substituted for the other in production (i.e.,
shape of the isoquant) is measured by the marginal rate of technical substitution
(MRTS). To be able to easily substitute one input for another when the price of the
latter increases is extremely important to the firm to keep production costs down.
(b) Petroleum as an energy source (particularly to run automobiles) does not have good
substitutes. Thus, isoquants of petroleum and other energy sources are likely to have a
great deal of curvature.
Since petroleum does not have good substitutes (especially in the short run), most
energy users faced sharply increased production costs when the price of petroleum
increased sharply during the 1970s because they could not readily substitute other
energy sources for petroleum.
10. (a) If two firms face the same wage rate and rental price of capital but spend different
amounts on labor and capital, their isocost lines will have the same slope (i.e., they are
parallel) but the firm spending more on labor and capital will have a proportionately
higher isocost line. If the wage rate increases, the isocost line of both firms will
become proportionately steeper (if labor is plotted along the horizontal axis).
(b) If the wage rate increases, the isocost line becomes steeper and the firm will have to
substitute capital for labor in order to combine labor and capital optimally in
production. As a result, the capital-labor ration (K/L) increases.
(c) The capital-labor ratio (K/L) gives the quantity of capital divided by the quantity of
labor used in production. The expansion path shows the optimal K/L needed to produce
various levels of output. The expansion path is obtained by joining tangency points of
isocost lines with isoquants.

11. Most workers in the United States earn more than the legislated minimum wage. Only some
unskilled low-wage labor is affected by a change in the minimum wage. An increase in the
minimum wage will lead firms to substitute capital (machines) for those unskilled workers
whose marginal revenue product falls below the new higher minimum wage.
Thus, the benefit resulting from an increase in the minimum wage to those unskilled
workers who remain employed must be balanced against the loss of jobs of other unskilled
workers. The workers who lose their jobs need to be trained so that their marginal revenue
product increases sufficiently to make it profitable for firms to hire them.

12. The statement is false. To maximize profits a firm should hire any input as long as its marginal
revenue product exceeds the marginal cost of hiring the input, and until they are equal.
Assuming that the input price is constant, the condition for profit maximization requires that the
firm hire any input until its marginal revenue product equals its price.
According to marginal productivity theory, in order to hire the most qualified and productive
worker the firm must also pay a wage higher than for a less qualified and productive worker.
The firm will hire the most productive and qualified worker only if the ratio of the marginal
revenue product to the wage of the most qualified and productive worker exceeds the ratio of
the marginal revenue product to the wage of the less qualified and productive worker.

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PART THREE PRODUCTION AND COST ANALYSIS

13. (a) With 2L and 2K, output is 18 units. With 4L and 4K (i.e., with a 100% increase in
inputs), output increases to 40 units (a 122% increase). Thus, we have increasing
returns to scale in this range of the production function. That is, in this case h =100%
and λ = 122%. Since λ > h, we have increasing returns to scale.

(b) With 2L and 4K, output is 28Q units. With 3L and 6K (i.e., with a 50% increase in
inputs), output increases to 31 units (an 11% increase). Thus, we have decreasing
returns to scale in this range of the production function. That is, in this case h = 50%
and λ = 11%. Since λ < h, we have decreasing returns to scale.

14. (a) The output elasticity of capital (EK) is given by the exponent of K in the estimated
production function. Thus, EK = a = 0.6. Similarly, the output elasticity of labor (EL) is
given by the exponent of L in the estimated production function. Thus, EL = b = 0.8.
If the firm increases the quantity of capital used in production by 10 percent, but keeps
the quantity of labor used constant, output increases by 6 percent. On the other hand, if
the firm increases the quantity of labor used in production by 10 percent but keeps the
quantity of capital used constant, output increases by 8 percent. Thus, the estimated
production function exhibits positive but diminishing returns to both capital and labor.

(b) Since a + b = 0.6 + 0.8 = 1.4 and exceeds one, the estimated production function
exhibits increasing returns to scale. Thus, if the firm increases both the quantity of
capital and labor used by 10 percent, its output would increase by 14 percent.

15. (a) An innovation refers to the introduction of a new or improved product (product
innovation) or production process (process innovation).

(b) There are many factors that determine how innovative a firm is. Two of the most
important are (1) the existence of strong domestic rivalry and (2) geographic
concentration in the industry. Both stimulate firms to develop new or improved
products and production processes. They also force the firm to be alert to quickly
imitate successful innovations introduced by other domestic or foreign firms.

(c) The closed innovation model refers to the situation where companies generate, develop
and commercialize their own ideas, innovations, or technological breakthroughs. The
open innovation model is where companies commercialize both, its own ideas and
innovations, as well as the innovations of other firms, and deploy external as well as
internal or in-house pathways to market.

(d) Computer-aided design (CAD) refers to the technique that allows research and
development engineers to design a new or changed product or component on a
computer screen.
Computer-aided manufacturing (CAM) is the technique that allows research and
development engineers to issue instructions to a network of integrated machine tools to
produce a prototype of the new or changed product.

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 CHAPTER 7 PRODUCTION THEORY AND ESTIMATION

(e) 3-D printing is an innovation that revolutionizes production by using computer-guided

technology that directs a printer to create a three-dimensional object from powdered
material.

(f) Disruptive innovation is an innovation that revolutionizes production and markets. 3-D
printing is a disruptive innovation because is refers to a radically different from the
traditional way of making or producing things that relies on cutting, drilling, shaving,
stamping, or molding a material (metal, wood, sand, plastic, etc). 3-D printing
dismantles the barriers between design and manufacturing and it turns conventional
manufacturing on its head by producing objects from bottom up rather than from top to
bottom as in the past. As such, this is truly a disruptive innovation.

ANSWERS TO PROBLEMS

1. (a) FE is the output that results when the firm uses L1 = 1 of labor and K2 = 4 of capital.
From Table 7-1 in the text, we see that with L = 1 and K = 4, output (Q) is 12 units.

(b) BA is the output that results when the firm uses L2 = 6 of labor and K1 = 1 of capital.
From Table 7-1, we see that with L = 6 and K = 1, Q = 12.

(c) DC is the output with L2 = 6 and K2 = 4. From Table 7-1, we see that Q = 36.

2. (a) See Table 1.

Table 1
Total, Marginal, and Average Product of Labor, and Output Elasticity

Labor Output Marginal Average Output

(Number of or Total Product Product Elasticity
Workers) Product of Labor of Labor of Labor
(1) (2) (3) (4) (5)
0 0 — — —
1 12 12 12 1
2 28 16 14 8/7
3 36 8 12 2/3
4 40 4 10 2/5
5 40 0 8 0
6 36 -4 6 -2/3

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PART THREE PRODUCTION AND COST ANALYSIS

(b) See Figure 1 on the page after next.

(c) When capital is fixed at 4 units rather than 1 unit, the MPL and APL are both greater
than when capital is held constant at 1 unit. This is reasonable. With more capital to
work with, each unit of labor is more productive, so that both the MPL and the APL are
higher, and diminishing returns sets in later (i.e., after more units of labor have been
used).

3. (a) See Table 2.

Table 2
Total, Marginal, and Average Product of Capital, and Output Elasticity

Capital Output Marginal Average Output

(Units) or Total Product Product Elasticity
Product of Capital of Capital of Capital
(1) (2) (3) (4) (5)
0 0 — — —
1 3 3 3 1
2 7 4 3 1/2 8/7
3 10 3 3 1/3 9/10
4 12 2 3 2/3
5 12 0 2 2/5 0
6 10 -2 1 2/3 -6/5

(b) See Figure 2 on the next page.

(c) The rational producer would use between 2K and 4.5K (i.e., he or she will produce in
stage II of capital, which is also stage II of labor) so that the MP of L and K are
diminishing but positive. Precisely how much capital the producer will use depends
on the price of capital, labor, and output.

4. Ms. Smith should hire workers as long as their marginal revenue product (MRP) exceeds their
marginal resource cost (MRC), and until MRP = MRC. We can find the MRP and MRC of
labor by constructing a table analogous to Table 6-3 in the text, as shown below.
Since Ms. Smith can hire additional workers at the given daily wage (w) of $40, RC = w =
$40 (column 6 in Table 3). The firm's total profits will be maximum when it hires five
workers at which MRP = MRC = $40. Note that in Table 3 the law of diminishing returns
begins to operate with the employment of the first worker.

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CHAPTER 7 PRODUCTION THEORY AND ESTIMATION

131
PART THREE PRODUCTION AND COST ANALYSIS

Table 3

Number of TP MPL MR = P MRPL = MRCL = w

Workers (L) (3)x(4)
(1) (2) (3) (4) (5) (6)
0 0 — $10 — $40
1 12 12 10 $120 40
2 22 10 10 100 40
3 30 8 10 80 40
4 36 6 10 60 40
5 40 4 10 40 40
6 42 2 10 20 40

5. We can find the marginal revenue product of each additional worker hired by calculating the
change in total revenue that results from the sale of the output produced by the additional
worker. This is shown in Table 4.

Table 4

Number of TP P TR = MRPL = MRCL = w

Workers (L) (TP)(P) ΔTR/ΔL
(1) (2) (3) (4) (5) (6)
0 0 $10 $ 0 -- $40
1 12 10 120 $120 40
2 22 10 220 100 40
3 30 10 300 80 40
4 36 10 360 60 40
5 40 10 400 40 40
6 42 10 420 20 40

Since Mr. Smith can hire additional workers at the given daily wage (w) of $40, MRC = w
= $40 (column 6 in Table 4), and the firm's total profits will be maximum when it hires five
workers so that RP = MRC = $40. The result is the same as that obtained in Problem 4,
where the MRP was obtained by multiplying the MP of labor by the MR or P of the
commodity. This is shown in Figure 3 on page 100. Note that the MRP values are plotted
at the midpoint of each additional unit of labor used in Figure 3.

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 CHAPTER 7 PRODUCTION THEORY AND ESTIMATION

Figure 3

6. (a) The isoquants for 8Q, 12Q, and 16Q are shown in Figure 4 on the page after next.

(b) The ridge lines are shown in Figure 4. The ridge line on the right or bottom or bottom
joins points on the three isoquants at which their slope is zero. On the other hand, the
top or left ridge line joins points at which the three isoquants have infinite slope (i.e.,
they are vertical).

7. (a) The MRTS on isoquant 8Q between (1L,3K) and (1.5L, 1.5K) is equal to
- ΔK/ΔL = 1.5/0.5 = 3.

(b) The MRTS on isoquant 8Q between (3L, 1K) and (1.5L, 1.5K) is equal to
- ΔK/ΔL = 0.5/1.5 = 1/3.

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PART THREE PRODUCTION AND COST ANALYSIS

(c) The MRTS on isoquant 8Q at (1.5L, 1.5K) is equal to 1. This is given by the absolute
slope of the isoquant at (1.5L, 1.5K). See Figure 6 on the page after next.

(d) At (3L, 1K) the slope of the isoquant or MRTS is zero. This is the point where the
right the right or lower ridge line crosses isoquant 8Q. On the other hand, at (1L, 3K)
the slope or MRTS of isoquant 8Q is infinite. This is the point where the left or top
ridge line crosses isoquant 8Q.

(e) The relevant range of isoquant 8Q is its negatively sloped (and convex) portion
between between points (3L, 1K) and (1L, 3K) between the ridge lines. This
corresponds to stage II of production for labor and capital in which both labor and
capital face diminishing but positive returns.

8. (a) With w = r = $2, the optimal combination of labor and capital needed to produce 12Q
is given by point R at which isocost TU is tangent to isoquant 12Q in Figure 7 on page
111. At point R, the firm uses 2L and 1.5K at a total cost of $7, so that K/L = 1.5/2 =
3/4.

(b) With w = $1 and r = $3, the optimal combination of labor and capital needed to
produce 12Q is given by point S at which isocost VW is tangent to isoquant 12Q in
Figure 8 on page 111. At point S, the firm uses 3L and 1K at a total cost of $6, so that
K/L = 1/3. Note that as w declined and r increased from part (a), the K/L ratio declined
from ¾ to 1/3.

9. (a) The firm is not maximizing output or minimizing costs (i.e., the firm is not using the
optimal input combination) because MPL/w = 40/$20 = 2 is not equal to MPK/r =
120/$30 = 4.

(b) The firm can maximize output or minimize costs by hiring fewer workers and renting
more machines. Since the firm produces in stage II of production for both labor and
capital, as the firm employs fewer workers, the MP of the last remaining worker rises.
On the other hand, as the firm rents more machines, the MP of the last machine rented
declines. This process should continue until MPL/w = MPK/r. One such point of output
maximization or cost minimization might be where MPL/w = 60/$20 = MPK/r = 90/$30
= 3.

10. Mr. Wilson can decide which alternative to increase output is more efficient by calculating the
marginal product per dollar of each alternative. The marginal product per dollar spent on
renting the more automated equipment is 1,000/$100 = 10 (i.e., 10 hamburgers per dollar of
expenditure). On the other hand, the marginal product per dollar spent on keeping the
restaurant open for two more hours (at a cost of $50 per hour) is 1,200/$100 = 12.

Since the marginal product per dollar of keeping the restaurant open for an extra 2 hours
exceeds the marginal product per dollar from renting the more automated equipment, it
would would be better for Mr. Wilson to use the former than the latter method to increase
output.

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CHAPTER 7 PRODUCTION THEORY AND ESTIMATION

135
PART THREE PRODUCTION AND COST ANALYSIS

11. The left panel of Figure 9 on the page after next shows constant returns to scale. Here, doubling
inputs from 3L and 3K to 6L and 6K doubles output from 100 (point A) to 200 (point B). Thus
OA = AB along ray OE.

The middle panel shows increasing returns to scale. Here, output can be doubled by less
than doubling the quantity of inputs. Thus, OA > AC and the isoquants become closer
together. The right panel shows decreasing returns to scale (output changes proportionately
less than L and K and OA < AD).

12. (a) The production function exhibits constant returns to scale because when L=1 and K=1,
Q= 10 1 =10, when L = 2 and K = 2, Q = 10 4 = 20, and when L = 3 and K = 3, Q =
30.

(b) The production function exhibits diminishing returns to capital an labor through out.
For example, holding capital constant at K = 1 and increasing labor from L = 1 to L = 2,
increases Q from 10 to 10 2 = 14.14. Therefore, MPL = 4.14. Increasing labor to L =
3 results in Q = 10 3 = 17.32, and MPL = 3.18 (i.e., the MPL declines).

13. (a) False. A firm always produces in the area of diminishing returns in the short run (see
Figure 7-4 in the text).

(b) True. If economies of scale were present, larger and more efficient firms would drive
smaller firms out of business in the long run.

14. (a) Economies of scale (an increase in output proportionately greater than the increase in
inputs) can result from technological change, but technological progress can occur even
with a constant level of output.

(b) With a labor-saving innovation, isoquants become flatter along a given ray from the
origin as they shift toward the origin (so that at given relative input prices, capital is
substituted for labor and production becomes more K-intensive).

(c) A K-saving technological progress is the opposite of part (b).

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CHAPTER 7 PRODUCTION THEORY AND ESTIMATION

137
PART THREE PRODUCTION AND COST ANALYSIS

15. (a) ln Q = 2.303 + 0.4 ln(200) + 0.6 ln(400) + 0.2 ln(4,000)

= 2.303 + 0.4(5.298) + 0.6(5.991) + 0.2(8.294)

= 9.6760

The antilog of ln Q = 15,931. Therefore, Q = 15,931 miles per day.

(b) The power form of the estimated Cobb-Douglas production function is

Q = 10K0.4L0.6G0.2

where 10 is the antilog of 2.303, a = 0.4, b = 0.6, and c = 0.2.

(c) With K = 200, L = 400, and G = 4,000 and Q = 15,924 (found in part (a)):

MPK = a Q = 0.4(15,931)/200 = 31.86;

K

MPL = bQ = 0.6(15,931)/400 = 23.90;

L

MPG = C Q = 0.2(15,931)/4,000 = 0.80;

G

Since a, b, and c are positive but smaller than one, the MPK, MPL, and MPG are
positive but diminishing.

(d) EK = a = 0.4; EL = b = 0.6; EG = c = 0.2

Increasing K only by 10%, leads to a 4% increase in Q;

increasing L only by 10%, leads to a 6% increase in Q;
increasing G only by 10%, leads to a 2% increase in Q.

(e) Since EK + EL + EG = 0.4 + 0.6 + 0.2 = 1.20, the firm faces increasing returns to scale.
By increasing the quantity used of K, L, and G at the same time by 10%, the firm’s
output would increase by 12%.

(f) The firm would be using the optimal combination of capital, labor, and gasoline if

MPK/r = MPL/w = MPG/g

Using the MPK, MPL, and MPG found in part (c) and r = $40, w = $30, and g = $1, we have

31.86/$40 = 23.90/$30 = 0.8/$1 = 0.8

Thus, the firm is using the optimal combination of K, L, and G.

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 CHAPTER 7 PRODUCTION THEORY AND ESTIMATION

(g) For profit maximization, the marginal revenue product of K, L, and G must equal r, w,
and g, respectively. The marginal revenue product (MRP) of any input is equal to its
marginal product (MP) times the marginal revenue or price (P) of the commodity or
service (on the assumption that output price is constant). For example, for capital

MRPK = (MP)(P) = r
Thus,
P = r/MPK = $40/31.86 = $1.25
Similarly,
P = w/MPL = $30/23.90 = $1.25
and
P = g/MPG = $1/0.8 = $1.25

So that r/MPK = w/MPL = g/MPG = $1.25.

(h) All of the estimated coefficients are statistically significant at the 5% level because
their t-values exceed the critical value of t=1.806 with v = n – k = 24 – 4 = 20 degrees
of freedom from Table B.2 of the t-distribution.

The regression “explains” 94% of the variation in output (from R2 = 0.94).

Since D-W = 2.20 exceeds the critical value of dU = 1.66 from Table B.4 for the
Durbin-Watson Statistic at the 5% level of significance, there is no evidence of
autocorrelation.

Finally, since all slope coefficients are statistically significant at the 5% level and the
regression explains more than 94% of the variation in Q, there seems to be no
multicollinearity problem.

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PART THREE PRODUCTION AND COST ANALYSIS

ANSWER TO SPREADSHEET PROBLEMS

1. (a)

A B C D E F G H I
1
2 L 0 1 2 3 4 5
3 Qx 0 10 18 24 28 30
4 MPL — 10 8 6 4 2
5 MRPL — $50 40 30 20 10
6 w
7

(b) At w = $50, the firm will hire 1 worker per day. At w = $40, the firm will hire 2
workers per day. The firm will hire 3 workers per day at w = $30, 4 workers at w =
$20 and 5 workers at w = $10. Since labor is the only variable input, the MRPL curve
represents this firm’s demand curve for labor.

2. The spreadsheet should look like the following. Since Mr. Smith can hire additional workers at
the given daily wage (w) of $40, MRC = w = $40, and the firm’s total profits will be maximum
when it hires five workers so that MRP = MRC = $40. The result is the same as that obtained
by multiplying the MP of labor by the MR or P of the commodity. This is shown in the graph.

A B C D E F G H
1
TR = MRPL = Change in TR /
2 Workers TP P TP(P) Change in L MRCL = w
3 0 0 $10 $0 — $40
4 1 12 10 120 $120 40
5 2 22 10 220 100 40
6 3 30 10 300 80 40
7 4 36 10 360 60 40
8 5 40 10 400 40 40
9 6 42 10 420 20 40
10

140
 CHAPTER 7 PRODUCTION THEORY AND ESTIMATION

$140

$120

$100

$80
MRP(L)
MRC = w = $40
$60

$40

$20

$0
1 2 3 4 5 6

3.

A B C D
1
2
3 Q 500.0
4 TC 174.9
5 K 13.1
6 L 12.2
7

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PART THREE PRODUCTION AND COST ANALYSIS

APPENDIX PROBLEMS

1. In order to determine the amount of labor and capital that the firm should use to maximize
output with the given production function and C* = $1,000, w = $30,and r = $40, we proceed
as follows

Z = 100 L0.5 K 0.5 + λ($1,000 - $30L - $40K)

∂Z
= 50 L-0.5 K 0.5 - λ $30 = 0
∂L
∂Z
= 50 L0.5 K -0.5 - λ $40 = 0
∂K
∂Z
= 1,000 - $30L - $40K = 0
∂λ

Dividing the second partial derivative by the first, we have

K/L = 3/4
so that
K = (3/4)(L).

By then substituting this value of K into the cost or expenditure constraint of the firm, we get

$1,000 = $30L + $40(3/4)(L)

$1,000 = $60L

so that L = 16.67 units.

Substituting this value of L into K = (3/4)L, we have

K = (3/4)(16.67) = 12.50

With L = 16.67 and K = 12.50, the output of the firm is

Q = 100 16.67 12.50 = 1,444

That is, the maximum output that the firm can produce is 1,444 units of the commodity.

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 CHAPTER 7 PRODUCTION THEORY AND ESTIMATION

2. In order to determine the amount of labor and capital that the firm should use to maximize
output with the given production function and C* = $1,000, w = $50, and r = $40, we proceed
as follows

Z = 100 L0.5 K 0.5 + λ($1,000 - $50L - $40K)

∂Z
= 50 L-0.5 K 0.5 - λ $50 = 0
∂L
∂Z
= 50 L0.5 K -0.5 - λ $40 = 0
∂K
∂Z
= 1,000 - $50L - $40K = 0
∂λ

Dividing the second partial derivative by the first, we have

K/L = 5/4

so that
K = (5/4)(L)

By then substituting this value of K into the cost or expenditure constraint of the firm, we get

$1,000 = $50L + $40(5/4)(L)

$1,000 = $100L

so that L = 10 units.

Substituting this value of L into K = (5/4)L, we have

K = (5/4)(10) = 12.50

With L = 10 and K = 12.50, the output of the firm is

Q = 100 10 12.50 = 1,118

That is, the maximum output that the firm can produce is 1,118 units of the commodity.

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PART THREE PRODUCTION AND COST ANALYSIS

3. In order to determine the amount of labor and capital that the firm should use to minimize the
cost of producing 1,444 units of output (Q*), given Q = 100K0.5L0.5, w = $30, and r = $40, we
proceed as follows:

Z ′ = $30L + $40K + λ ′(Q * -100 L0.5 K 0.5 )

∂Z ′
= $30 - λ ′50 L-0.5 K 0.5 = 0
∂L
∂Z ′
= $40 - λ ′50 L0.5 K -0.5 = 0
∂K
∂Z ′
= Q * - 100 L0.5 K 0.5 = 0
∂λ ′

Dividing the first partial derivative equation by the second, we have

3/4 = K/L

so that
K = (3/4)(L).

By then substituting this value of K into the given production function for 1,444 units of
output, we get

1,444 = 100 L0.5 (0.75L )0.5

so that

1,444 = 100L 0.75

and

L = 1,444/86.6 = 16.67

which is the same as in the problem in Section A6.1, except for rounding.

Substituting the value of L = 16.67 into K = (3/4)L, we then get

K = (3/4)16.67 = 12.51

which is the same as in the problem in Section A6.1, except for rounding.

Thus, in order to minimize the cost of producing 1,444 units of the output the firm should
use 16.67L and 12.51K at a cost of C = $30(16.67) + $40(12.51) = $1,000.50. This is the
same as in the problem in the Appendix in the chapter, except for rounding.

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 CHAPTER 7 PRODUCTION THEORY AND ESTIMATION

4. In order to determine the amount of labor and capital that the firm should use to minimize the
cost of producing 1,118 units of output (Q*), given Q = 100K0.5L0.5, w=$50, and r=$40, we
proceed as follows:

Z ′ = $50L + $40K + λ ′(Q * -100 L0.5 K 0.5 )

∂Z ′
= $50 - λ ′50 L-0.5 K 0.5 = 0
∂L
∂Z ′
= $40 - λ ′50 L0.5 K -0.5 = 0
∂K
∂Z ′
= Q * - 100 L0.5 K 0.5 = 0
∂λ ′

Dividing the first partial derivative equation by the second, we have

5/4 = K/L
so that
K = (1.25)(L).

By then substituting this value of K into the given production function for 1,118 units of
output, we get

1,118 = 100 L0.5 (1.25L )0.5

so that

1,118 = 100L 1.25

and

L = 1,118/111.8 = 10

which is the same as in problem 2 in Section A6.1.

Substituting the value of L = 10 into K = 1.25L, we then get

K = 1.25(10) = 12.5

which is the same as in problem 2 in Section A7.1. Thus, in order to minimize the cost of
producing 1,118 units of output the firm should use 10L and 12.51K at a cost of

C = $50(10) + $40(12.50) = $1,000.

This is the same as in problem 2 in the Appendix in the text.

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PART THREE PRODUCTION AND COST ANALYSIS

5. To determine the amount of labor and capital that the firm should use in order to maximize
profits, given 100L0.5K0.5, and K = 100, P = $1, w = $30, and r = $40, we first substitute K=100
into the production function and get:

Q = 100L0.51000.5

= 1,000L0.5

Then we find the equation of the marginal product of labor (MPL):

MPL = ∂Q/∂L = 500L-0.5

To maximize profits the firm should hire labor until the MRPL=w. Since P = MR = $1,

MRPL = (MR)(MPL) = ($1)(500L-0.5) = $30 = w

Thus,

L = (500/$30)2 = 278

With L = 278 and K = 100

Q = 100(278)0.5(100)0.5 = 16,673

The total revenue and the total costs of the firm are

TR = (P)(Q) = ($1)(16,673) = $16,673

TC = wL + rK = $30(278) + $40(100) = $12,340

so that the total profit of the firm is

π = TR - TC = $16,673 - $12,340 = $4,333

This represents the maximum profits that the firm can earn.

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6. To determine the amount of labor that the firm should use in order to maximize profits, given
100L0.5K0.5, and K = 100, P = $1, w = $50, and r = $40, we first substitute K = 100 into the
production function and get

Q = 100L0.51000.5

= 1,000L0.5

Then we find the equation of the marginal product of labor (MPL):

MPL = ∂Q/∂L = 500L-0.5

To maximize profits, the firm should hire labor until the MRPL = w. Since P = MR = $1,

MRPL = (MR)(MPL) = ($1)(500L-0.5) = $50 = w

Thus,

L = ($500/$50)2 = 100

With L = 100 and K = 100

Q = 100(100)0.5(100)0.5 = 10,000

The total revenue and the total costs of the firm are

TR = (P)(Q) = ($1)(10,000) = $10,000

TC = wL + rK = $50(100) + $40(100) = $9,000

so that the total profit of the firm is

π = TR - TC = $10,000 - $9,000 = $1,000

This represents the maximum profits that the firm can earn.

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 CHAPTER 8

COST THEORY AND ESTIMATION

8-1 THE NATURE OF COSTS

8-2 SHORT-RUN COST FUNCTIONS

Short-Run Total and Per-Unit Cost Functions
Short-Run Total and Per-Unit Cost Curves
Case Study 8-1: Per-Unit Cost Curves in the Cultivation of Corn and in Traveling

8-3 LONG-RUN COST CURVES

Long-Run Total Cost Curves
Long-Run Average and Marginal Cost Curves
Case Study 8-2: The Long-Run Average Cost Curve in Electricity Generation

8-4 PLANT SIZE AND ECONOMIES OF SCALE

Case Study 8-3: The Shape of the Long-Run Average Cost Curve in Various US Industries

8-5 LEARNING CURVE

Case Study 8-4: To Reduce Costs, Firms Often Look Far Afield

8-6 MINIMIZING COSTS INTERNATIONALLY—THE NEW ECONOMIES OF SCALE

International Trade in Inputs
BOX 8 – Managerial Economics at Work: Dell PCs and Apple iPads Sold in the United
States Are All but American!
The New International Economies of Scale
Immigration of Skilled Labor

8-7 LOGISTICS AND SUPPLY CHAIN MANAGEMENT

Case Study 8-5: Logistics at National Semiconductors, Saturn, and Compaq

8-8 COST VOLUME PROFIT ANALYSIS AND OPERATING LEVERAGE

Cost-Volume-Profit Analysis
Operating Leverage
Case Study 8-6: Breakeven Analysis for Lockheed’s Tri-Star Airbus and Europe’s Airbus
Industrie

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 CHAPTER 8 COST THEORY AND ESTIMATION

8-9 EMPIRICAL ESTIMATION OF COST FUNCTIONS

Data and Measurement Problems in Estimating Short-Run Cost Functions
The Functional Form of Short-Run Cost Functions
Case Study 8-7: Estimates of Short-Run and Long-Run Cost Functions
Estimating Long-Run Cost Functions with Cross-Section Regression Analysis
Estimating Long-Run Cost Functions with Engineering and Survival Techniques

SUMMARY
DISCUSSION QUESTIONS
PROBLEMS
SPREADSHEET PROBLEMS
APPENDIX TO CHAPTER 8: COST ANALYSIS WITH CALCULUS
SUPPLEMENTARY READINGS
SUPPLEMENTARY READINGS
INTERNET SITE ADDRESSES
INTEGRATING CASE STUDY 4: PRODUCTION AND COST FUNCTIONS IN THE
PETROLEUM INDUSTRY
INTEGRATING CASE STUDY 5: THE THIRD INDUSTRIAL REVOLUTION
INTEGRATING CASE STUDY 6: TOYOTA: THE MACHINE THAT RAN TOO HOT
INTEGRATING CASE STUDY 7: STREAMLINED PLANE MAKING
KEY TERMS (in the order of their appearance)
_________________________________________________________________________
Explicit costs Long-run average cost (LAC)
Implicit costs Long-run marginal cost (LMC)
Alternative or opportunity costs Planning horizon
Economic costs Economies of scope
Accounting costs Learning curve
Relevant cost Foreign sourcing of inputs
Incremental cost New international economies of scale
Sunk costs Brain drain
Total fixed costs (TFC) Logistics
Total variable costs (TVC) Cost-volume-profit or breakeven analysis
Total costs (TC) Contribution margin per unit
Average fixed cost (AFC) Japanese cost-management system
Average variable cost (AVC) Operating leverage
Average total cost (ATC) Degree of operating leverage (DOL)
Marginal cost (MC) Engineering technique
Long-run total cost (LTC) Survival technique

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PART THREE PRODUCTION AND COST ANALYSIS

ANSWERS TO DISCUSSION QUESTIONS

1. (a) Economic costs refer to the alternative or opportunity costs. These include not only
the explicit or out-of-pocket expenditures of the firm to purchase or hire inputs but
also the implicit costs or the value (imputed from their best alternative use) of inputs
owned and used by the firm in its production processes.
Accounting costs, on the other hand, are the historical explicit costs of the firm. These
are used for the firm’s financial reporting to stock holders and for tax purposes. For
managerial decision making, however, the firm must use economic costs.

(b) Profits equal total revenue minus total costs. But costs refer to the economic rather
than the accounting costs. That is, in calculating profits, the firm must include among
its costs not only the explicit or accounting costs but also its implicit costs. Thus, it is
quite possible that accounting profits might actually involve economic losses for the
firm.

2. (a) Marginal cost is the change in total costs per unit change in output. Incremental cost,
on the other hand, refers to the total increase in costs resulting from the
implementation of a particular managerial decision, such as the introduction of a new
product, entering a new market, improving the quality of the firm’s product, etc.

While the two concepts are related, the marginal cost refers simply to the increase in
total costs from producing one additional unit of the commodity, or the reduction in
total costs resulting from the reduction of output by one unit.

Incremental cost refers instead to the increase in total costs from implementing an
entire managerial decision. It may involve a large increase in output or no increase at
all (if the firm simply wishes to change only the quality of its product).

(b) Sunk costs are those costs that are incurred regardless of the current managerial
decisions of the firm. Thus, sunk costs are entirely irrelevant in determining the best
course of action by the firm in the present period.

For example, it pays for the firm to produce an output even if it incurs a loss as long as
the loss is smaller than the sunk costs. The reason is that if the firm decided not to
produce the output it would incur the larger loss equal to its sunk costs. While the
concept of sunk costs is a somewhat broader and looser term than the short-run
concept of fixed costs (discussed in Section 8.2), the two concepts are closely related.

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3. (a) Fixed costs refer only to the short run. In the long run all inputs are variable, and so all
costs are variable (i.e., there are no fixed costs in the long run).

(b) The ATC curve reaches its lowest point at a greater level of output than the AVC curve
because, for a while, the decline in AFC exceeds the rise in AVC.

(c) The MC curve intersects from below the AVC and the ATC curves at their lowest
points because for the AVC and ATC to decline the MC must be lower, and for the
AVC and the ATC to rise the MC must be higher. At the lowest point of the AVC and
ATC curves, AVC and ATC are neither rising nor declining, and so the MC must be
equal to them.

(d) The AFC, AVC, and ATC at each level of output are equal to the slope of a ray from
the origin to the TFC, TVC, and TC curves, respectively. On the other hand, the MC
at each level of output is equal to the slope of the TVC or TC curves.

4. (a) If the total variable cost curve faced down or increased at a decreasing rate from zero
output (i.e., from the very beginning), then the average variable, average total, and
marginal cost curves would decline continuously from the start, rather than be U-
shaped. The reason for this is that the law of diminishing returns would be operating
from the very beginning (i.e., there would be no range of increasing returns).

(b) The shape of the average fixed cost curve would decline continuously (i.e., the average
fixed cost curve would have the shape of a rectangular hyperbola and would equal the
vertical distance between the average total cost and the average variable cost curves)
as shown in the bottom panel of Figure 8-1 in the text.

(c) The Cobb-Douglas production function (examined in Section 7-7) showing decreasing
returns to scale (i.e., for which the sum of the output elasticities of labor and capital, or
a + b, is smaller than 1) would have cost curves of the shape indicated in part (a).

5. The statement that the U shape of the SAC and LAC curves are both due to the operation of the
law of diminishing returns is false. Only the U-shape of the SAC curve is due to the law of
diminishing returns. That is, the SAC curve begins to rise or turns upward when the law of
diminishing returns begins to operate.

On the other hand, the U shape of the LAC curve is based on increasing, constant, and
decreasing returns to scale, respectively. That is, as long as increasing returns to scale
predominate, LAC declines. When increasing returns to scale are just balanced by
decreasing returns to scale, the LAC is minimum. When decreasing returns to scale
predominate, the LAC rises.

Increasing, constant, and decreasing returns to scale refer to the long run. This is not to be
contrasted with the law of diminishing returns, which refers to the short run.

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PART THREE PRODUCTION AND COST ANALYSIS

6. (a) The long run is often referred to as the planning horizon because the firm can build the
plant that minimizes the cost of producing any anticipated level of output in the long
run. Once the plant has been built, the firm operates in the short run. Thus, the firm
plans for the long run and operates in the short run.

(b) The firm would not build the plant that minimizes the cost of producing a specific
level of output in the long run if the firm is not certain of the output it will produce in
the future. The firm would then prefer to build a plant that is more flexible for the
range of outputs that the firm expects to produce in the future rather than to build the
most efficient plant that would minimize the cost of producing a specific level of
output.

3. The SAC curve turns upward (i.e., is U-shaped) when the rise in AVC (resulting from the
operation of the law of diminishing returns) exceeds the decline in AFC. However, in the long
run, all inputs are variable (i.e., there are no fixed inputs) and so the law of diminishing returns
is not applicable.
The U shape of the LAC curve depends instead on increasing and decreasing returns to
scale. That is, as output expands from very low levels, increasing returns to scale prevail
and cause the LAC curve to fall. As output continues to expand, the forces for decreasing
returns to scale eventually begin to overtake the forces for increasing returns to scale and
the LAC curve begins to rise.

8. Empirical studies seem to indicate that in many industries the LAC curve has a very shallow
bottom or is nearly L-shaped. This means that economies of scale are rather quickly exhausted,
and constant or near-constant returns to scale prevail over a considerable range of outputs. This
permits relatively small and large firms to coexist in the same industry.

9. (a) Economies of scope refer to the lowering of costs that a firm often experiences when it
produces two or more products together rather than producing each product separately.
This differs from economies of scale, which refer instead to declining long-run
average cost to produce a given product or products resulting from increasing the level
of output or the scale of operation.

(b) The learning curve shows the decline in average costs with rising cumulative total
outputs over time. Economies of scale, by contrast, refer to declining average cost as
the firm’s output per time period increases.
The learning curve can be used to forecast the needs for personnel, machinery, raw
materials, and for scheduling production, determining the price at which to sell output,
and even to evaluate suppliers’ price quotations.
Foreign sourcing of inputs is often a requirement in order to remain competitive. Firms
that do not look abroad for cheaper inputs face a loss of competitiveness in world
markets and even in the domestic market. An increasing number of US firms look
abroad for skilled personnel that they cannot find at home.

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10. (a) Cost-volume-profit or breakeven analysis examines the relationship among total
revenue, total costs, and total profits of the firm at various levels of output. It can be
used to determine the output level at which the firm breaks even or earns a desired
target profit.
It can also be used to show the effect on the breakeven output and the output at which
the firm earns a specific target profit resulting from a change in the product price, and in
the firm's total fixed costs and total variable costs.
When prices and average variable costs are not fixed, nonlinear cost-volume-profit
charts and analysis must be used. Difficulties can arise when the product mix of the
firm changes over time and it is difficult to allocate the fixed costs among the various
products.

(b) The operating leverage of the firm refers to the ratio of its total fixed costs to total
variable costs. When a firm becomes more highly leveraged, its total fixed costs
increase, its average variable costs decline, its breakeven output is larger, and its
profitability becomes more variable.
The sensitivity or responsiveness of the firm’s profits to a given change in its output or
sales is measured by the degree of operating leverage (DOL). This increases as the
firm becomes more highly leveraged or capital intensive.
A highly leveraged firm is likely to earn larger profits than a less highly leveraged firm
at large levels of output but it is also likely to incur larger losses at small levels of
output. The larger profits of the more highly leveraged firm when output is high can
thus be regarded as the return for its greater risk.

11. (a) The firm breaks even at the output levels at which TR = TC. These are Q = 2 and Q = 4.

(b) The firm earns a total profit (π) of $30 at Q = 3. This is the maximum profit. That is, at
Q = 3, TR exceeds TC by the greatest amount.

(c) The difference between the optimization analysis examined in the Appendix to Chapter
3 and the cost-volume-profit analysis examined in Section 8.7a is in the objective of the
analysis. In optimization analysis, the objective is to determine the optimum price and
output of the firm. In cost-volume-profit analysis, the objective is to determine the
output level at which the firm breaks even or earns a desired target profit.

12. (a) The most common method of estimating the firm’s short-run cost functions is
regressing total variable costs on output, input prices and other operating conditions,
using time-series data over a period during which the plant size is unchanged.

(b) One fundamental problem that arises is that opportunity costs must be extracted from
the available accounting cost data. Costs must be correctly apportioned to the various
products produced, must be matched with output over time, and must be deflated by the
appropriate price index to correct for inflation.

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PART THREE PRODUCTION AND COST ANALYSIS

13. (a) The most common method of estimating the long-run average cost curve is regressing
long-run average cost on output and input prices using cross-sectional data on a number
of firms at a given point in time. Time-series data are seldom used because the period
of observation must be sufficiently long for the firm to have changed its scale of plant
several times, and this will inevitably also involve changes in the type of product that
the firm produces and in the technology it uses.

(b) Some of the difficulties encountered in estimating the long-run average cost curve with
cross-section regression analysis arise from the need to reconcile the different
accounting and operational practices of the various firms in the sample. We must also
make sure that each firm is operating the optimal scale of plant at the optimal level of
output (i.e., at the point on its SAC curve which forms part of its LAC curve).
Otherwise, the shape of the estimated LAC curve will be biased.

(e) Most empirical studies have found that in the short run MC are constant (so that the
AVC curve approaches the horizontal MC curve in the observed range of outputs.)
Most empirical studies have also found increasing returns to scale (falling LAC curve)
at low levels of output followed by near-constant returns to scale at higher levels of
output (i.e., the LAC curve seems to be L-shaped or nearly so).

14. (a) The advantages of the engineering technique of estimating the long-run average cost
curve are: it allows the estimation of the LAC curve for new products or technologies
where historical data are not available; it is based on the present technology, thus
avoiding mixing the old and current technology; no problem arises from different input
prices in different geographical regions, and the difficult cost-allocation and input-
valuation accounting problems that plague regression estimation are also avoided.

The disadvantages of the engineering technique arise because it deals only with the
technical aspects of production without considering administrative, financing, and
marketing costs; it deals with production under ideal rather than real-world conditions,
and it is based on current technology, which may soon become obsolete.

(b) The main advantage of the survival technique for estimating the long-run average cost
curve, or better still, the presence of economies or diseconomies of scale is that it is
very simple to understand and apply.

Its main disadvantage is that it implicitly assumes a highly competitive form of market
structure in which survival depends only on economic efficiency. Furthermore, the
survival technique does not allow us to measure the degree of economies or
diseconomies of scale.

(c) The results obtained with engineering and survival techniques seem to confirm those
obtained with cross-section regression analysis. That is, the LAC curve seems to be
L-shaped.

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15. (a) Logistics or supply chain management refers to the merging at the corporate level of the
purchasing, transportation, warehousing, distribution, and customer services functions,
rather than dealing with each of them separately at the division level. This increases the
efficiency and profitability of the firm.

(b) The forces that are likely to lead to the rapid spread of logistics in the future are (1) the
development of much faster algorithms and computers, (2) the growing use of just-in-
time inventory management and the increasing trend toward globalization of production
and distribution in today's world.

ANSWERS TO PROBLEMS

1. (a) The explicit costs are : $10,000 + $20,000 + $15,000 + $5,000 = $50,000.

(b) The accounting costs would be equal to the explicit costs of $50,000. The implicit
costs are $60,000 (the earnings that would be foregone from his present occupation).
The economic costs are the sum of the explicit costs of $50,000 and implicit costs of
$60,000 or $110,000.

(c) Since the estimated total revenues from opening his own law practice are $100,000
while the total estimated economic costs are $110,000, Kevin Coughlin should not
start his own law practice.

2. (a) TFC = $30. These are the total costs that the firm incurs at Q=0. Subtracting TFC
from the TC schedule gives the TVC schedule. AFC = TFC/Q; AVC = TVC/Q; ATC
= TC/Q; MC = ΔTVC/ΔQ = ΔTC/ΔQ. All of these schedules are shown in Table 1.

Table 1
Total and Per-Unit Cost Schedules

Quantity Total Total Total Average Average Average Marginal

of Fixed Variable Costs Fixed Variable Total Cost
Output Costs Costs Cost Cost Cost
0 $30 $ 0 $ 30 — — — —
1 30 20 50 $30 $20 $50 $20
2 30 30 60 15 15 30 10
3 30 51 81 10 17 27 21
4 30 88 118 7.50 22 29.50 37
5 30 150 180 6 30 36 62

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PART THREE PRODUCTION AND COST ANALYSIS

(b) See Figure 1.

3. (a) Running the night flight leads to an extra revenue of $2,000 (from the 10 extra
passengers) and an extra cost of $1,200 in overnight charges for the plane remaining in
New York in comparison to a morning flight. Since the extra revenue exceeds the
extra costs, it pays for the airline to maintain its night flight rather than replacing it
with a morning flight.

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 CHAPTER 8 COST THEORY AND ESTIMATION

(b) The total cost of running the plane for a day is $25,000 ($11,000 in operating costs for
the two flights per day plus the $3,000 of fixed costs). Also, the airline pays $1,200
per day to remain in New York overnight. Thus, total costs equal $26,200. Since the
total revenue of the airline is $26,000 for each day (the 80 passengers for the night
flight plus the 50 passengers in the afternoon flight, each paying $200 for a one-way
ticket), it pays for the airline to remain in business in the short run even though it
incurs a loss of $200 per day.

Unless the airline could find a more profitable use for the plane, it would incur the
larger loss of $3,000 equal to the fixed costs of the plane if it kept the plane idle. In the
long run, all costs are variable and it would be better for the airline to discontinue its
Los Angeles to New York service altogether.

4. (a) Since to expand output in the short run to meet peak electricity demand, electrical
companies bring into operation older and less efficient equipment, their short-run
marginal costs rise sharply.

(b) New generating equipment would have to be run continuously (i.e., around the clock),
or nearly so, for the AFC to be sufficiently low to make the ATC lower than for older
equipment. Thus, to meet only peak demand, older and fully depreciated generating
equipment is cheaper.

5. (a) The firm is not maximizing output or minimizing costs because MPL/w = 300/$50 = 6
is not equal to MPK/r = 200/$25 = 8.

(b) The firm can maximize output or minimize costs by hiring fewer workers and renting
more machines. Since the firm produces in stage II of production for both labor and
capital, as the firm employs fewer workers, the MP of the last remaining worker rises. On
the other hand, as the firm rents more machines, the MP of the last machine rented
declines. The process should continue until MPL/w = MPK/r. One such point of output
maximization or cost minimization might be at MPL/w = 350/$50 = MPK/r = 175/$25
= 7.

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PART THREE PRODUCTION AND COST ANALYSIS

6. (a) See Figure 2 on the page after next. Note that in the top panel of Figure 2, the isoquant
for 3Q is not shown in order not to clutter the figure.

The LTC, LAC, and LMC schedules are calculated in Table 2 and shown in the middle
and bottom panels of Figure 2. Note that the LMC values are plotted half-way
between the various levels of output, the LMC curve intersects the LAC curve from
below at the lowest point on the LAC curve, and the SAC curves are tangent to the
LAC curve.

Table 2

L K Q LTC LAC LMC

0 0 0 $ 0 — —
2 2 1 40 $40 $40
3 3 2 60 30 20
3.45 3.45 3 69 23 9
4 4 4 80 20 11
6 6 5 120 24 40
9 9 6 180 30 60

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 CHAPTER 8 COST THEORY AND ESTIMATION

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PART THREE PRODUCTION AND COST ANALYSIS

(b) If the firm could build only the four plants indicated by the short-run average cost
curves shown in the bottom panel of Figure 2, the long-run average cost curve of the
firm would be A"B*C"E*G"J*R". If, on the other hand, the firm could build a very
large or infinite number of plants in the long run, the LAC curve of the firm would be
the smooth curve A"C"E"J"R".

7. See Figure 3 on the page after next. The top panel of Figure 3 shows a total output curve that
exhibits first increasing returns to scale (increases at an increasing rate) and then decreasing
returns to scale (increases at a decreasing rate). This corresponds to the LTC curve in the
bottom panel that first increases at a decreasing rate (so that LAC falls) and then increases at an
increasing rate (so that LAC rises).

8. With constant returns to scale, the LTC curve is a straight line through the origin. This is shown
in the left panel of Figure 4 on the page after next. Since the LTC curve is a straight line is
through the origin, LAC = LMC and equals the constant slope of the LTC curve. This is shown
in the middle panel of Figure 4. Finally, since the LAC is horizontal, the SAC curves are
tangent to the LAC curve at the lowest points on the SAC curves (see the right panel of
Figure 4).

9. See Figure 5 on the page after next. The figure shows that to produce output level Q2, the plant
represented by SAC is better (i.e., it leads to lower per-unit costs) than the plant indicated by
SAC'. However, for outputs smaller than Q1 or larger than Q3, plant SAC' leads to lower per-
unit costs. Thus, if the firm is not sure that its output will be between Q1 and Q3, it may prefer
to build plant SAC'.

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 CHAPTER 8 COST THEORY AND ESTIMATION

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PART THREE PRODUCTION AND COST ANALYSIS

10. (a) For Q = 1, log C = 3-0.31log(1) = 3-0.3(0); thus, C = $1,000;

For Q = 2, log C = 3-0.31log(2) = 3-0.3(0.30103) = 2.909691; thus, C = 812.25;
For Q = 4, log C = 3-0.31log(4) = 3-0.3(.60206) = 2.819382; thus, C = 659.75

(b) From Q = 1 to Q = 2, C declines by ($1,000-$812.25)/$1,000 = 0.188 or 18.8%;

From Q = 2 to Q = 4, C declines by ($812.25-659.75)/$812.25 = 0.188 or 18.8%.
Thus, C declines at a constant rate for each doubling in cumulative total output.

11. (a) With TFC = $100,000, P = $30 and AVC = $20

TFC $100,000
QB = = = 10,000
P - AVC $30 - $20

At QB = 10,000 and P = $30, TR = ($30)(10,000) = $300,000.

These are shown in Figure 6 on the page after next.

(b) With TFC = $100,000, π = $60,000, P = $30, and AVC = $20

TFC + πT $100,000 + $60,000 $160,000

QT = = = = 16,000
P - AVC $30 - $20 $10

At QT = 16,000 and P =$30, TR = ($30)(16,000) = $480,000

These are shown in Figure 7 on the page after next.

12. (a) With TFC' = $40,000, P = $30 and AVC = $20

T ′FC $40,000 $40,000

Q B′ = = = = 4,000
P - AVC $30 - $20 $10

T ′FC + T $40,000 + $60,000 $100,000

QT ′ = = = = 10,000
P - AVC $30 - $20 $10

These are shown in Figure 8 on the page after next.

(b) With TFC = $100,000, P = $30 and AVC' = $10

TFC $100,000 $100,000

Q B" = = = = 5,000
P - A′VC $30 - $10 $20

TFC + T $100,000 + $60,000 $160,000

QT" = = = = 8,000
P - A′VC $30 - $10 $20

These are shown in Figure 9.

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(e) With TFC = $100,000, P* = $40, and AVC = $20

TFC $100,000 $100,000

Q B* = = = = 5,000
P * -AVC $40 - $20 $20

TFC + πT $100,000 + $60,000 $160,000

QT * = = = = 8,000
P * -AVC $40 - $20 $20

These are shown in Figure 10.

13. (a) The breakeven output for the first (QB) and the second firm (QB') are

QB = TFC _ = $100 _ = 25
P - AVC $10 - $6

QB' = TFC' _ = $300 _ = 45

P - AVC' $10 - $3.33

These are shown in Figure 11. The breakeven output of the second firm (i.e., the more
highly leveraged firm) is larger than that for the first firm because the second firm has
larger overhead costs. Thus, it takes a greater level of output for the second firm to
cover its larger overhead costs.

(b) At Q = 60, the degree of operating leverage of firm 1 (DOL) and firm 2 (D’OL) are

Q(P - A ′ VC) 60($10 - $3.33) $400

D ′OL = = = =4
Q(P - A ′ VC) - T ′FC 60($10 - $3.33) - $300 $100

Thus, the more highly leveraged firm has a higher DOL (i.e., greater variability of

Q(P - AVC) 60($10 - $6) $240

DOL = = = = 1.71
Q(P - AVC) - TFC 60($10 - $6) - $100 $140

profits) than the less highly leveraged firm. The reason for this is that firm 2 has a
larger contribution margin per unit (i.e., P-AVC) than firm 1. Graphically, this is
reflected in a larger difference between the slopes of TR and TC' than between TR and
TC.

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PART THREE PRODUCTION AND COST ANALYSIS

At Q = 70, DOL and DOL' are, respectively

70($10 - $6) $280

DOL = = = 1.56
70($10 - $6) - $100 $180

70($10 - $3.33) $467

D′OL = = = 2.8
70($10 - $3.33) - $300 $167

Thus, the larger the level of output, the smaller are DOL and D’OL. The reason is that
the farther we are from the breakeven point the smaller is the percentage change in
profits (since the level of profits is higher).

14. (a) Substituting W = 10 into the estimated regression equation, we get

TVC = 0.5 + 0.8Q

Thus, the TVC function is a straight line with a vertical intercept of $0.50. The AVC
function is then

TVC 0.5
AVC = = + 0.8
Q Q

The MC function is the slope of the TVC curve. That is,

MC = 0.8

(b) The AVC curve declines rapidly and gets closer and closer to the horizontal MC curve,
as in the right bottom panel of Figure 8-10 in the text.

(c) Anderson fit a linear TVC function to the data because he was aware that most
empirical studies found that the linear formulation fit the data better than the q uadratic
or cubic forms.

that the farther we are from the breakeven point the

The MC function is the slope of the TVC curve. That is,

MC = 0.8

(b) The AVC curve declines rapidly and gets closer and closer to the horizontal MC curve,
as in the right bottom panel of Figure 7-10.

(c) Anderson fit a linear TVC function to the data because he was aware that most
empirical studies found that the linear formulation fit the data better than the quadratic
or cubic forms.

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 CHAPTER 8 COST THEORY AND ESTIMATION

165
PART THREE PRODUCTION AND COST ANALYSIS

(d) Based on the excellent results obtained, Anderson seems to have made the correct
decision in fitting a linear TVC function to the data. All estimated coefficients are
statistically significant at better than the 1 percent level, the regression “explains” 92
percent of the variation in TVC, and the DW statistic indicates the absence of
autocorrelation.

15. (a) TVC = aQ + bQ2 + cQ3 = 60Q - 12Q2 + 1Q3

AVC = a + bQ + cQ2 = 60 - 12Q + Q2

MC = a + 2bQ + 3cQ2 = 60 - 24Q + 3Q2

When the AVC and MC curves cross AVC = MC. Setting the AVC function equal to
the MC function, we get

60 - 12Q + Q2 = 60 - 24Q + 3Q2

12Q - 2Q2 = 0

Q(12-2Q) = 0

so that Q = 0 and Q = 6

Thus, the AVC = MC = $60 at Q = 0 and Q = 6.

The AVC and MC curves of the firm are plotted in Figure 12 three pages after this.

(b) The breakeven and profit-maximizing levels of output of the firm can be found by
comparing the total costs and total revenues of the firm at various levels of output.

TC = TFC + TVC

= $100 + 60Q - 12Q2 + Q3

and

TR = (P)(Q) = $60Q

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 CHAPTER 8 COST THEORY AND ESTIMATION

Q 100 +60Q -12Q2 +Q3 TC TR π

0 100 0 0 0 $100 $ 0 $-100
1 100 + 60 - 12 + 1 149 60 - 89
2 100 +120 - 48 + 8 180 120 - 60
3 100 +180 - 108 + 27 199 180 - 19
4 100 +240 - 192 + 64 212 240 28
5 100 +300 - 300 + 125 225 300 75
6 100 +360 - 432 + 216 244 360 116
7 100 +420 - 588 + 343 275 420 145
8 100 +480 - 768 + 512 324 480 156
9 100 +540 - 972 + 729 397 540 143
10 100 +600 -1200 +1000 500 600 100
11 100 +660 -1452 +1331 639 660 21
12 100 +720 -1728 +1728 820 720 -100

Thus, the firm breaks even between Q = 3 and Q = 4 and between Q = 11 and Q = 12.
The firm maximizes total profits at Q = 8.

The profit-maximizing level of output can also be found by setting MC = P

60 - 24Q + 3Q2 = $60

-24Q + 3Q2 = 0

Q(-24 + 3Q) = 0

so that Q=0 and Q=8

and the firm maximizes profits at Q = 8.

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PART THREE PRODUCTION AND COST ANALYSIS

(c) With w = $20 and r = $10,

TC = 50 + 20Q + 2w + 3r = 50 + 20Q + 2($20) + 3($10) = 120 + 20Q

LAC = TC = 120 + 20
Q Q

LMC = 20 (the slope of the TC curve)

The LAC and LMC curves are plotted in Figure 13 on the next page.

The LAC and LMC curves are similar to those found in other empirical studies.

(d) The corporation should adopt the new technology; otherwise, it will be unable to
compete with other firms that do at any level of output. The LAC curve of the firm
would continue to fall and get closer and closer to LMC=$20 as the firm expands
output. Since the firm can sell cameras at $60, its profits will increase as output
increases until it may capture the entire market for cameras.

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 CHAPTER 8 COST THEORY AND ESTIMATION

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PART THREE PRODUCTION AND COST ANALYSIS

ANSWERS TO SPREASHEET PROBLEMS

1. Calculating the values for AFC, AVC, ATC, and MC gives you the following chart:

A B C D E F G H I
1
Total
Quantity Variable Total
2 of Output Costs Costs AFC AVC ATC MC
3 0 $0 $30
4 1 20 50 30 20 50 $20
5 2 30 60 15 15 30 $10
6 3 48 78 10 16 26 $18
7 4 90 120 7.5 22.5 30 $42
8 5 170 200 6 34 40 $80
9

2. The spreadsheet should look like the following:

A B C D E F G H
1
2 P TFC AVC TFC' AVC'
3 $10 $100 $6 $300 $3.33
4
5 Breakeven Output DOL (Q=60) Breakeven Output DOL (Q=60)
6 25 1.71 45 4.00
7
8 DOL (Q=70) DOL (Q=70)
9 1.56 2.8
10

The breakeven output of the second firm (i.e., the more highly leveraged firm) is larger than
that for the first firm because the second firm has larger overhead costs. Thus, it takes a
greater level of output for the second firm to cover its larger overhead costs.
The more highly leveraged firms has a higher DOL (i.e., a greater variability of profits) than
the less leveraged firm. The reason for this is that firm 2 has a larger contribution margin
per unit (that is, P – AVC) than firm 1.
The larger the output, the smaller are DOL and DOL'. The reason for this is that the farther
we are from the breakeven point, the smaller is the percentage change in profits (since the
level of profits is higher).

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 CHAPTER 8 COST THEORY AND ESTIMATION

3. (a) AC = 251.2 for the 100th unit,

(b) AC = 204.0 for the 200th unit, and

(c) AC = 165.7 for the 400th unit.

A B C D
1
2 Q AC
3 100 251.2
4 200 204.0
5 400 165.7
6

APPENDIX PROBLEMS

1. (a) Given: TC = 100 + 60Q - 12Q2 + Q3

then
TVC = 60Q - 12Q2 + Q3

AVC = TVC = 60 - 12Q + Q2

Q

MC = d(TC) = d(TVC) = 60 - 24Q + 3Q2

dQ dQ

(b) The AVC is minimum when

d(AVC) = -12 + 2Q = 0
dQ
so that
Q=6

At Q=6, AVC is minimum and the AVC curve is U-shaped because

d2(AVC) = 2 > 0
dQ2

The MC is minimum when

d(MC) = -24 + 6Q = 0
dQ
so that
Q=4

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PART THREE PRODUCTION AND COST ANALYSIS

At Q = 4, MC is minimum and the MC curve is U-shaped because

d2(MC) = 6 > 0
dQ2

(c) The MC curve intersects the AVC at the lowest point on the latter. Substituting
Q = 6 into the equation for the AVC curve, we get

AVC = 60 - 12(6) + 36 = $24 = MC

2. (a) Given: TC = 120 + 50Q - 10Q2 + Q3

then
TVC = 50Q - 10Q2 + Q3

AVC = TVC = 50 - 10Q + Q2

Q

MC = d(TC) = d(TVC) = 50 - 20Q + 3Q2

dQ dQ

(b) The AVC is minimum when

d(AVC) = -10 + 2Q = 0
dQ
so that
Q=5

At Q = 5, AVC is minimum and the AVC curve is U-shaped because

d2(AVC) = 2 > 0
dQ2

The MC is minimum when

d(MC) = -20 + 6Q = 0
dQ
so that
Q = 3.3

At Q = 3.3, MC is minimum and the MC curve is U-shaped because

d2(MC) = 6 > 0
dQ2

(c) The MC curve intersects the AVC at the lowest point on the latter. Substituting
Q = 5 into the equation for the AVC curve, we get

AVC = 50 - 10(5) + 25 = $25 = MC

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 CHAPTER 9

MARKET STRUCTURE: PERFECT COMPETITION, MONOPOLY, AND MONOPOLISTIC

COMPETITION

9-1 MARKET STRUCTURE AND DEGREE OF COMPETITION

9-2 PERFECT COMPETITION

Meaning and Importance of Perfect Competition
Case Study 9-1 Competition in the New York Stock Market
Price Determination under Perfect Competition
Short-Run Analysis of a Perfectly Competitive Firm
Short-Run Supply Curve of the Perfectly Competitive Firm and Market
Long-Run Analysis of a Perfectly Competitive Firm
Case Study 9-2: Long-Run Adjustment in the US Cotton Textile Industry

9-3 COMPETITION IN THE GLOBAL ECONOMY

Domestic Demand and Supply, Imports, and Prices
The Dollar Exchange Rate and International Competitiveness of US Firms
Case Study 9-3: Foreign Exchange Quotations of the Dollar
Case Study 9-4 The Depreciation of the US Dollar and the Profitability of US Firms

9-4 MONOPOLY
Sources of Monopoly
Case Study 9-5: Barriers to Entry and Monopoly by Alcoa
Short-Run Price and Output Determination under Monopoly
Long-Run Price and Output Determination under Monopoly
Case Study 9-6: The Market Value of Monopoly Profits in the New York City Taxi Industry
Comparison of Monopoly and Perfect Competition
BOX 8 – Managerial Economics at Work: De Beers Abandons Its Diamond Monopoly

9-5 MONOPOLISTIC COMPETITION

Meaning and Importance of Monopolistic Competition
Case Study 9-7: The Monopolistically Competitive Restaurant Market
Short-Run Price and Output Determination under Monopolistic Competition
Long-Run Price and Output Determination under Monopolistic Competition
Product Variation and Selling Expenses under Monopolistic Competition
Case Study 9-8: Advertisers Are Taking on Competitors by Name … and Being Sued

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PART FOUR MARKET STRUCTURE AND PRICING PRACTICES

SUMMARY
DISCUSSION QUESTIONS
PROBLEMS
SPREADSHEET PROBLEMS
APPENDIX CHAPTER 9: PROFIT MAXIMIZATION WITH CALCULUS
SUPPLEMENTARY READINGS
INTERNET SITE ADDRESSES
KEY TERMS (in the order of their appearance)
_________________________________________________________________________

Market Foreign exchange rate

Market Structure Depreciation
Perfect competition Appreciation
Monopoly Natural monopoly
Monopolistic competition Consumers’ surplus
Oligopoly Deadweight loss
Imperfect competition Differentiated product
Price taker Excess capacity
Shut-down point Overcrowding
Short-run supply curve of the Product variation
perfectly competitive firm Selling expenses
Foreign exchange market

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 CHAPTER 9 MARKET STRUCTURE: PERFECT COMPETITION, MONOPOLY, AND MONOPOLISTIC
COMPETITION

ANSWERS TO DISCUSSION QUESTIONS

1. This concept of perfect competition is diametrically opposite to the economist's view of perfect
competition. It describes a competitive market, which stresses the rivalry among firms. The
economist’s view stresses the impersonality of a perfectly competitive market.

That is, according to the economist, in a perfectly competitive market there are so many
sellers and buyers of the commodity, each so small in relation to the market, as not to regard
others as competitors or rivals at all. The products of all firms in the market are
homogeneous, and so there is no rivalry among firms based on advertising and quality style
differences.

2. (a) A firm should continue to produce in the short run even if it incurs losses as long as
the price of the product (P) that the firm receives exceeds the average variable cost
(AVC) of the firm. The reason is that the excess of P over AVC will cover part of the
firm’s fixed costs, so that the total losses of the firm would be smaller than its total
fixed costs.

If the firm went out of business, the firm would incur the higher losses equal to its total
fixed costs. Thus, even if a firm is incurring losses in the short run, as long as P >
AVC, the firm minimizes its total losses by continuing to produce the product (i.e.,
staying in business).

(b) The normal return on investment or opportunity costs are included as part of the costs
of the firm and are incorporated into the firm's cost curves. Thus, when we say that a
firm earns a profit in managerial economics, we mean that it earns above normal
returns on investments.

3. (a) The market supply curve of a product is more price elastic than the supply curve of one
of the firms in the market. The reason is that for any given price change, the market
quantity response reflects the change in output of all the firms in the market.
For example, for an increase in price from $25 to $45 in Figures 9-1 and 9-2 in the
text, the quantity increases by 100 units for the market as a whole but by only 1 unit
for each of the 100 identical firms in the market.

(b) An increase in input prices will cause the short-run marginal cost curve of the firm to
shift upward and this will cause the competitive firm's supply curve to become steeper
or less price elastic.

(c) A competitive firm’s short-run supply curve is not affected by a change in the firm’s
fixed costs since they do not affect the firm's short-run marginal cost curve, and the
firm’s short-run supply curve is derived from its short-run marginal cost curve.

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PART FOUR MARKET STRUCTURE AND PRICING PRACTICES

4. (a) The best level of output for a perfectly competitive firm in the long run is given by the
point where P = LMC.

(b) The optimal scale of plant for a perfectly competitive firm when the firm is in long-run
equilibrium is given by the SATC curve that is tangent to the LAC curve of the firm at
the best level of output.

(c) When the competitive market and firms are in long-run perfectly competitive
equilibrium, the best level of output is the one at which P = LMC = lowest LAC. The
optimal scale of plant is the one with SATC curve tangent to the lowest point on the
LAC curve of the firm.

5. (a) A competitive firm is in short-run equilibrium when P = MR = SMC and P > AVC. In
the short run, some inputs (especially the firm’s plant) are fixed. In the long run, the
firm can build the optimal plant to produce the best level of output (given where P =
LMC). Thus, a competitive firm that is in short-run equilibrium need not be in long-
run equilibrium.

(b) A firm is in long-run equilibrium when it has built the optimal scale of plant and is
producing the best level of output. Thus, if a perfectly competitive firm is in long-run
equilibrium it must necessarily be in short-run equilibrium also.

6. (a) An import tariff is like a tax per unit and, as such, it can be shown by an upward shift
of the foreign supply curve of the nation's imports (SF) by the amount of the tax per
unit. The student is asked to measure the effect of such an import tariff in Problem 7.

(b) In Figure 9-4 in the text, any import tariff equal to or greater than $2 per unit would be
prohibitive. An import tariff of $2 per unit would shift the foreign supply curve of
imports of the commodity to the nation to Px = $5. At Px= $5, all of the quantity
demanded of the commodity domestically would be supplied by domestic production,
and so imports of commodity X by the nation would be zero. Obviously, any per-unit
import tariff greater than $2 would also be prohibitive.

7. In a world of two currencies, the dollar and the euro, a depreciation of the dollar means that the
euro appreciates. Specifically, a 10 percent depreciation of the dollar refers to an appreciation
of the euro by 10 percent.

8. (a) The dollar price that the US importer pays rises by 10 percent.

(b) The dollar price that a US exporter receives falls by 10 percent.

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 CHAPTER 9 MARKET STRUCTURE: PERFECT COMPETITION, MONOPOLY, AND MONOPOLISTIC
COMPETITION

9. (a) A monopoly may arise if the firm (1) controls the entire supply of a needed raw
material; (2) owns a patent or copyright necessary to produce the product or service,
(3) has very large economies of scale, and (4) has a government franchise.

(b) Alcoa used the first three reasons at different times to establish a monopoly or near
monopoly in the production of aluminum.

10. (a) A monopolist, just like a perfectly competitive firm, can earn profits or incur losses in
the short run. The monopolist will earn profits if P > ATC, break even if P = ATC, and
incur losses if P < ATC. However, as long as P > AVC, the monopolist will minimize
total losses by continuing to produce. If the monopolist stopped producing its total
losses would be larger and equal to its total fixed costs.

(b) A monopolist earning short-run profits can increase these profits in the long run by
building the optimal or most appropriate scale of plant to produce the best level of
output in the long run. The best level of output of the monopolist in the long run is the
one at which P = LMC.
The optimal scale of plant is the one with SATC curve tangent to the LAC at the best
level of output. Because under monopoly entry is blocked, the monopolist can continue
to earn profits in the long run and can in fact increase total profits in the long run by
building the optimal scale of plant.

(c) A monopolist, just like a perfect competitor, produces where MR = MC. Since MC is
positive, MR must also be positive at the best level of output. But for MR to be positive,
the demand curve faced by the monopolist must be elastic. Another way of saying this,
is that only when the demand curve is elastic, will a reduction in the product price
increase TR, so that MR is positive. Thus, a monopolist will never operate in the
inelastic portion of the demand curve.

11. Under perfect competition the best level of output of the firm is given at the point where P =
MR = MC. Thus, given P, we can determine the quantity supplied by a perfectly competitive
firm from the point where P = MC. For a monopolist, on the other hand, MR = MC < P at the
best level of output.
Since a given MR can be associated with a different P depending on the price elasticity of
demand, there is no unique relationship between P and the quantity supplied by the
monopolist (i.e., we cannot derive the supply curve of the monopolist from the rising
portion of SMC above the AVC, as was done for the perfectly competitive firm).

12. We can prove that perfect competition leads to a more efficient use of society’s resources than
monopoly only when technology allows many firms to operate efficiently in the market. Often,
economies of scale operate over such a large range of outputs that only one or a few firms can
satisfy the entire market demand for the commodity.
In such cases, perfect competition is either impossible or would lead to prohibitively high
per-unit costs of production. There is also disagreement on whether technological progress
is more likely to take place under monopoly or under perfect competition.

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PART FOUR MARKET STRUCTURE AND PRICING PRACTICES

13. (a) The choice-related variables for a monopolistically competitive firm are price, product
variation, and selling expenses. That is, in order to maximize short-run profits, the firm
can charge the price at which MR = MC. The firm can also undertake product variation
and increase selling expenses until the MR from these efforts equals the MC. This is to
be contrasted to the case under perfect competition where the firm only determines the
best level of output to produce.

(b) Nonprice competition refers to all the efforts on the part of firms to increase sales or
make the demand curves that they face less elastic through product variation and selling
expenses.

(c) Product variation refers to changes in some of the characteristics of the product in order
to make it more appealing to consumers. For example, beer makers have put on the
market light beer for weight-conscious consumers and have introduced plastic bottles
because they are lighter and unbreakable.

(d) Selling expenses are all those expenses that the firm incurs to advertise its product, to
increase its sales force, to provide more and better servicing of the product, and to
otherwise induce consumers to purchase the product.

14. According to the theory of monopolistic competition, a firm should increase its advertising
expenditures as long as the MR that it gets from them exceeds MC, and up to the point where
MR=MC. When firms have adequate information on the effect of advertising on their sales and
profits, they do try to follow the above profit-maximizing rule.

However, firms often do not have enough information to follow the above rule precisely. In
those cases, the best that the firm can do is to set its advertising expenditures as a
percentage of its targeted sales goal. In the absence of better information, firms believe that
the rule that they follow is as likely as any other to lead to profit maximization.

15. The more price elastic is the demand curve faced by a monopolistically competitive firm when
in long-run equilibrium, the closer to the lowest point on its LAC curve will the firm be when
in long-run equilibrium. Since excess capacity is measured by the distance between the two
points, the more elastic is the demand curve, the smaller is the amount of excessive capacity
under monopolistic competition (see Figure 8-10 in the text).

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 CHAPTER 9 MARKET STRUCTURE: PERFECT COMPETITION, MONOPOLY, AND MONOPOLISTIC
COMPETITION

ANSWERS TO PROBLEMS

1. (a) QD = QS
10,000 - 1,000P = -2,000 + 1,000P
12,000 = 2,000P
P = $6 (equilibrium price)

Substituting the equilibrium price into either the market demand or supply function,
we get the equilibrium quantity. That is,

QD = 10,000 - 1,000($6) = 4,000 or

QS = -2,000 + 1,000($6) = 4,000

(b) See Figure 1.

2. (a) With QD' = 12,000 - 1,000P, we have

QD' = QS
12,000 - 1,000P = -2,000 + 1,000P
14,000 = 2,000P
P' = $7

Q' = 12,000 - 1,000($7) = 5,000 or

Q' = -2,000 + 1,000($7) = 5,000

With QD" = 8,000 - 1,000P, we have

QD" = QS
8,000 - 1,000P = -2,000 + 1,000P
10,000 = 2,000P
P" = $5

Q" = 8,000 - 1,000($5) = 3,000 or

Q" = -2,000 + 1,000($5) = 3,000

(b) With QS* = -4,000 + 1,000P

QD = QS*
10,000 - 1,000P = -4,000 + 1,000P
14,000 = 2,000P
P* = $7
Q* = 10,000 - 1,000($7) = 3,000 or
Q* = -4,000 + 1,000($7) = 3,000

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 CHAPTER 9 MARKET STRUCTURE: PERFECT COMPETITION, MONOPOLY, AND MONOPOLISTIC
COMPETITION

With QS** = 1,000P

QD = QS**
10,000 - 1,000P = 1,000P
10,000 = 2,000P
P** = $5
Q** = 10,000 - 1,000($5) = 5,000 or
Q** = 1,000($5) = 5,000

(c) See Figure 2 on the previous page.

3. (a) When P = $18, the best or optimum level of output is 7,000 units (given by point A).
The firm earns $4 of profit per unit (AN) and a total profit of $28,000. This represents
the maximum total profit that the firm can make at this price.

(b) When P = $13, the best level of output is 6,000 units (point B) and the firm breaks
even.

(c) When P = $9, the best level of output is 5,000 units (point C). At this level of output,
the firm incurs a loss of $5 per unit (CD) and $25,000 in total. If the firm went out of
business, however, it would incur a total loss equal to its TFC of $40,000 (obtained by
multiplying the AFC of DE or $8 per unit times 5,000 units). Thus, the firm would
minimize its total losses in the short run by staying in business.

(d) When P = $5, the best level of output is 4,000 (point F). However, since P = AVC and
thus TR= TVC (= $20,000), the firm is indifferent whether it produces or not. In either
case, the firm would incur a short-run loss equal to its TFC of $40,000. Point F is thus
the shut-down point.

(e) Since P is smaller than AVC, TR ($9,000) does not cover TVC ($18,000). Therefore,
the firm would incur a total loss equal to its TFC ($40,000) plus the $9,000 amount by
which TVC exceeds TR ($18,000 - $9,000 = $9,000). Thus, it pays for the firm to shut
down and minimize its total losses at $40,000 (its TFC) over the period of the short
run.

4. (a) See Figure 3.

(b) The firm's short-run supply curve is given by the rising portion of its MC curve above
its AVC curve. If the supplies of inputs to the industry are perfectly elastic (that is, if
the prices of the factors of production remain the same regardless of the quantity of
factors demanded per unit of time by the industry), then the market or industry short-
run supply curve is obtained by the horizontal summation of the MC curves (over their
respective AVC curves) of all the firms in the industry.

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PART FOUR MARKET STRUCTURE AND PRICING PRACTICES

To be noted is that when a single firm expands its output (and demands more factors), it
is reasonable to expect that factor prices will remain unchanged. When all firms expand
output (and demand more factors), however, factor prices are likely to rise.

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 CHAPTER 9 MARKET STRUCTURE: PERFECT COMPETITION, MONOPOLY, AND MONOPOLISTIC
COMPETITION

(c) If the short-run market price for the service is $9, each of the 100 identical firms in the
industry will produce and sell 5,000 units of the output (point C) and the total for the
industry will be 500,000 units. At P = $18, each firm produces and sells 7,000 units
and the industry total is 700,000 units. No output of the service is produced at prices
below $5 per unit (i.e., below the shut-down point, the supply curves coincide with the
price axis).

5. (a) The best or optimum level of output for this firm in the short run is given by the point
where P = SMC1. At this level of output (400 units), the firm earns a profit of $4 per
unit and $1,600 in total.

(b) If only this firm adjusts to the long run (a simplifying and unrealistic assumption for a
perfectly competitive market), this firm will produce where P = SMC3 = LMC. The
firm will build the scale of plant indicated by SAC3 and will produce and sell 800 units
of output. The firm will earn a profit of $5 per unit and $4,000 in total per time period.

Note that since we are dealing with a perfectly competitive firm, we can safely assume
that if only this firm expanded its output, the effect on equilibrium price will be
imperceptible.

6. (a) In the long run, all firms in the market will adjust their scale of plant and their level of
output, and more firms will enter the market, attracted by the short-run profits. This
will increase the industry supply of the product and thus cause a fall in the equilibrium
price to $8 (see the figure). At this price, P = MR2 = SMC2 = LMC = SAC2 = LAC.

Each firm produces 500 units of output (if they all have the same cost curves) and receives
only a “normal return” (equal to the implicit opportunity cost) of its owned factors. If firms
were making short-run losses to begin with, the exact opposite would occur. In any event
when all firms are in long-run equilibrium, they all produce at the lowest point on their
LAC curve, they all break even, and spend little if anything on sales promotion.

(b) In the solution to part (a), the implicit assumption was made that factor prices
remained unchanged as more firms entered the industry and industry output was
expanded. If, as more firms enter the market and demand more inputs, input prices
increase, all of the firm's cost curves shift up, so that when the perfectly competitive
industry is in long-run equilibrium, P = LMC = lowest LAC, but the lowest LAC is
now higher than when input prices were assumed to be constant.

7. A 33 percent import tariff on commodity X will shift the foreign supply curve of imports of
commodity X to the nation (i.e., SF) upward by $1, so that the tariff-inclusive Px = $4. At Px =
$4, domestic consumers would purchase 500X (given by the point on Dx at Px = $4), of which
300X would be produced domestically (given by the point on Sx at Px = $4), and the difference
of 200X between the quantity consumed and produced domestically would be imported (see
Figure 9-4). Thus, the consumption effect of the tariff is -100X, the production effect is +100X,
and the trade effect is -200X. The nation’s government also collects the revenue $200 ($1 on
each of the 200X imported). This is the revenue effect of the tariff.

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PART FOUR MARKET STRUCTURE AND PRICING PRACTICES

8. (a) The Company faces a foreign exchange risk. The risk is that the dollar will depreciate
between the time the company orders imports and the time it will have to pay for those
imports in euros. In that case, the price that the Company would have to pay will rise
by the same percentage as the dollar depreciation. Since most food retailers operate a
thin profit margin, even a small depreciation of the dollar with respect to the euro
could wipe out the Company’s profits and even lead to a loss. It is true that if the
dollar appreciates, the company will have to pay fewer dollars for its imports, but the
Company has enough to worry about in its own market and would not want to worry
also about a possible dollar depreciation.

(b) The company could cover (avoid) its foreign risk by acquiring the euros it needs at the
time it orders imports and leave the acquired euros on deposit in its bank until it needs
to make the payment. That way any depreciation of the dollar before the Company
needs to make the payment will not affect it. It is more efficient (and it will not tie up
the Company’s capital), however, if the Company buys the euros it needs in the future
on the forward exchange market at the exchange rate (forward rate) prevailing at the
time it orders the imports but for delivery and payment of the euros at the agreed rate
at the specified future date.

9. See Figure 4.
The figure shows that an increase in average fixed costs shifts up the ATC curve by $5 but
does not change the MC curve. Since the D and MR curves are also unchanged, the best
level of output for the monopolist remains at 500 units (given by point E at which MR =
MC) and the price remains at $11 (point A on the D curve).
Since ATC = $13 now (point F'), the monopolist incurs a loss of F'A = $2 per unit and
F'AB'C' = $1,000 in total. The monopolist, however, minimizes losses by staying in
business. By going out of business the monopolist would incur the larger loss of F'A'= $6
per unit (equal to AFC) and F'A'B"C' = $3,000 in total (equal to its total fixed costs).

10. (a) See Figure 5.

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COMPETITION

In the figure, the D and MR curves are the same as in Figure 9-7 in the text, but all the
Cost curves are higher than those in Figure 9-7. The reason is that in the long run there
are no fixed costs and an increase in costs shift all cost curves upward.
The best level of output of the monopolist is 600 units and is given by point E" at which
MR = SMC' = LMC'. At Q = 600, P = SAC = LAC = $10 and the monopolist breaks even.

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PART FOUR MARKET STRUCTURE AND PRICING PRACTICES

(b) See Figure 6 on the previous page.

In the figure, the LAC and LMC curves are the same as in Figure 9-7, but D' and MR'
curves are higher than those in Figure 9-7. Since the MR' intercepts the LAC curve at
its lowest point, the monopolist produces at that point (i.e., Q = 900 units given by point
E*, at which MR' = LMC). Since P = $13 (point A* on the D' curve) while LAC = $4,
the monopolist earns a profit of A*E* = $9 per unit and A*E*B*C* = $8,100 in total.

11. Authors would like publishers to maximize total revenue. This would occur when the demand
curve for book sales has unitary price elasticity. Publishers, on the other hand, want to
maximize total profits, which occurs when MR = MC (and MC is rising). Since MC is positive,
MR is also positive (i.e., the publisher operates on the inelastic portion of its demand curve).
Thus, there is a basic conflict between the interest of authors and those of publishers.

12. (a) See Figure 7.

(b) At the best short-run level of output of 80 haircuts, MR = SMC (point E in the figure)
and P = $8 (point A). Since ATC = $10 the firm incurs a loss of A'A = $2 per unit and
$160 in total. However, since P = $8 and AVC = $6, the firm minimizes losses by
remaining in business in the short run.
Specifically, if the firm stopped producing it would incur a total loss of $320 (equal to
the $4 average fixed costs at Q = 80 times the output of 80 units) as compared to the
total loss of only $160 by continuing to produce.

13. (a) See Figure 8.

In the figure, the best level of output for the monopolistically competitive firm when the
market is in long-run equilibrium is 60 units and is given by point E" at which MR" =
LMC, and P = LAC = $6 (point A" in the figure). This compares with 90 units of
output, given by point E"' at which P = LMC = LAC = $5 for a perfectly competitive
firm when the market is in long-run equilibrium.

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COMPETITION

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(b) The amount of overcapacity for the monopolistic competitor is 30 units. This is equal to
the difference between the best level of output of 60 units for the firm under
monopolistic competition and the best level of output of 90 units for the perfect
competitor when the market is in long-run equilibrium.
Because of the overcapacity in a monopolistically competitive market, more firms are
allowed to exist in the long run than if the market had been organized along perfectly
competitive lines.

(c) When the market is in long-run equilibrium, the perfectly competitive firm produces at
the lowest point on its LAC curve and P = lowest LAC. Because the demand curve
facing a monopolistically competitive firm is negatively sloped as a result of product
differentiation, a monopolistic competitor produces on the negatively-sloped portion of
its LAC curve when the market is in long-run equilibrium. Thus, at the best level of
output, P = LAC but exceeds the lowest LAC.
The difference in the price charged by the monopolistic competitor and the perfect
competitor is small, however, because the demand curve faced by the former is very
elastic. The higher price charged by the monopolistically competitive firm can be
regarded as the cost of providing consumers with a variety of differentiated products
rather than with the single undifferentiated product supplied by the perfect competitor.

14. (a) Since the movie market is monopolistically competitive, P = LAC in the long run. Thus

9 - 0.04Q = 10 - 0.06Q + 0.001Q2

1 - 0.02Q + 0.001Q2 = 0 or
10,000 - 200Q + Q2 = 0

which can be factored as

(Q - 100)(Q - 100) = 0

so that Q = 100

Substituting Q = 100 into the demand function we have

P = 9 - 0.04(100) = $5
(b) At Q = 100
AC = 10 - 0.06(100) + 0.0001(100)2
= 10 - 6 + 1
= $5

Since P = LAC = $5, the Plaza Movie House breaks even in the long run.

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COMPETITION

15. (a) QD = QS
60,000 - 25,000P = 25,000P
50,000P = 60,000
P = $1.20 (equilibrium price)
Q = 60,000 - 25,000 ($1.20) = 30,000 or
Q = 25,000($1.20) = 30,000

(b) See Figure 9.

(c) In Figure 9, the market price of gasoline is $1.20 per gallon and the equilibrium
quantity in the market is 30,000 gallons per day (point E in the left panel). Since the
market is nearly perfectly competitive, each of the 100 identical firms will face a
horizontal demand curve at P = $1.20. Each firm will supply 1/100 of the market or 300
gallons per day (point E', at which the MC = s curve crosses the d curve).
Assuming that the cost of the gasoline and the cost of the other inputs remain constant,
the horizontal summation of the MC = s curves above P = $0.60 give the market supply
curve (S in the left panel). The intersection of the D and S curves in the left panel then
determine the equilibrium price which is given to each firm. Thus, the circle is
complete—from the market to the firm and back to the market.

(d) See Figure 10.

Figure 10 shows that the level of output of the monopolist is 20,000 per day (given by
point E at the intersection of the MR and the S = ΣMC curve).

(e) The monopolist would operate 66.5 or 67 gasoline stations and close the other 33. If
ATC = $1.20, the monopolist would earn $0.40 per gallon and $8,000 in total per day.
This compares to zero profits for the perfect competitors.

(f) The monopolist supplies less (20,000 gallons per day as compared with 30,000 under
perfect competition) and charges a higher price ($1.60 per gallon as compared with
$1.20 under perfect competition). This results in a less efficient use of society's
resources than under perfect competition.

The reason is that consumers are willing to pay $1.60 for the last gallon of gasoline
supplied while it costs the monopolist only $0.80 to supply it. The true or deadweight
loss to society from moving from perfect competition to monopoly in this market is
given by area E*EE' = $4,000 in Figure 10.

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COMPETITION

ANSWERS TO SPREADSHEET PROBLEMS

1. (a) P = $30

(b) P = $42

(c) P = $18

(d) for (a), profit = $30(3,250) – 0.005(3,250)2 + 3,250 = $47,937.5

for (b) , profit = $42(3,250) – 0.005(3,250)2 + 3,250 = $86,937.5
for ( c) , profit = $18(3,250) – 0.005(3,250)2 + 3,250 = $8,937.5.

2. (a)
A B C D E F
1
2 P Q TR MR
3 $55 0 $0 —
4 50 1 50 $50
5 45 2 90 40
6 40 3 120 30
7 35 4 140 20
8 30 5 150 10
9 25 6 150 0
10 20 7 140 -10
11

(b) D is unitary elastic at Q = 5.5, elastic for Q < 5.5, and inelastic for Q > 5.5

(c) MR = P(1 + 1/η)

25 = 40(1 + 1/ η)
0.625 = 1 + 1/ η
-0.375 = 1/ η
0.375 = -1/ η
η = -1/0.375
η = -2.66

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ANSWERS TO APPENDIX PROBLEMS

1. Starting with TR = 45Q - 0.5Q2 and TC = Q3 - 8Q2 + 57Q + 2

MR = d(TR) = 45 -Q
dQ
and
MC= d(TC) = 3Q2 - 16Q + 57
dQ

Setting MR=MC and solving for Q, we get:

45 - Q = 3Q2 - 16Q + 57

3Q2 - 15Q + 12 = 0

(3Q-3) (Q-4) = 0

so that
Q = 1 and Q = 4

Thus, MR = MC at Q = 1 and Q = 4

But in order for profits to be maximized rather than minimized, the algebraic value of the slope
of the MC curve must be greater than the algebraic value of the MR curve. The slope of the
MR is

MR = d(TR) = d(45-Q) = -1
dQ dQ

The equation of the slope of the MC curve is

MC= d(TC) = d(3Q2 -16Q+57) = 6Q -16

dQ dQ

At Q = 1, the slope of the MC curve is -10, which is algebraically less than the slope of the MR
curve (i.e., -1) and so π is minimized at Q = 1.

At Q = 4, the slope of the MC curve is 8. Since this is larger than the slope of the MR curve, π
is maximized at Q = 4. This is the same result as that obtained from the total approach in the
Appendix to Chapter 9.

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COMPETITION

2. Starting with TC = 0.04Q3 - 0.9Q2 + 10Q + 5

MC = d(TC) = 0.12Q2 - 1.8Q + 10

dQ

Setting MC = MR = P = $4, we have

0.12Q2 - 1.8Q + 10 = 4
0.12Q2 - 1.8Q + 6 = 0

Dividing each term of the above expression by 0.12, we get

Q2 - 15Q + 50 = 0
(Q-5)(Q-10) = 0

therefore, Q = 5 and Q = 10

At the best level of output, the MC curve must be rising (i.e., the slope of the MC curve must
be positive). The equation of the slope of the MC function is given by

d(MC) = 0.24Q - 1.8

dQ

At Q = 5,

d(MC) = 0.24(5) - 1.8 = -0.6 and the MC curve is declining

dQ

At Q = 10,

d(MC) = 0.24(10) - 1.8 = 0.6 and the MC curve is rising

dQ

Therefore, the best level of output of the firm is Q = 10.

At Q =10 and P = $4, the total profits (π) of the firm are

= PQ - (0.04Q3 - 0.9Q2 + 10Q + 5)

= (4)(10) - 0.04(10)3 + 0.9(10)2 - 10(10) - 5
= 40 - 40 + 90 - 100 - 5
= -$15

Since the firm incurs a loss which exceeds the $5 fixed costs of the firm at the best level of
output, it pays for the firm to shut down and minimize its short-run losses at $5.

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 CHAPTER 10

OLIGOPOLY AND FIRM ARCHITECTURE

10-1 OLIGOPOLY AND MARKET CONCENTRATION

Oligopoly: Meaning and Sources
Concentration Ratios, the Herfindahl Index, and Contestable Markets
Case Study 10-1: Brands: Thrive or Die
Case Study 10-2: Industrial Concentration in the United States

10-2 OLIGOPOLY MODELS

The Cournot Model
The Kinked Demand Curve Model
Cartel Arrangements
Case Study 10-3: The Organization of Petroleum Exporting Countries (OPEC) Cartel
Price Leadership

10-3 PROFITABILITY AND EFFICIENCY IMPLICATIONS OF OLIGOPOLY

Porter’s Strategic Framework
Efficiency Implications of Oligopoly
Case Study 10-4: Firm Size and Profitability
Case Study 10-5: Measuring the Pure Efficiency of Operating Units

10-4 THE SALES MAXIMIZATION MODEL

10-5 THE MARCH OF GLOBAL OLIGOPOLISTS

Case Study 10-6: The Globalization of the Auto Industry
Case Study 10-7: The Rising Competition in Global Banking
Case Study 10-8: The Globalization of the Pharmaceutical Industry
BOX 10 – Managerial Economics at Work: Multinational Corporations Follow
Better Management Practices than National Corporations

10-6 THE ARCHITECTURE OF THE IDEAL FIRM AND THE CREATIVE COMPANY
The Architecture of the Ideal Firm
The Evolution of the Creative Company
Case Study 10-9: Firm Architecture and Organizational Competitiveness of
High-Performance Organizations
Case Study 10-10: The Most Innovative Companies in the World

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10-7 THE VIRTUAL CORPORATION AND RELATIONSHIP ENTERPRISES

The Virtual Corporation
Relationship Enterprises
Case Study 10-11: Relationship Enterprises in Aerospace, Airline, Telecommunications and
Automobiles

SUMMARY
DISCUSSION QUESTIONS
PROBLEMS
SPREADSHEET PROBLEMS
APPENDIX TO CHAPTER 10: OLIGOPOLY THEORY MATHEMATICALLY
The Cournot Model
The Kinked Demand Curve Model
The Centralized Cartel Model
The Market-Sharing Cartel
The Sales Maximization Model
Appendix Problems
SUPPLEMENTARY READINGS
INTERNET SITE ADDRESSES
KEY TERMS (in the order of their appearance)
____________________________________________________________________________

Oligopoly Market-sharing cartel

Duopoly Centralized cartel
Pure oligopoly Price leadership
Differentiated oligopoly Barometric firm
Nonprice competition Porter’s strategic framework
Limit pricing Sales maximization model
Concentration ratios Firm architecture
Herfindahl index (H) Virtual corporation
Theory of contestable markets Relationship enterprises
Cournot model Creative company
Bertand model Reaction function
Kinked demand curve model Cournot equilibrium
Collusion Nash equilibrium

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ANSWERS TO DISCUSSION QUESTIONS

1. (a) The distinguishing characteristic of oligopoly is the interdependence or rivalry among

the firms in the industry. This is the natural result of fewness. Because of
interdependence, managerial decisions are much more difficult than under other forms
of market organization.

(b) Oligopoly is the most prevalent form of market organization in the manufacturing
sector of the economy of the United States and other industrial nations. There are
several reasons for this, but the most important is the prevalence of strong economies
of scale in most manufacturing industries in modern economies.

2. (a) The advantages of the Herfindahl index over concentration ratios is that the former
uses information on all the firms in the industry, not just information on the market
share of the largest 4, 8, or 12 firms in the industry and gives a larger weight to the
larger firms in the industry.

(b) The disadvantage of concentration ratios and the Herfindahl index is that for the
reasons indicated in Case Study 9-3 both may grossly overestimate the market power
of the largest firms in the industry.

3. With limit pricing a firm charges a lower than the profit-maximizing price in order to
discourage potential entrants into the market. In a contestable market, however, economic
profits are zero because entry is absolutely free and exit is entirely costless.

4. (a) In the Cournot model each duopolist assumes that the other will keep its quantity
constant as it tries to maximize its profits. The result is that each duopolist will supply
one third of the perfectly competitive industry output.

(b) We study the Cournot model because it clearly shows the interdependence among
firms in an oligopolistic market. The Cournot model is also the first oligopoly model
and represents the point of departure for game theory (discussed in the next chapter).

5. In the Bertand model each duopolist assumes that the other will keep its price constant (rather
than its quantity constant, as in the Cournot model) as it tries to maximize its profits. The result
is that the price will be the perfectly competitive price with only two firms. The Bertrand model
is the precursor of the price war models.

6. (a) The kinked demand curve model seeks to explain the price rigidity often found in
oligopolistic markets.

(b) The model seeks to explain price rigidity by postulating that oligopolists match price
reductions but not price increases. This results in a demand curve with a kink at the
prevailing price, highly elastic for price increases and inelastic for price reductions.

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 CHAPTER 10 OLIGOPOLY AND FIRM ARCHITECTURE

(c) The existence of the kink has been questioned by George Stigler, who studied 7
oligopolistic industries in depth. In addition, the model rationalizes the existence of the
kink but does not explain at which price the kink would occur in the first place.

7. (a) Even though cartels are illegal in the United States, US corporations can (and often do)
belong to international cartels. Furthermore, many cartel-like arrangements such as in
the marketing of some agricultural products and in the operation of some professional
associations) are sanctioned or condoned by the US government.

(b) Cartels are unstable and often fail because: (1) it may be difficult to organize more
than a few producers into a cartel, (2) it may be difficult to reach agreement on how to
share profits, (3) there is a strong incentive for each firm to remain outside the cartel or
to cheat, (4) monopoly profits attract other firms in the industry.

8. OPEC resembles a cartel because it meets regularly to fix petroleum prices and assign output
and export quotas to its members. Agreement has seldom been reached, however. OPEC
seemed successful during the 1970s when petroleum supplies were tight, but with the excess
supplies that prevailed in the 1980s the cartel has collapsed or is near collapse.

9. (a) The five forces in Porter’s strategic framework are: threat from substitute products,
threat of entry, bargaining power of buyers, bargaining power of suppliers, and
intensity of rivalry among existing competitors.

(b) Oligopoly may lead to many of the same harmful effects of monopoly. In addition,
oligopolists generally spend too much on advertising and model changes. However,
economies of scale make large-scale production and oligopoly inevitable in many
industries and may even lead to more technological change.

10. (a) The sales maximization model postulates that oligopolistic firms seek to maximize sales
after a satisfactory rate of profit has been earned.

(b) The sales-maximization model reaches the same conclusion as the profit maximization
model if the minimum profit requirement of the firm is equal to the maximum profits
that the firm can earn. However, according to the sales- maximization model,
oligopolistic firms have an incentive to push output past this point, until total sales are
maximized (as long as a satisfactory rate of profit is being earned). Often, to earn a
satisfactory rate of profit, the oligopolistic firm will have to produce an output smaller
than the one at which sales are maximized but larger than the one at which the firm
maximizes total profits.

(c) In the past, evidence was introduced that executives' salaries were correlated more with
sales than with profits (thus, providing support for the sales-maximization model).
More recently, the opposite has been found. In general, the profit-maximization model
provides the best vantage point from which to study the behavior of a firm.

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11. The most important force that led to the rise and rapid spread of global oligopolists is the belief
that the survival of the firm requires that it become one of a handful of world corporations in
order to remain competitive.

12. (a) Firm architecture refers to the way the firm is organized, operates, and responds to
changes in markets.

(b) The ideal firm specializes in its core competencies; it is a learning organization; it has a
flat organizational structure and short lines of command; it operates factories that are
highly specialized and capable of rapidly shifting to produce new products; and, above
all, the ideal firm is agile and able to quickly respond to changing market conditions.

(c) The creative company has creativity as its core competency, not production efficiency.

13. (a) A virtual corporation is a temporary network of independent companies (suppliers,

customers, and even rivals) coming together with each contributing its core competence
to quickly take advantage of a fast-changing opportunity.

(b) The advantage of a virtual corporation over a traditional corporation is that a virtual
corporation can be much quicker in taking advantage of a new market opportunity than
a traditional corporation. Sometimes, a traditional corporation may not be capable at all
to take on a new market opportunity.

14. (a) A relationship enterprise is a network of independent firms that form strategic alliances
to build the capabilities and have the geographic presence needed to be global leaders in
their field.

(b) A relationship enterprise is more long term, more stable and a broader relationship
among firms than the virtual corporation.

15. The advantage of relationship enterprises over mergers are: (1) regulations and nationalism
often make it impossible for one company to buy another; (2) a company may not have the
resources to purchase all the large competitors necessary to operate globally and, in any event,
they may not be available or be willing to be acquired; (3) they are not directly accountable to
the company’s shareholders; (4) they allow the company to avoid the high risk of owning
subsidiaries in emerging market economies, which are more prone to financial crises; and
(5) they have been found to create more value, to be more efficient, to need less capital, and to
maintain their advantage over peers even in a broad market decline.

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ANSWERS TO PROBLEMS

1. (a) H = (70)2 + (20)2 + (10)2 = 4,900 + 400 + 100 = 5,400.

(b) H = (50)2 + 10(5)2 = 2,500 + 10(25) = 2,750

(c) H = 10(10)2 = 10(100) = 1,000.

2. (a) Each oligopolist would produce one-fifth of the perfectly competitive equilibrium. The
reason is that, as we saw in the text, with two firms, each produces one-third of the
perfectly competitive output; with three firms, each produced one-fourth of the
perfectly competitive output, and so, by extension, each of four firms would produce
one-fifth of the perfectly competitive equilibrium. In this case, since production costs
are zero and firms break even in the long run, price is zero and the perfectly
competitive output is 10 (see the demand equation). Thus each of the four oligopolists
would produce 1/5(10) = 2.

(b) The general rule that we can deduce is that each oligopolists would produce 1/(n+1) of
the perfectly competitive output according to the Cournot model if we assume, for
simplicity, that production costs are zero.

3. (a) With QD = 10 - P, P = 10 - QD. Since each oligopolists produces 2 units and all
together they produce 8 units, P = 10 – 8 = 2.

(b) With three oligopolists, each would produce 2.5 units for a total of 7.5 units.
Thus, P = 10 - 7.5 = 2.5.

4. (a) Substituting a value of Q B = 0 into A’s reaction function, we get

QA = 1/2(12-0) = 6 (point A in Figure 10-1)

Substituting a value of Q B =3 into A’s reaction function, we get

QA = 1/2(12-3) = 4.5 (point A' in Figure 10-1)

Substituting a value of Q B = 4 into A’s reaction function, we get

QA=1/2(12-) = 4 (point A' in Figure 10-1 in the text)

Thus, QA = 1/2(12 - Q B) is the duopolist A’s reaction function because given the value
of QB, QA gives the best or profit maximizing level of sales of oligopolist A.

(b) By complete analogy or symmetry, we get that duopolist B’s reaction function is
QB = 1/2(12 - Q A)

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5. Removing the parenthesis from B’s reaction function [QB = 1/2(12-Q A)] and A’s reaction
function [QA = 1/2(12 - Q B), we get QB = 6 - 1/2Q A and QA = 6-1/2Q B. Substituting B’s
reaction function into A’s reaction function, we get

QA = 6 - 1/2(6-1/2 QA)
= 6 -3+1/4QA
= 3 + 1/4A
3/4QA = 3
QA = 4 = QB (by symmetry)

6. (a) See Figure 1 on the next page.

(b) The best level of output is 30 units and is given by point E at which MR* = MC. At Q
= 30, P = $6 (point B in Figure 1), ATC = $4, and profits are BN = $2 per unit and $60
in total.

(c) The firm’s MC curve can shift up to MC = $5 and down to MC = $3 (i.e., within the
vertical segment GH of the MR curve) without inducing the firm to change its best
level of output of 30 units and price of $6.

7. (a) See Figure 2 on the page after next.

The best level of output is now 15 units and is given by point E* at which
MR* = MC. At Q = 15, P = $4.50 (point B* in Figure 2), ATC = $3.75, and profits
are B*N* = 0.75 per unit and $11.25 in total.

(b) When the firm’s demand curve for price increases shifts down or to the left, the firm
will reduce its price and output to P = $4.50 and Q = 15, respectively. In this case the
change in demand is too large for the firm to avoid a price change. If other oligopolists
face similar demand changes (so that they, too, would like to lower price and
quantity), an orderly price change is usually accomplished through price leadership.

8. See Figure 3 on the page after next.

The best level of output for the cartel is 30 units and is given by point E at which ΣMC =
MR. For Q = 30, the output of firm 1 is 10 units (given by point E1 at which MC1 = MR)
and the output of firm 2 is 20 units (given by point E2 at which MC2 = MR). The profits are
B1F1 = $4 per unit and $40 in total (the shaded area for firm 1) and B2F2 = $5 per unit and
$100 in total for firm 2.

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 CHAPTER 10 OLIGOPOLY AND FIRM ARCHITECTURE

9. (a) Solving demand function Q = 20 - 2P for P, we get P = 10 - 1/2Q. The MR function

has the same constant (vertical intercept) and twice the absolute slope. Therefore,
MR = 10 - Q

(b) Solving the marginal cost MC = 2Q for Q, we get Q = 1/2MC.

Since there are two identical firms, Q = ΣMC, so that ΣMC = Q

10. The best level of output of the cartel is given where MR = ΣMC or 10-Q = Q, so that 2Q = 10
and Q = 5 With P = 10-12Q, P = 10-1/2(5) = 7.5.

11. (a) See Figure 4 on the next page.

In the figure, D is the total market demand curve, and D' is the half-share demand curve
facing each duopolist in the equal market-sharing cartel. The best level of output of
each duopolist is 20 units and is given by point E', at which MR' = MC', so that P = $8
(point A' on the D' curve). Each duopolist earns a profit of A'F' = $6 per unit and $120
in total (the shaded area in the figure).

(b) The solution for this market-sharing cartel is the monopoly solution because D' would
be the monopolist's MR curve for market demand curve D, and the ATC' curve equals
the ΣMC = MR at Q = 40 (twice the output of each duopolist under the equal market-
sharing cartel), so that P = $8 (point A on the D curve).
The monopolist’s ATC would have half the slope of the ATC' in the figure, so that the
monopolist would earn a profit of $6 per unit and $240 in total (equal to the sum of the
profits of the two duopolists under the market sharing cartel).

In the real world, the market need not be shared equally and we may have more than
two firms, each facing different cost curves. Therefore, the solution is not likely to be
the neat monopoly solution given above.

12. (a) See Figure 5 on the next page.

Using Figure 5, we see that the best level of output for this cartel is 80 units and is
given by the point where MR = ΣMC. The cartel will set the price of $16. This is the
monopoly solution.

(b) If the cartel wants to minimize costs of production, it will set a quota of 8 units of
production for each firm (given by the condition MC1 = MC2 = ... = MC10 = MR = $8,
where the subscripts refer to the firms in the cartel). This is the same as for the
multiplant monopolist.

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 CHAPTER 10 OLIGOPOLY AND FIRM ARCHITECTURE

(c) If the ATC = $12 at Q=8 for each firm, each firm will earn a profit of $4 per unit and
$32 in total. The cartel as a whole will earn a profit of $320. In this case, each firm
will very likely share equally in the cartel's profits. In other more complicated and
realistic cases, it may not be so easy to decide on how the cartel's profits should be
shared. The bargaining strength of each firm then becomes important.

13. (a) See Figure 6 on the next page.

From Figure 6, we see that firm 1 would like to sell 40 units at the price of $16 (given
by point E1), thereby maximizing its total profits at $120. Firm 2 maximizes its total
profits (of $350) by selling 50 units at the price of $14 (given by point E2).

(b) Since the product is homogeneous, the product must sell at the single price of $14. That
is, the high-cost firm (firm 1) will have to follow the price leadership of the low-cost
firm (firm 2). Thus, only firm 2 will produce the best level of output (given by point
E2) and maximize its total profit (at $350). Firm 1 will now also have to charge the
price of $14 and sell 50 units, and so it will now earn a profit of only $85 (1.70 per unit
times 50 units).

(c) In some cases, the price that the low-cost firm would set at its best level of output is so
low that it would drive the high cost firm(s) out of business. When this is true, the low-
cost firm might want to forego profit maximization and set a (higher) price that would
allow other firms to remain in business. By doing so it would avoid becoming a
monopoly and face possible prosecution under US antitrust laws.

14. The statement is false because even though the followers behave as perfect competitors or price
takers and produce where P = ΣMCF, the price set by the dominant firm to maximize its total
profits is not necessarily or usually equal to the LAC of the dominant or of the follower firms
with restricted entry in the long run.

15. (a) See Figure 7 on the next page.

(b) When the dominant salon operates as a price leader, its demand curve, DL, is HNFG
(obtained from DT - ΣMCF ) and its marginal revenue is MRL. With MCL as the
marginal cost curve of the price leader, the best level of output for the price leader is 20
units (given by point E at which MCL = MRL) and the price is $10. At P = $10, all the
followers together will then supply a total of JR = NC = 60 hair stylings per day.

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 CHAPTER 10 OLIGOPOLY AND FIRM ARCHITECTURE

(c) If the price leader formed a centralized cartel, the marginal cost curve for the entire
cartel is obtained from the horizontal summation of the MCF and MCL curves and is
shown by ΣMCF + MCL in Figure 7. The best level of output for the entire cartel is then
50 units and is given by point E' at which ΣMCF + MCL = MRT. The cartel price would
then be $13 (point B' on DT). At P = $13, J'N' = R'E'=10 would be supplied by the
dominant salon and J'R' = N'E' = 40 will be supplied by all the small salons together.

(d) If the dominant salon did not exist and the small salons operate as perfect competitors,
then ΣMCF curve would represent the competitive market supply curve. The
equilibrium output level would then be 70 and the equilibrium price would be $11
(given by point B at which ΣMCF = S = DT).

(e) If the large scale salon did exist but operated as a perfect competitor, just like the small
salons, then the competitive market supply curve would be ΣMCF + MCL and the
equilibrium quantity and price would be given at the intersection of the ΣMCF + MCL
and DT (i.e., Q = 82.5 and P = $9.75).

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ANSWERS TO SPREADSHEET PROBLEMS

1. (a) The best level of output is where MC = MR or where 1/4Q = 10 – Q, so Q = 8. P = 6.

(b) If the cartel wants to minimize production costs, it will set a quota of 2 units of output
for each member (given by the condition MC1 = MC2 = MC3 = MC4, where the
numbers refer to the firms in the cartel).

(c) If ATC = $4, at Q = 2 for each firm, each of the four firms will earn a profit of $2 per
unit and $4 in total. Thus, the cartel as a whole will make a total profit of $16. In this
case, each firm will very likely share equally in the cartel profits.

2. The dominant firm will set P = $3.50 where MRd = MCd at which the dominant firm maximizes
its profits. The small firms will behave as price takes and together will supply 10 units of the
commodity at P = $3.50. The dominant firm will then fill the market by supplying 3 units of the
commodity.

A B C D E F G
1
2 P Q MRd MCd MCs
3 9.50 1.0 9.0 -15.0 1.25
4 9.00 2.0 8.0 -14.0 1.5
5 8.50 3.0 7.0 -13.0 1.75
6 8.00 4.0 6.0 -12.0 2
7 7.50 5.0 5.0 -11.0 2.25
8 7.00 6.0 4.0 -10.0 2.5
9 6.50 7.0 3.0 -9.0 2.75
10 6.00 8.0 2.0 -8.0 3
11 5.50 9.0 1.0 -7.0 3.25
12 5.00 10.0 0.0 -6.0 3.5
13 4.50 11.0 -1.0 -5.0 3.75
14 4.00 12.0 -2.0 -4.0 4
15 3.50 13.0 -3.0 -3.0 4.25
16 3.00 14.0 -4.0 -2.0 4.5
17 2.50 15.0 -5.0 -1.0 4.75
18

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 CHAPTER 10 OLIGOPOLY AND FIRM ARCHITECTURE

ANSWERS TO APPENDIX PROBLEMS

1. (a) Duopolist A’s and duopolist B’s reaction function are, respectively,

QA = 6 - QB QB = 6 - QA
2 2

(b) The Cournot solution can be obtained by substituting dupolist B’s reaction function
into dupolist A’s reaction function. When we do this, we get

QA = 6 - (6 - QA)/2
2

= 6 - 3 + QA/2
2

= 1.5 + QA/4

Multiplying both sides by 4, we get

4QA = 6+ QA
so that
3QA = 6
and
QA = 2

With QA = 2
QB = 6 - 2
2
so that
QA = 2= QB (Cournot equilibrium)
and
Q = QA + QB = 2+ 2= 4

(c) Solving equation Q = 6 - P for P, we get

P=6-Q

With Q = 4 at Cournot equilibrium, the price at which each duopolist will sell spring
water is

P = 6 - 4 = $2

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2. (a) TR1 = P1Q1 = (7 - Q1)Q1 = 7Q1 – Q12

30 30

MR1 = d(TR1) = 7 - Q1
dQ1 15

TR2= P2Q2 = (9 - Q2)Q2 = 9Q2 – Q22

10 10

MR2 = d(TR2) = 9 - Q2
dQ2 5

MC = d(TC) = 3.5 - Q2
dQ2 30

(b) Setting Q1 = Q2, we get

7 - Q_ = 9 – Q_
30 10

Q=2
15

so that Q = 30

and P = 7 – 30 = $6
30

(c) MR1 = 7 – 30 =$5

15

MR2 = 9 – 30 =$3
5

Since MC = 3.5 + 30 = $4.50

30

the MC curve intersects the vertical portion of the MC curve.

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 CHAPTER 10 OLIGOPOLY AND FIRM ARCHITECTURE

(d) π = TR – TC = PQ – 3.5 – Q2 -6(30) – 3.5 (30) – (30)2 = $60

60 60

or π = (P – ATC)Q

ATC = TC = 3.5Q + Q2/60 = 3.5 + Q = 3.5 + 30 = $4

Q Q 60 60

or π = (6 – 4)30 = $60

The graphical solution to this problem is shown in Figure 1 in the answer to Problem 6.

3. With Q = 150 - 10P or P = 15 - 0.1Q

TR = PQ = (15 - 0.1Q)Q = 15Q - 0.1Q2

MR = d(TR) = 15 - 0.2Q
dQ

Setting ΣMC = MR, we have

3 + 0.1Q = 15 - 0.2Q

so that 12 = 0.3Q and Q = 40

Then P = 15 - 0.1(40) = 15 - 8 = $7

At Q = 40, MR = 15 - 0.2(40) = 15 - 8 = $7

Setting MC1 and MC2 equal to MR, we have

4 + 0.2Q1 = $7 so that Q1 = 15 and

2 + 0.2Q2 = $7 so that Q2 = 25

Thus, Q = Q1 + Q2 = 15 + 25 = 40

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Therefore,

π1 = TR1 - TC1 = PQ1 - 4Q1 - 0.1Q12

= 11(15) - 4(15) -0.1(15)2 = 165 - 60 - 22.50 = $82.50

π 2 = TR2 - TC2 = PQ2 -2Q2 - 0.1Q22

= 11(25) - 4(25) - 0.1(25)2 = 275 - 100 - 62.50 = $112.50

and π = π 1 + π 2 = $82.50 + $112.50 = $195

4. The monopolist will face the market demand function

Q = 120 - 10P or P = 12 - 0.1Q

Therefore,

TR = PQ = (12 - 0.1Q)Q = 12Q - 0.1Q2

and MR = d(TR) = 12 - 0.2Q

dQ

The MC function of the monopolist has one half the slope of the MC curve for each
duopolist, so that

ΣMC = 1/2(MC') = 0.2Q /2 = 0.1Q

Setting ΣMC equal to MR, we get

0.1Q = 12 - 0.2Q

so that

Q = 40 and P = 12 - 0.1(40) = $8 (the same as for each duopolist)

The total profits of the monopolist are

π = TR - TC

TC = ∫ π MC = 0.05Q2

Therefore,

π = 12Q - 0.1Q2 - 0.05Q2

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 CHAPTER 10 OLIGOPOLY AND FIRM ARCHITECTURE

= 12(40) - 0.1(40)2 - 0.05(40)2

= 480 - 160 - 80

= $240

This is the same as the sum of the total profits of the two duopolists under the equal
market-sharing cartel.

5. (a) Q = 120 - 10P so that P = 12 - 0.1Q and TR = 12Q - 0.1Q2

Since TC = 90 + 2Q, π = TR - TC = 12Q - 0.1Q2 - 90 - 2Q = -90 + 10Q - 0.1Q2

The firm maximizes profits where

dπ = 10 - 0.2Q = 0
dQ

so that Q = 50 and P = 12 - 0.1(50) = $7

TR = 12(50) - 0.1(50)2 = 600 - 250 = $350

π = -90 + 10(50) - 0.1(50)2 = -90 + 500 - 250 = $160

(b) The firm maximizes TR where

d(TR) = 12 - 0.2Q = 0; so that Q = 60 and P = 12 - 0.1(60) = $6

dQ

TR = 12(60) - 0.1(60)2 = 720 - 360 = $360

π = -90 + 10(60) - 0.1(60)2 = -90 + 600 - 360 = $150

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(c) When the minimum profit constraint of the firm is $155

π = -90 + 10Q - 0.1Q2 = $155

-245 + 10Q - 0.1Q2 = 0

0.1Q2 - 10Q + 245 = 0

Taking the larger of these outputs, we have

P = 12 - 0.1(57.07) = $6.29

and

TR = 12(57.07) - 0.1(57.07)2 = 684.84 - 325.70 = $359.14

so that

π = -90 + 10(57.07) - 0.1(57.07)2 = -90 + 570.70 - 325.70 = $155

This is the minimum π required.

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 CHAPTER 11

GAME THEORY AND STRATEGIC BEHAVIOR

11-1 STRATEGIC BEHAVIOR AND GAME THEORY

Case Study 10-1: Military Strategy and Strategic Business Decisions

11-2 DOMINANT STRATEGY AND NASH EQUILIBRIUM

Dominant Strategy
Nash Equilibrium
Case Study 11-2: Dell Computers and Nash Equilibrium

11-3 THE PRISONERS’ DILEMMA

11-4 PRICE AND NONPRICE COMPETITION, CARTEL CHEATING, AND

THE PRISONERS’ DILEMMA
Price Competition and the Prisoners’ Dilemma
Case Study 11-3: The Airlines’ Price Wars and the Prisoners’ Dilemma
Nonprice Competition, Cartel Cheating, and the Prisoners’ Dilemma

11-5 REPEATED GAMES AND TIT-FOR-TAT STRATEGY

11-6 STRATEGIC MOVES

Threat, Commitments, and Credibility
Entry Deterrence
Case Study 11-4: Wal-Mart’s Preemptive Expansion Marketing Strategy

11-7 STRATEGIC BEHAVIOR AND INTERNATIONAL COMPETITIVENESS

BOX 11 – Managerial Economics at Work: Companies’ Strategic Mistakes and Failures

11-8 SEQUENTIAL GAMES AND DECISION TREES

Case Study 11-5: Airbus’s Decision to Build the A380 and Boeing’s Sonic Cruiser
Response and the 747-8

SUMMARY
DISCUSSION QUESTIONS
PROBLEMS
SPREADSHEET PROBLEMS

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SUPPLEMENTARY READINGS
INTERNET SITE ADDRESSES
KEY TERMS (in the order of their appearance)
_________________________________________________________________________

Strategic behavior Nonzero-sum game

Game theory Dominant strategy
Players Nash equilibrium
Strategies Prisoners’ dilemma
Payoff Repeated games
Payoff matrix Tit-for-tat
Zero-sum game Decision tree

ANSWERS TO DISCUSSION QUESTIONS

1. Game theory offers many insights into oligopolistic interdependence and the strategic behavior
of oligopolistic firms that could not be examined with the traditional tools of analysis presented
in the previous chapter. Specifically, game theory is used to identify all the possible responses
of a competitor to the actions of an oligopolist and on how the oligopolist can choose the best
strategy or choice open to it.

2. (a) Strategies are the decisional choices open to a player or firm in theory of games.

(b) The payoff is the outcome or consequence of each strategy in game theory.

(c) The payoff matrix gives the payoffs from all the strategies open to the firm and to the
rivals’ response.

3. (a) A zero-sum game is a game in which the gain of one player or firm comes at the
expense and is exactly equal to the loss of the other player or firm.

(b) A nonzero-sum game is a game in which the gain or loss of one player or firm does not
come at the expense of or provide equal loss to the other player or firm.

4. (a) Game theory is a general theory that can be used to analyze the choice of optimal
strategies in any conflict situation, not just oligopolistic interdependence. For example,
it can be used in deciding the optimal amount of defense expenditures in the face of
the nation’s desire for defense and in light of the possible responses that its defense
expenditures elicit in the defense expenditures of other nations.

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 CHAPTER 11 GAME THEORY AND STRATEGIC BEHAVIOR

(b) Game theory is similar to playing chess in the sense that both involve players,
strategies, and payoffs. Specifically, they both involve the choice of optimal strategies
in conflict situations.

5. When each firm chooses its dominant strategy (assuming they have one), we automatically
have a Nash equilibrium without even the need for each firm to consider the strategy of its
rival.

6. (a) The Cournot equilibrium is a Nash equilibrium because each firm has adopted its
optimal output given its rival’s output.

(b) The Cournot equilibrium differs from the Nash equilibrium given in Table 11-2 in the
text because in the Cournot equilibrium neither firm has a dominant strategy, while in
Table 11-2, firm B has a dominant strategy while firm A does not.

7. In the prisoners’ dilemma, each prisoner (player or firm) has a dominant strategy and chooses
that dominant strategy. When each player chooses his optimal strategy, we automatically have
a Nash equilibrium, but the players could do better by cooperating.

8. The concept of the prisoners’ dilemma is useful in explaining the type of price competition in
which each firm adopts its dominant strategy of charging a high or low price but could do better
by cooperating and doing the opposite (i.e., charging a low or high price, respectively).

9. Auto makers face a prisoners’ dilemma in introducing yearly style changes if each automaker
introduces yearly style changes only because it would lose a great deal of sales if it didn’t and
other auto producers did, but introducing yearly style changes reduces every automaker’s
profit.

10. (a) Each member of a cartel has an incentive to cheat because by cheating it can increase its
profits over and above those that it would receive without cheating. However, when every
cartel member cheats, each will earn less profits than if no member cheated.

(b) A cartel can prevent or reduce cheating by monitoring the sales of each member and
punishing cheaters.

(c) It is more likely for a cartel to collapse, the greater is the number of its members and the
more differentiated is the product because it is more difficult to closely monitor the
sales of each cartel member in those situations.

11. The duopolists in a Cournot equilibrium do face a prisoners’ dilemma because each adopts its
dominant strategy but could do better by coordination (i.e., by choosing to jointly produce the
monopoly output and share equally in the higher profits).

12. The duopolists in a Cournot equilibrium do face a prisoners’ dilemma because each adopts its
dominant strategy but could do better by coordination (i.e., by choosing to jointly produce the
monopoly output and share equally in the higher profits).

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PART FOUR MARKET STRUCTURE AND PRICING PRACTICES

13. Before the 1971 law that banned cigarette advertising on television, each producer spent too
much on advertising and this cut into its profits. Yet no producer would unilaterally reduce its
advertising because others would then have an incentive to continue advertising heavily to
increase their market share and profits. While the 1971 law that banned TV cigarette
advertising was intended to avoid encouraging the public from increasing the public from
increasing smoking (and to some extent the law achieved its purpose), it also had he unintended
effect of solving the prisoners’ dilemma for cigarette producers. By being forced to reduce TV
advertising, cigarette producers were able to reduce costs and increase profits—something that
they had been unable to do on their own.

14. (a) Tit-for-tat is the best strategy in repeated or multiple-move prisoners’ dilemma games.
It postulates that each firm should begin by cooperating and cooperate as long as the rival
cooperates and refuse to cooperate when the rival does not cooperate.

(b) The following conditions are usually required for tit-for-tat to be the best strategy. (1)
There must be a reasonably stable set of players; (2) the number of players must be
small, preferably two; (3) each firm must be able to quickly detect (and be willing and
able to quickly retaliate for) cheating by other firms; (4) demand and cost conditions
must be relatively stable; (5) the number of moves must be infinite, or at least a very
large and uncertain.

15. (a) A Nash equilibrium refers to the situation when each player is adopting the best
strategy, given what the other player is doing. On the other hand, a strategic move refers
to a player’s strategy of constraining his own behavior to make a threat credible so as to
gain a competitive advantage. This means even accepting lower profits, which is not a
Nash equilibrium.

16. A decision tree is a diagram of figure with nodes and branches depicting points at which
decisions are made and the outcome of each decision used for showing or analyzing sequential
games.

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 CHAPTER 11 GAME THEORY AND STRATEGIC BEHAVIOR

ANSWERS TO PROBLEMS

1. (a) When firm B charges a low price, firm A will earn a profit of 1 when it also charges a
low price and a profit of -1 (i.e., a loss of 1) when it charges a high price. Similarly, when
firm B charges a high price, firm A earns a profit of 3 when it charges a low price and a
profit of 2 when it charges a high price. Therefore, charging a low price is the dominant
strategy for firm A.

(b) When firm A charges a low price, firm B earns a profit of 1 when it also charges a low
price and a profit of -1 when it charges a high price. Similarly, when firm A charges a
high price, firm B earns a profit of 3 when it charges a low price and a profit of 2 when it
charges a high price. Therefore, charging a low price is also the dominant strategy for
firm B.

(c) The optimal strategy for each firm is to adopt its dominant strategy of charging a low
price.

2. (a) When firm B charges a low price, firm A will earn a profit of 1 when it also charges a
low price and a profit of -1 (i.e., a loss of 1) when it charges a high price. When firm B
charges a high price, firm A earns a profit of 3 when it charges a low price and a profit of
4 when it charges a high price. Therefore, firm A does not have a dominant strategy.

(b) When firm A charges a low price, firm B earns a profit of 1 when it also charges a low
price and a profit of -1 when it charges a high price. Similarly, when firm A charges a
high price, firm B earns a profit of 3 when it charges a low price and a profit of 2 when it
charges a high price. Therefore, charging a low price is the dominant strategy for firm B.

(c) The optimal strategy for firm B is its dominant strategy of charging a low price. The
optimal strategy for firm A is a low price, given that firm B will charge a low price.

(d) The Nash equilibrium occurs when each firm charges a low price.

3. (a) If firm B produces small cars, firm A will earn a profit of 4 if it also produces small
cars and has a payoff of -2 (i.e., incurs a loss of 2) if it produces large cars. If firm B
produces large cars, firm A will earn a profit of 4 if it also produces large cars and it
incurs a loss of 2 if it produces small cars. Therefore, firm A does not have a dominant
strategy.

(b) If firm A produces large cars, firm B will earn a profit of 4 if it produces small cars
and has a payoff of -2 (i.e., incurs a loss of 2) if it also produces large cars. If firm A
produces small cars, firm B will incur a loss of 2 if its also produces small cars and it
earns a profit of 4 if it produces large cars. Therefore, firm B does not have a dominant
strategy.

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PART FOUR MARKET STRUCTURE AND PRICING PRACTICES

(c) The optimal strategy is for one firm to produce small cars and the other to produce
large cars. In that case, each firm earns a profit of 4. If both firms produce either small
cars or large cars, each incurs a loss of 2.

(d) In this case we have two Nash equilibria: Either firm A produces large cars and firm B
produces small cars (the top left cell in the given payoff matrix), or firm A produces small
cars and firm B produces large cars (the bottom right cell in the payoff matrix).

(e) A situation such as that indicated in the payoff matrix of this problem might arise if
each firm does not have the resources to invest in the plant and equipment necessary to
produce both large and small cars, and the demand for either small or large cars is not
sufficient to justify the production of small or large cars by both firms. Specifically, if
both firms produced the same type of car, the oversupply of that type of car will result in
low car prices and losses for both firms.

4. The following table provides a hypothetical payoff matrix for example 2 in the text.

Other Computer Firms

No Mail Orders Mail Orders
_______________________________
No Mail order 0,1 0,8
Dell Computers
Mail orders 6,2 4,4
_______________________________

The payoff matrix in the above table shows that when other computer companies do not sell
computers through mail orders, Dell Computer earns zero profit if it also does not sell through
the mail (since Dell was created specifically to sell only through the mail) but a profit of 6 if it
does. Similarly, when other computer companies do sell through the mail, Dell earns zero
profits if it does not sell through the mail and 4 if it does. Thus, Dell's dominant strategy is to
sell computer through the mail regardless of what the other computer companies do.

On the other hand, when Dell does not sell through the mail (i.e., when Dell is not in the
market), other computer companies earn a profit of 10 if they do not sell through the mail and 8
if they do (at least that is what they believed). But if Dell is in the market and sells through the
mail, other computer companies will earn 2 if they do not accept mail orders and 4 if they do.
Thus, the other computer companies do not have a dominant strategy.

With Dell in the market and following its dominant strategy of selling through the mail,
however, the other computer companies are also forced to enter the mail-order business. This is
the Nash equilibrium.

5. (a) Individual A has the dominant strategy of confessing because if individual B

confesses, individual A gets a 5-year sentence if he also confesses and a 10-year sentence
if he does not. Similarly, if individual B does not confess, individual A gets a 1-year
sentence if he confesses and a 2-year sentence if he does not confess.

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 CHAPTER 11 GAME THEORY AND STRATEGIC BEHAVIOR

(b) For individual B the dominant strategy is also to confess because if individual A
confesses, individual B gets a 5-year sentence if he also confesses and a 10-year
sentence if he does not. Similarly, if individual A does not confess, individual B gets a
1-year sentence if he confesses and a 2-year sentence if he does not confess.

(c) The optimal strategy for each individual is to adopt his dominant strategy, which is to
confess.

(d) Individuals A and B face the prisoners’ dilemma. That is, when each individual adopts
his dominant strategy of confessing, each gets a 5-year sentence. However, if each did
not confess, each would get a 2-year sentence only.

6. We have seen in the answer to problem 1c above that each firm adopts its dominant strategy of
charging the low price and earns a profit of 1 (see the top left cell of the payoff matrix in
problem 1c). Each firm, however, would earn a profit of 2 if each charged a high price (see the
bottom right cell). But that could only be achieved through cooperation. Thus, firms A and B
face the prisoners’ dilemma.

7. Even though the payoff matrix in problem 2 shows that firm B has a dominant strategy while
firm A does not, both firms still face the prisoners' dilemma. As we have seen in the answer to
problem 2, firm B adopts its dominant strategy of charging a low price. The optimal strategy for
firm A is then also to charge a low price. When each firm charges a low price, each earns a
profit of 1 (the top left cell of the payoff matrix of problem 2). If both firms charged a high
price, however, firm A could earn a profit of 4 and firm B a profit of 2. Thus, the firms face the
prisoners’ dilemma.

8. (a) Each firm adopts its dominant strategy of cheating (the top left cell), but could do
better by cooperating not to cheat (the bottom right cell). Thus the firms face the
prisoners’ dilemma.

(b) If the payoff in the bottom right cell were changed to (5,5), the firms would still face
the prisoners’ dilemma by cheating.

9. The tit-for-tat strategy for the first 5 of an infinite number of games for the payoff matrix of
problem 1, when firm A begins by cooperating but firm B does not cooperate in the next period
is given by the following table:

Period Firm A Firm B

______________________________________
1 2 2
2 -1 3
3 1 1
4 3 -1
5 2 2

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PART FOUR MARKET STRUCTURE AND PRICING PRACTICES

The above table shows that in the first period, firm A sets a high price (i.e., cooperates) and
so does firm B (so that each firm earns a profit of 2). If in the second period firm B does not
cooperate and sets a low price while firm A is still cooperating and setting a high price, firm
B earns a profit of 3 and firm A incurs a loss of 1. In the third period, firm A retaliates and
also sets a low price. As a result, each firm earns a profit of only 1 in period 3. In period 4,
firm B cooperates again by setting a high price. With firm A still setting a low price, firm A
earns a profit of 3 while firm B incurs a loss of 1. In the fifth period, firm A also cooperates
again and sets a high price. Since both firms are now setting a high price, each earns a profit
of 2.

10. (a) From the payoff matrix of the problem, we see that firm A adopts its dominant strategy
of charging a high price and firm B enters the market. Thus, firm A earns a profit of 4
and firm B earns a profit of 5.

(b) The threat by firm A to lower price should not discourage firm B from entering the
market because the threat is not credible. The reason is that firm A earns a profit of 3 if
it charges the low price and a profit of 4 if it charges the high price.

(c) Short of building excess capacity, firm A can make its threat credible by cultivating a
reputation for aggressively fending off entry into the market by lowering price (and thus
imposing a loss on the potential entrant), even if this means lower profits.

11. The following table shows that by building excess capacity, firm A can make a credible threat
to lower price, which would deter firm B from entering the market.

Firm B
Enter Do Not Enter
___________________________

Low Price 3,-1 3,1

Firm A
High Price 2, 5 5,3
___________________________

The above payoff matrix is the same as in problem 10, except that firm A’s profits are now
lower when it charges a high price because idle or excess capacity increases firm’s A costs
without increasing its sales. On the other hand, we assume that charging a low price would
allow firm A to increase sales and utilize its newly built capacity so that costs and revenues
increase, leaving firm A’s profits the same as in problem 10 (i.e., the same as before firm
A expanded capacity). Building excess capacity in anticipation of future need now becomes a
credible threat because with excess capacity, firm A will charge a low price and earn a profit of
3 instead of a profit of 2 if it charged the high price. Firm B would then incur a loss of 1 if it
entered the market and would thus stay out. Entry deterrence is now credible and effective.

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12. (a) If the entries in the top left cell of Table 11-8 in the text, were changed to 10,10, then
both Boeing and Airbus would be producing the aircraft without the need for any subsidy,
and so no strategic industrial and trade policy would be needed either in the United States
or in Europe.

(b) If the entries in the top left cell of Table 11-8 in the text were changed to 5,0, then both
Boeing and Airbus would be producing the aircraft without the need for subsidies, and
so no strategic trade and industrial policy would be needed either in the United States or in
Europe. Note that even though Airbus only breaks even in this case, in economics we
include a normal return on investment as part of costs. Thus, Airbus would remain in
business because it would earn a normal rate of return on investment.

(c) If the entries in the top left cell of Table 11-8 were changed to 5,-10, then Boeing would
produce the aircraft without the need for a subsidy. Without a subsidy of $10 million,
however, Airbus would not enter or remain in the market. This would leave the entire
market to Boeing, which would then earn $100 million. With a subsidy of at least $10
million per year, however, Airbus would enter or stay in the market and break even. Boeing
would then earn a profit of only $5 million without any subsidy.

13. (a) The figure shows that the best payoffs (shown on the right-hand side of the figure) for
Boeing is to construct the sonic cruiser (the lower branch node) rather than the super-
jumbo jet (the top branch node). By building the sonic cruiser, Boeing would earn a
profit of $120 million if Airbus decided to build the super-jumbo jet and $150 million if
Airbus decided not to build the super-jumbo jet. If Boeing decided instead to build the
super-jumbo jet (the top branch of the tree) it would incur a loss of $10 million if
Airbus decided also to build the super-jumbo jet and earn a profit of $100 if Airbus
decided not to build the super-jumbo jet. Thus, Boeing would decide to build the sonic
cruiser plane rather than the super-jumbo jet.

(b) Given Boeing’s decision, Airbus decided to construct the super-jumbo jet and earn a
profit of $80 rather than abandon the project (which would involve zero profit).

14. (a) In Case Study 11-6, it was Airbus that made the first move and decided to build the
A380. In problem 13, instead, it was Boeing that made the first move and decided to build
the Sonic cruiser rather than the super-jumbo jet. Even though the results are the same
(with Airbus building the A380 and Boeing building the sonic cruiser but with somewhat
differ payoffs), the first mover has the advantage of first choice. The other player must then
adjust and adopt its best strategy, given the strategy chosen by the first player.

(b) The best strategy of Boeing and Airbus remains the same, except that now Boeing best
strategy of building the sonic cruiser results in profits of $120 million instead of $150
million.

15. (a) Firm A’s best strategy is to charge a low price and advertise. By doing so firm A will
earn a profit of $180 if firm B chooses to charge a high price and $140 if firm B chooses to
charge a low price. These payoffs for firm A are all higher than if firm A chose to charge a
high price with or without advertising.

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(b) Given firm A’s choice of charging a low price and advertise, firm B’s best strategy is to
also charge a low price and earn a profit of $140 instead of charging a high price and
earn a profit of only $80.

(c) The decision tree could be expanded further to the right by adding more decision nodes
and branches to analyze a possible further response of firm B to also advertise.

ANSWERS TO SPREADHSEET PROBLEMS

1. (a) Without knowledge of the other firm’s profit function, the best level of production for
The firm 1 is 1,000.

(b) The best level of production is still 1,000 if each firm has perfect knowledge because
there will not be an incentive for either firm to deviate from 1,000. However, if both
firms collude to produce only 200 units each, they can each make a larger profit.

2. The best level of output is 1,000 for each firm and this level of profit cannot be improved upon.

A B C D E F G H
1
2 Q2
3 Q1 200 400 600 800 1000
4 200 12000 32000 52000 72000 92000
5 400 24000 64000 104000 144000 184000
6 600 36000 96000 156000 216000 276000
7 800 48000 128000 208000 288000 368000
8 1000 60000 160000 260000 360000 460000
9

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 CHAPTER 12

PRICING PRACTICES

12-1 PRICING OF MULTIPLE PRODUCTS

Pricing of Products with Interrelated Demands
Plant Capacity Utilization and Optimal Product Pricing
Optimal Pricing of Joint Products Produced in Fixed Proportions
Optimal Pricing and Output of Joint Products Produced in Variable Proportions
Case Study 12-1: Optimal Pricing and Output by Gillette

12-2 PRICE DISCRIMINATION

Meaning of and Conditions for Price Discrimination
First and Second Degree Price Discrimination
Third Degree Price Discrimination Graphically
Third Degree Price Discrimination Algebraically
Case Study 12-2: Price Discrimination by Con Edison

12-3 INTERNATIONAL PRICE DISCRIMINATION AND DUMPING

BOX 12 – Managerial Economics at Work: Kodak Antidumping Dispute with Fuji and
Market Loss

12-4 TRANSFER PRICING

Meaning and Nature of Transfer Pricing
Transfer Pricing with No External Market for the Intermediate Product
Transfer Pricing with a Perfectly Competitive Market for the Intermediate Product
Transfer Pricing with an Imperfectly Competitive Market for the Intermediate Product
Case Study 12-3: Transfer Pricing by Multinationals Operating in Emerging Markets
Case Study 12-4 Transfer Pricing in Advanced Countries

12-5 PRICING IN PRACTICE

Cost-Plus Pricing
Evaluation of Cost-Plus Pricing
Incremental Analysis in Pricing
Case Study 12-5: Incremental Pricing at Continental Airlines
Peak-Load Pricing, Two-Part Tariff, Tying and Bundling
Case Study 12-6: Peak-Load Pricing by Con Edison
Case Study 12-7: Bundling in the Leasing of Movies
Other Pricing Practices
Case Study 12-8: No Haggling Value Pricing in Car Buying
Case Study 12-9: Name Your Price at Priceline

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PART FOUR MARKET STRUCTURE AND PRICING PRACTICES

SUMMARY
DISCUSSION QUESTIONS
PROBLEMS
SPREADSHEET PROBLEMS
APPENDIX TO CHAPTER 12: THIRD DEGREE PRICE DISCRIMINATION WITH
CALCULUS
SUPPLEMENTARY READINGS
INTERNET SITE ADDRESSES
INTEGRATING CASE STUDY 7: E-BAY AND COMPETITION ON THE INTERNET
INTEGRATING CASE STUDY 8: E-BOOKS REWRITE BOOK SELLING
INTEGRATING CASE STUDY 9: THE ART OF DEVISING AIRFARES
KEY TERMS (in order of their appearance)
____________________________________________________________________________

Demand interrelationships Incremental analysis

Price discrimination Peak-load pricing
First-degree price discrimination Two-part tariff
Consumers’ surplus Tying
Second-degree price discrimination Bundling
Third-degree price discrimination Prestige pricing
Dumping Price lining
Transfer pricing Skimming
Cost-plus pricing Value pricing
Fully allocated average cost Price matching
Markup on cost Electronic scanners
Profit margin Auction pricing

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ANSWERS TO DISCUSSION QUESTIONS

1. (a) Demand interrelationships refer to the substitutability and complementarity

relationships that exist among the products produced by a firm.

(b) Demand interrelationships are measured by the cross-marginal revenue effects in the
marginal revenue function for each product sold by the firm. For a two-product
(A and B) firm, the MRA function includes a ΔTRB term and the MRB function
ΔQA
includes a ΔTRA term, which measure demand interrelationships. Products A and
ΔQB
B are complements if the terms ΔTRB and ΔTRA are positive and substitutes if
ΔQA ΔQB
these cross-marginal revenue effects are negative.

(c) Optimal pricing and output decisions on the part of the firm require that the total
effect (i.e., the direct as well as the cross-marginal effects) be taken into
consideration. For example, if products A and B are complements but the firm
disregards the term ΔTRB (which is positive) and produces where
ΔQA
MRA = ΔTRA = MCA, the firm will produce too little of product A to be
ΔQA
maximizing its profits. On the other hand, if products A and B are substitutes but
the firm disregards the term ΔTRA (which is negative) and produces where
ΔQB
MRA = ΔTRA = MCA, the firm will produce too much of product A to be
ΔQA
maximizing its profits.

2. (a) Most firms produce more than one product in order to make fuller use of their
production capacities, thereby increasing their profits.

(b) In order to maximize profits, a firm introduces new products, in the order of their
profitability, until the price of the last product introduced equals its marginal cost. If
this is the nth product, the rule is to produce each of the n products until
MRA = MRB = MRC = ... = PN = MCN
and charge the price indicated on the demand curve for each product.

(c) A firm would produce a product on which it makes little or no profit in order to offer a
full range of products, to use it as a “loss leader,” to retain customers’ goodwill, to
keep channels of distribution open, and to keep the firm’s resources in use while
awaiting more profitable contracts.

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3. (a) Goods that are jointly produced in fixed proportions must be regarded as a single
production package because there is no rational way of allocating the cost of
producing the entire package to the individual products in the package. For example,
in raising cattle, beef and hides are produced in the proportion of one-to-one and it is
impossible to allocate the cost of raising cattle between beef and hides.

(b) Jointly produced products may be unrelated in consumption (as, for example, beef and
hides) and so we can treat the demand for each product as separate and independent.
Since the firm receives marginal revenue from the sale of each of the jointly produced
products, the marginal revenue curves for each product are summed vertically in order
to obtain the total marginal revenue (MRT) curve.

4. (a) The best level of output of products that are jointly produced in fixed proportions is
determined by the point at which the total marginal revenue (MRT) equals the marginal
cost of producing the entire production package.
If two products are produced jointly in the proportion of one-to-one, the output of each
product is the same and is equal to the output of the entire package. If two products are
jointly produced in the fixed proportion of two-to-one, then the number of units
produced of product 1 is twice that of product 2 and of the entire package, and so on.
The price of each of the products is then determined on its respective demand curve at
the best level of output of the entire package.

(b) A firm producing products jointly in fixed proportions would destroy a product if at the
best level of output of the entire package, the marginal revenue of the product is
negative. This means that selling all the units of the joint products for which its marginal
revenue is negative reduces the total profits of the firm. Thus, the firm only sells the
product until its marginal revenue is zero and destroys the excess quantity produced.

5. Figure 12-3 in the text is based on the assumption that PA and PB are constant. Since this
chapter deals with pricing practices, it is inappropriate to assume this. As pointed out in
footnote 5, however, the assumption that PA and PB are constant can be relaxed without
changing the essence of the analysis.

6. (a) An imperfectly competitive firm will have to lower PA and PB in order to sell the larger
quantities of products A and B produced by incurring greater total costs (i.e., by
moving outward from the origin in Figure 12-3). Unless PB/PA always remains the
same (a very unlikely occurrence), the isorevenue line will not be straight, but concave
to the origin, convex, or take any shape other than a straight line.

(b) Even if the isorevenue line is not straight, the analysis shown in Figure 12-3 remains
basically the same. That is, the profit-maximizing level of output for each particular
level of total costs will continue to be given by the point at which the particular
product transformation or TC curve is tangent to an isorevenue curve. The overall
profit-maximizing level of output is then the one that will lead to the highest overall
level of total profits for the firm (as in Figure 12-3).

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7. Quantity discounts do lead to savings on handling costs on the part of the firm. That is, the firm
may incur lower paperwork costs per unit sold for large than for small orders, may be charged
lower transportation costs per unit, and so on. To the extent that quantity discounts reflect only
these costs savings on the part of the firm in handling large orders, they do not represent price
discrimination. If the amount of the quantity discounts exceeds the cost savings that result to
the firm from handling large orders, then the difference does represent price discrimination.

8. (a) First-degree price discrimination requires that the firm have knowledge of the specific
demand function of each consumer and sell each unit of the product separately to each
consumer at the highest price possible. This is difficult or impossible to do in the real
world.
Second-degree price discrimination, on the other hand, is limited to cases where the
product or service can easily be measured or metered (as in the case of electricity, gas,
and water usage).
None of these restrictions apply to third-degree price discrimination. As a result, third
degree price discrimination is the most common form of price discrimination in our
economy today.

(b) Business travel is particularly heavy on Mondays, when businessmen leave home
offices to meet clients, suppliers, and regional officers, and on Fridays, when they
return home for the weekend. To encourage fuller use of capacity at mid week, airlines
offer mid-week fare discounts.
To the extent that the lower mid-week airfares reflect fully the lower marginal costs
per passenger for air travel at mid week, the lower mid-week airfares do not represent
third-degree price discrimination. The airfare differentials for mid-week differences
only. Thus, some price discrimination of the third degree may in fact be reflected in
this pricing practice by the airlines.

(c) If the price elasticity of demand for the product is the same in each market, then it
would be useless for the firm to charge different prices in the different markets, even if
the markets can be separated (i.e., even if they can be segmented). The reason is that
the firm’s profit-maximizing rule for third-degree price discrimination that MR1 =
MR2 = ...= MRn = MC would involve charging the same price in each market.

9. (a) Persistent dumping is good for domestic consumers because they can purchase the
commodity at a lower price than in the absence of dumping. If the gain to domestic
consumers is greater than the loss of domestic producers then the dumping is good for
the nation as a whole.

(b) The only type of dumping against which the nation may want to protect itself is
predatory dumping. The reason for this is that the aim of predatory dumping is to
unfairly drive domestic producers out of the market, after which the foreign
monopolist would raise prices to domestic consumers. It is often difficult, however, to
determine the type of dumping that is taking place.

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10. (a) The growth of the large-scale modern enterprise has been stimulated by economies of
scale in production (i.e., by the opportunity of taking advantage of very large cost
reductions with large-scale or mass production) and by the tremendous improvements in
communications.

(b) The rapid rise of the large-scale enterprise has been accompanied by decentralized
operations and the establishment of semi-autonomous profit centers in order to contain
the tendency toward rising communications and organizational costs.

(c) Decentralization and the establishment of semi-autonomous profit centers also led to the
transfer pricing problem. Transfer pricing refers to the pricing of intermediate products
sold by a semi-autonomous division of the firm and purchased by another semi-
autonomous division of the firm.

(d) Appropriate transfer pricing is essential in determining the optimal output of each
division and of the firm as a whole, in evaluating divisional performance, and in
determining divisional rewards.

11. (a) In the absence of an external market for the intermediate product, the transfer price for
the intermediate product is given by the marginal cost of the production division at the
best level of output for the intermediate product. If one unit of the intermediate product
is required to produce each unit of the final product, the best level of output of the
intermediate product is equal to the best level of output of the final product.

(b) When a perfectly competitive external market for the intermediate product exists, the
transfer price for intra-company sales of the intermediate product is given by the
external competitive price of the product.

(c) When the transfer product can be sold in an imperfectly competitive external market the
(internal) transfer price of the intermediate product is given at the point at which the net
marginal revenue of the marketing division of the firm is equal to the marginal cost of
the production division at the best level of output of the intermediate product, and the
price on the external market is given on the external demand curve.

12. (a) The total marginal cost curve of the marketing division of the firm (MCt) is obtained
from the vertical summation of the marginal cost curve of the marketing division for
assembling and marketing the final product (MCm), and the transfer price for the
intermediate product (Pt) required to produce the final product. That is, MCt = MCm +
Pt. Thus, the MCt curve (not shown in Figure 12-6 in the text) has the same slope as the
MCm curve and is $6 (the level of Pt) above it. Thus, the MCt curve would cross the
MRm curve of the marketing division on sales of the final product at point Em (the
same point at which the MC curve crosses the MRm curve in Figure 12-6).

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(b) The MCt curve was not shown in Figure 12-6 because it is superfluous. That is, the
MCt curve shows the same best level of output of the final product for the marketing
division of the firm as shown by the MC curve for the firm as a whole.
The reason for this is that Pt = MCp at every level of output in Figure 12-6, so that MCt
= MCm + Pt = MC = MCm + MCp. On the other hand, in Figure 12-7, Pt ≠ MCp,
except at point Ep', so that MCt ≠ MC, and the best level of output of the final product
is given by MCt.

13. (a) The advantages of cost-plus pricing are: (1) it requires less information than the MR =
MC rule, (2) it is relatively simple and easy to use, (3) it usually results in relatively
stable prices, and (4) it provides a clear indication for price increases when costs rise.

(b) The disadvantages of cost-plus pricing are: (1) it is often based on accounting and
historical costs rather than on replacement or opportunity costs (cost-plus pricing,
however, could be based on the appropriate cost concepts), (2) it is based on average
rather than on marginal costs (to the extent, however, that AC=MC over the normal or
standard level of output, this does not create much of a problem), (3) it ignores
conditions of demand (since firms usually apply higher markups to products with a less
elastic demand than to products with a more elastic demand, however, cost-plus pricing
leads to approximately the profit-maximizing price).

(c) The correct pricing and output decisions by a firm involve incremental analysis. That is,
a firm should lower the price of the product, introduce a new product, accept a new
order, etc., if the incremental revenue from the action exceeds the incremental cost.
When excess capacity exists in the short run, overhead or fixed costs are irrelevant.
Correct incremental analysis, however, involves taking into consideration the short-run
as well as the long-run implications of the managerial decision, and all the important
demand and production interrelationships. Only when the firm operates with no idle
capacity will incremental cost and full-cost pricing lead to the same results.

14. (a) Peak-load pricing refers to the firm’s charging of a higher price during peak times than
at off-peak times.

(b) Two-part tariff is the pricing practice in which consumers pay an initial fee for the right
to purchase a product or service, as well as a usage fee or price for each unit of the
product they purchase.

(c) Tying is the requirement that a consumer who buys or leases a product also purchases
another product needed in the use of the first.

(d) Bundling is the form of tying in which the firm requires customers buying or leasing
one of its products or services to also buy or lease another product or service when
customers have different tastes but the firm cannot price discriminate (as in tying).

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(e) Prestige pricing refers to the setting of high prices to attract prestige-oriented
consumers. This occurs particularly in cases where it is difficult to obtain objective
information on product quality and when consumers equate price with quality.

(f) Price lining is the pricing practice of setting a target price by a firm and then developing
a product that would allow the firm to maximize total profits at that price.

(g) Skimming refers to the setting of a high price when a product is first introduced and
then gradually lowering it subsequently. This occurs most often in the pricing of
durable goods when it is difficult to determine exactly the strength of demand when a
product is first introduced.

(h) Value pricing refers to the selling of quality goods at much lower prices than previously
but with manufacturers redesigning the product to lower costs so as to still earn a profit.

(i) Price matching is the pricing strategy where a firm advertises a price for the product or
services that it sells and promises to match any lower price offered by a competitor.

(j) Auction pricing is the pricing strategy where buyers and sellers make bids for the goods
on sale.

15. The statement is true. By equating price to marginal cost, both during the peak period when and
marginal cost are higher and during the off-peak period when demand and marginal cost are
lolower, peak-load pricing is an excellent example or application of the marginal principle.
Operating according to the marginal principle will greatly increase efficiency and consumer
welfare.

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ANSWERS TO PROBLEMS

1. See Figure 1 on the next page.

2. See Figure 2 on the next page.

With marginal cost curve MC (see the left panel of Figure 2) the best level of output of
pineapples and canned pineapple juice is 20 cans and is given at point E at which MRT =
MC. For Q = 20, PA = $12 on DA and PB = $6 on DB.
With marginal cost curve MC' (see the right panel of the figure), the best level of output of
pineapples is 35 units and is given by point E' at which MRT = MC'. The 35 units of
pineapples result in 35 cans of pineapples and 35 cans of pineapple juice being produced.
However, for Q>25, MRB < 0.
Thus, the firm sells 35 units of product A (canned pineapples) at PA' = $9, on DA, but only
25 units of product B (pineapple juice) at PB' = $5 (at which TRB is maximum and MRB =
0). The firm keeps from the market and disposes of the remaining 10 units of pineapple
juice in order not to depress its price below the one for which MRB < 0.

3. Adding the MRA and MRB functions together, we get:

MRT + MRA + MRB = 16 - 0.4QA + 10 - 0.4QB = 26 - 0.8Q

Setting MRT = MC, we get

MRT = 26 - 0.8Q = 8 + 0.1Q = MC

0.9Q = 18 so that Q = 20

Since at Q = 20,

MRA = 16 - 0.4(20) = 8 > 0 and

MRB = 10 - 0.4(20) = 2 > 0

Q=20 is the profit-maximizing level of output and sales of each product.

On the other hand, with MC', we have

MRT = 26 - 0.8Q = 2Q/35 = MC'

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 CHAPTER 12 PRICING PRACTICES

0.8Q + 2Q/35 = 26

(28 + 2)Q = 26
35

30Q = 910

Q = 30.3

However, setting MRB = 0, we get

MRB = 10 - 0.4QB = 0

QB = 25

Therefore, MRB < 0 for QB = Q > 25 and so MRT = MRA for Q > 25

Setting MRA = MC', we have

MRA = 16 - 0.4Q = 2Q/35 = MC'

0.4Q + 2Q/35 = 16

(14 + 2)Q = 16
35

16Q = 560 and Q=35

Thus, the best level of sales (as opposed to output) is 35 units of product A but only 25 units
of product B (i.e., the firm disposes of or keeps off the market 10 units of product B in order
not to sell it at MRB < 0).

At sales of QA = 35, PA' = 16 - 0.2(35) = $9

At sales of QB = 25, PB' = 10 - 0.2(25) = $5

4. From Figure 12-2, we can determine that

QA = 160 - 10PA or PA = 16 - 0.1QA and MRA = 16 - 0.2QA

QB = 90 - 10PB or PB = 9 - 0.1QB and MRB = 9 - 0.2QB

Adding the MRA and MRB functions, we get

MRT = MRA + MRB = 16 - 0.2QA + 9 - 0.2QB = 25 - 0.4Q

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Setting MRT = MC, we have:

MRT = 25 - 0.4Q = 1 + 0.2Q = MC

0.6Q = 24

Q = 40

Since at Q = 40

MRA = 16 - 0.2(40) + $8 > 0

MRB = 9 - 0.2(40) = $1 > 0

and Q = 40 is the profit-maximizing level of sales of each product.

Thus, PA = 16 - 0.1(40) = $12 and PB = 9 - 0.1(40) = $5

(see the left panel of Figure 12-2 in the text).

On the other hand, with MC', we have

MRT = 25 - 0.4Q = 1 + 0.05Q = MC'

0.45Q = 24

Q = 53.3

However, setting MRB = 0, we get:

MRB = 9 - 0.2QB = 0

QB = 45

Therefore, MRB < 0 for QB > 45, and so MRT = MRA for Q > 45.

Setting MRA = MC', we have:

MRA = 16 - 0.2Q = 1 + 0.05Q = MC'

0.25Q = 15

Q = 60

Thus, the best level of sales is 60 units of product A but only 45 units of product B.

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At sales of QA = 60, PA' = 16 - 0.1(60) = $10

At sales of QB = 45, PB' = 9 - 0.1(45) = $4.50

(see the right panel of Figure 12-2).

5. See Figure 3 on the next page.

The figure shows that TR = $120 is the highest isorevenue curve that the firm can reach
with TC = $70. Note that the TR line has the absolute slope of PB/PA = 1. With TC = $70,
the maximum profit is π = $60, which the firm earns when it produces and sells 50A and
70B (point G in the figure).
With TC = $90, the maximum profit is π = $70, which the firm earns when it produces and
sells 70A and 90B and reaches the TR = $160 isorevenue line at point E. Finally, with TC =
$140, the maximum profit is π = $50, which the firm earns when it produces and sells 80A
and 120B and reaches the TR = $200 isorevenue line at point H. Thus, the overall maximum
profit is π = $70 at point E.

6. See Figure 4 on the next page.

With PA = $0.50 and PB = $1.00, the isorevenue lines have slopes of PB/PA = $1/$0.50 = 2.
With TC = $70, the maximum profit is π = $30, which the firm earns when it produces and
sells 20A and 90B and reaches the TR = $100 isorevenue line at point G'.
With TC = $90, the maximum profit is π = $45, which the firm earns when it produces and
sells 30A and 120B and reaches the TR = $135 isorevenue line at point E'. With TC = $140,
the maximum profit is π = $30, which the firm earns when it produces and sells 40A and
150B and reaches the TR = $170 isorevenue line at point H'. Thus, the overall maximum
profit is π = $45 at point E'.

7. See Figure 5 on page after next.

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 CHAPTER 12 PRICING PRACTICES

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PART FOUR MARKET STRUCTURE AND PRICING PRACTICES

D1 and MR1 in panel (a) are the demand and marginal revenue curves that the firm faces in
market 1, D2 and MR2 in panel (b) are the demand and marginal revenue curves that the
firm faces in market 2, and D and MR in panel (c) are the overall total demand and marginal
revenue curves faced by the firm for the two markets together. D = ΣD1+2 and MR =
ΣMR1+2, by horizontal summation. The total cost function, TC = 120 + 4Q, indicates that
the firm faces total fixed costs of $120 and a marginal cost of $4.

The best level of output of the firm is 120 units and is given by point E in panel (c), at
which MR = MC = $4. With third-degree price discrimination, the firm should sell 60 units
of the product in each market, so that MR1 = MR2 = MR = MC = $4 (points E1, E2, and E).
For Q1 = 60, P1 = $10 (on D1) in market 1, so that TR1 = $600. For Q2 = 60, P2 = $7 (on D2)
in market 2, so that TR2 = $420. Thus, the overall total revenue of the firm is TR = TR1 +
TR2 = $600 + $420 = $1,020.

For Q = 120, TC = 120 + 4(120) = $600, so that ATC = TC = $600 = $5.

Q 120

Thus, the firm earns a profit of P1-ATC = $10-$5 = $5 per unit and $300 in total in market
1, and a profit of P2-ATC = $7 - $5 = $2 per unit and $120 in total in market 2. Thus, the
overall total profit of the firm is π = π1 + π2 = $300 + $120 = $420. In the absence of third-
degree rice discrimination, Q = 120, P = $8 (in panel c), TR = (8)(120) = $960, and profits
are $3 per unit and $360 in total.

8. With TC = 120 + 4Q, MC=$4 (the coefficient of Q). With third-degree price discrimination,
the condition for profit maximization for the firm is

MR1 = MR2 = MR = MC

Setting MR1 = MC and MR2 = MC, we get

MR1 = 16 - 0.2Q1 = 4 = MC and MR2 = 10 - 0.1Q2 = 4 = MC

so that 0.2Q1 = 12 0.1Q2 = 6

and Q1 = 60 Q2 = 60

The price that the firm should charge in each market is then

P1 = 16 - 0.1(60) = $10 and P2 = 10 - 0.05(60) = $7

so that TR1 = P1Q1 = ($10)(60) = $600 and TR2 = P2Q2 = ($7)(60) = $420

and TR = TR1 + TR2 = $600 + $420 = $1,020.

For Q=120, TC = 120 + 4(120) = $600 and ATC = TC = $600 = $5

Q 120

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 CHAPTER 12 PRICING PRACTICES

Thus the profit per unit (π/Q) and in total (π) of the firm with third-degree price
discrimination is

π1/Q1 = P1 - ATC = $10 - $5 = $5 and π2/Q2 = P2 - ATC = $7 - $5 = $2

and
π1 = (π1/Q1)Q1 = ($5)(60) = $300 and π2/Q2 = (π2/Q2)Q2 = ($2)(60) = $120

so that

π = π1 + π2 = $300 + $120 = $420

The total profits of the firm can also be found by

π = TR1 + TR2 - TC = $600 + $420 - $600 = $420

In the absence of price discrimination, the firm will sell the product at the same price in
both markets (i.e., P1 = P2 = P). The total market demand function faced by the firm for
prices below $10 (for which Q2 > 0) is

Q = Q1 + Q2

= 160 - 10P1 + 200 - 20P2

= 360 - 30P

so that

P = 12 - 0.0333Q

and

MR = 12 - 0.0667Q

Setting MR = MC, we get

MR = 12 - 0.667Q = 4 = MC

so that

0.0667Q = 8

and

Q = 119.94 ≈ 120

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PART FOUR MARKET STRUCTURE AND PRICING PRACTICES

At Q = 120

P = 12 - 0.0333(120) = 12 - 3.996 ≈ $8

so that

TR = (P)(Q) = ($8)(120) = $960

(as compared with TR = $1,020 with third-degree price discrimination).

The profit per unit (π/Q) and in total (π) are

π/Q = P - ATC = $8 - $5 = $3

and

π = (π/Q)Q = ($3)(120) = $360 or π = TR - TC = $960 - $600 = $360

(as compared with π = $420 with third-degree price discrimination).

These results are shown graphically in Figure 5 on the next page.

9. See Figure 6 on the next page.

In the figure, MC, the marginal cost of the firm, is equal to the vertical summation of MCp
and MCm, the marginal cost curves of the production and the marketing divisions of the
firm, respectively. Dm is the external demand for the final product faced by the marketing
division of the firm, and MRm is the corresponding marginal revenue curve.
The firm's best level of output of the final product is 30 units and is given by point Em, at
which MRm = MC, so that Pm = $13. Since the production of each unit of the final product
requires one unit of the intermediate product, the transfer price for the intermediate product,
Pt, is set equal to MCp at Qp = 30. Thus, Pt = $6. With Dp = MRp = Pt = MCp = $6 at Qp
= 30 (see point Ep), Qp = 30 is the best level of output of the intermediate product for the
production division.

10. See Figure 7 on the next page.

This figure is identical to Figure 12-6, except that MC'p is lower than MCp. At the perfectly
competitive external price of Pt = $6 for the intermediate product, the production division of
the firm faces Dp = MRp = Pt = $6. Therefore, the best level of output of the intermediate
product is Qp = 40 and is given by point E'p at which Dp = MRp = Pt = MC'p = $6.

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 CHAPTER 12 PRICING PRACTICES

243
PART FOUR MARKET STRUCTURE AND PRICING PRACTICES

Since the marketing division can purchase the intermediate product (internally or
externally) at Pt = $6, its total marginal cost curve, MCt, is equal to the vertical summation
of MCm and Pt. Thus, the best level of output of the final product by the marketing
division is 30 units and is given by point Em, at which MRm = MCt, so that Pm = $13 (as in
Figure 6).

11. The demand and marginal revenue curves for the final product faced by the marketing division
of the firm in Figure 7 can be represented algebraically as:

Qm = 160 - 10Pm or Pm = 16 - 0.1Qm and MRm = 16 - 0.2Qm

The marginal cost functions of each division are, respectively:

MCp' = 2 + 0.1Qp and MCm = 1 + 0.1Qm

Since Pt=$6, the total marginal cost function of the marketing division (MCt) is:

MCt = MCm + Pt = 1 + 0.1Qm + 6 = 7 + 0.1Qm

The best level of output of the intermediate product by the production division is given by the
point at which MCp' = Pt. Thus,

MCp' = 2 + 0.1Qp = 6 = Pt

so that
0.1Qp = 4
and
Qp = 40

The best level of output of the final product by the marketing division is given by the point at
which MCt = MRm. Thus,

MCt = 7 + 0.1Qm = 16 - 0.2Qm = MRm

so that

0.3Qm = 9

and

Qm = 30

Pm = 16 - 0.1(30) = $13

These are the same results obtained graphically in Figure 7 in Problem 10.

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12. (a) The monopolist’s total revenue will be larger with second degree price discrimination
when the batches on which the monopolist charges a uniform price are smaller. In fact, the
smaller the batches are, the more the monopolist approaches the results of first degree price
discrimination (under which the monopolist extracts all of the consumers’ surplus and
maximizes total revenue and profits). As pointed out in the text, however, this is very
difficult or prohibitively expensive to do.

(b) A two-part tariff is the pricing practice whereby a monopolist maximizes its total profits
by charging a usage fee or a price equal to its marginal cost and an initial or membership
fee equal to the entire consumer surplus. Bundling, on the other hand, is a common form of
tying in which the monopolist requires customers buying or leasing one of its products or
services to also buy or lease another product or service when customers have different
tastes but the monopolist cannot price discriminate.

13. (a) SMC = dTC = d{(1/2)Q2 + 100,000} = Q

dQ dQ

SMC: P = Q

(b) To find Po, set Do' equal to SMC:

4-P=P
4 = 2P
2 = Po

To find Qo, set Do equal to SMC:

4-Q=Q
4 = 2Q
2 = Qo

(c) To find Pp set Dp' equal to SMC:

8-P=P
8 = 2P
4 = Pp

To find Qp, set Dp equal to SMC:

8-Q=Q
8 = 2Q
4 = Qp

(d) The total demand for electricity, Qo + Qp, equals 2 + 4 = 6 million kWh.

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PART FOUR MARKET STRUCTURE AND PRICING PRACTICES

14. (a) Do: P = 4 - Q

P=3
3=4-Q
Qo* = 1

(b) Dp: P = 8 - Q
P=3
3=8-Q
Qp* = 5

(c) The new total demand for electricity, Qo* + Qp*, = 1 + 5 = 6 million kWh.

15. (a) In order to determine the price that the plant manager should charge for the calculators,
he or she must first determine the fully-allocated average cost (C) for the normal or
standard level of output. This is 75 percent of the capacity output of 200,000, or
150,000 units.

C = AVC + average overhead charge

= TVC + Total overhead charge

Q Q

Since the total overhead charge is 120 percent of the TVC of $900,000, the total
overhead charge is $1,080,000. Thus,

C= $900,000 + $1,080,000 = $6.00 + $7.20 = $13.20

150,000 150,000

Since the manager wants to apply a 20 percent markup on cost (m), the price that he or
she should charge for the calculators is

P = C(1 + m) = $13.20(1 + 0.20) = $15.84

(b) If the price charged is the profit-maximizing price and Ep is the price elasticity of
demand

m= Ep - 1
Ep+1

so that

0.20 = Ep - 1
Ep+1

1.20 = Ep
Ep+1

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 CHAPTER 12 PRICING PRACTICES

(Ep+1)(1.20) = Ep

1.2Ep + 1.2 = Ep

0.2Ep = -1.2

Ep = -6

(c) If Ep = -4, then

m = -4 - 1 = -4 - 1 = 1.33 - 1 = 0.33 or 33%.

-4+1 -3

(d) Since the price of the calculators on the additional order exceeds the average variable
cost of producing the calculators, the manger should accept the order.

For P = $10, TR = $200,000 for the additional order of 20,000 calculators. With AVC =
$6, TVC = $120,000. Thus, the new order would contribute $80,000 toward covering
the plant's overhead charges. This is an example of incremental analysis in pricing in
which the incremental cost rather than the fully allocated average cost is the appropriate
cost concept use.

(e) If the firm wants to add the pocket calculator produced by the plant to its own product
line on a regular basis, the transfer price would be $13.20, or the fully allocated
Faverage cost for the pocket calculator. That is, in the long run, the plant must cover at
least all of its variable and overhead costs.

(f) At the best level of output of pocket calculators by the plant, MRm = MCp = MRe =
MRp = MCp = $13.20. Thus, the net marginal revenue of the marketing division of the
firm is MRm – MCp = $13.20. To find the price at which the plant should sell the
pocket calculator, we start with

MR = P(1 + 1)
Ep

Solving for P, we get:

P = MR( Ep ) = 13.20( -2 ) = $26.40

Ep+1 -2+1

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PART FOUR MARKET STRUCTURE AND PRICING PRACTICES

ANSWERS TO APPENDIX PROBLEMS

1. (a) TR = $24. Since the consumer would be willing to pay $33 for 6 units of the
commodity, the consumer’s surplus is $9.

(b) With first-degree price discrimination, the monopolist’s TR = $33 and the consumer’s
surplus is zero.

(c) By charging P = $5.50 for the first three units of the commodity and $4 for the next
three units, the monopolist’s TR = $28.50 and the consumer’s surplus is $4.50. In this
case, the monopolist would be practicing second-degree price discrimination.

2. (a) Market 1: Market 2: Market 3:

Q = 9 – 1/20P Q = 10 – 1/10P Q = 16 – 1/5P
P = 180 – 20Q P = 100 – 10Q P = 80 – 5Q
TR = 180Q – 20Q2 TR = 100Q – 10Q2 TR = 80Q – 5Q2
MR = 180 – 40Q MR = 100 – 20Q MR = 80 – 10Q
Q = 4.5 – 1/40MR Q = 5 – 1/20MR Q = 8 – 1/10MR

Between P = 180 and P = 100 (MR = 180 and MR = 100 for MR curve) use equations:
Q = 9-1/20P and Q = 4.5 – 1/40MR or MR = 180 – 40Q

Between P = 100 and P = 80 (MR = 100 and MR = 80) use equations:

Q = (9 + 10) – (1/20 + 1/10) P and Q = (4.5 + 4) – (1/40 + 1/20) MR
Q = 19 – 3/20P and Q = 9.5 – 3/40MR or MR = 126.7 – 40/3Q

Between P = 80 and P = 0 (MR = 80 and MR = 0) use equations:

Q = (9 + 10 + 16) – (1/20 + 1/10 + 1/5) P and
Q = (4.5 + 5 + 8) – (1/40 + 1/20 + 1/10) MR
or
Q = 35 – 7/20P and Q = 17.5 – 7/40MR or MR = 100 – 40/7Q

For the marginal cost function,

TC = -50Q + 5/2Q2 + 490, Q > 10
MC = -50 + 5Q, Q > 10
ATC = -50 + 5/2Q + 490/Q

Since the last equation for MR is the only one that will give a positive marginal revenue
if the firm produces above Q = 10, the firm chooses this equation. The optimal quantity
to produce is 14, which corresponds to MC = MR = 20 and ATC = -50 + 5/2(14) + 490/14
= 20.

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 CHAPTER 12 PRICING PRACTICES

(b), (c)

Market 1: Q = 4.5 – 1/40(20) = 4, P = 180 – 20(4) = $100, TR = 4($100) = $400, TC =

4(20) = $80
Profit = $400 - $80 = $320.

Market 2: Q = 5 – 1/20(20) = 4, P = 100 – 10(4) = $60, TR = 4($60) = $240, TC = $80

Profit = $240 - $80 = $160

Market 3: Q = 8 – 1/10(20) = 6, P = 80 – 5(6) = $50, TR = 6($50) = $300, TC = 6(20) =

$120
Profit = $300 - $120 = $180

Total Profit = $320 + $160 + $180 = $660

(d) Without Price Discrimination, P = $60, TR = $840, TC = $280, Profit = $560. Firm
recuperates $100 from consumer surplus.

A B C D E F G H I
1
Marke
2 Q MR MC ATC t1
3 10 42.9 0 24 Q 4
4 11 37.1 5 22.05 P 100
5 12 31.4 10 20.83 Profit 320
6 13 25.7 15 20.19
Marke
7 14 20.0 20 20 t2
8 15 14.3 25 20.17 Q 4
9 16 8.6 30 20.63 P 60
10 17 2.9 35 21.32 Profit 160
11 18 -2.9 40 22.22
Marke
12 19 -8.6 45 23.29 t3
-
13 20 14.3 50 24.5 Q 6
14 P 50
15 Profit 180
16
Total
17 Profit 660
18
Without Price
19 Discrimination
20 P 60
21 Profit 560
22

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PART FOUR MARKET STRUCTURE AND PRICING PRACTICES

ANSWERS TO APPENDIX PROBLEMS

1. With P1 = 12 - 0.1Q1 and P2 = 6 - 0.05Q2

TR1 = 12Q1 - 0.1Q12 and TR2 = 6Q2 - 0.05Q22 as in the example in text.

If TC = 20 + 4(Q1 + Q2)

π = 12Q1 - 0.1Q12 + 6Q2 - 0.0522 - 20 - 4(Q1 + Q2)

and
∂π ∂π
= 12 - 0.2 Q1 - 4 = 0 = 6 - 0.1 Q 2 - 4 = 0
∂ Q1 ∂ Q2
so that

0.2Q1 = 8 and Q1 = 40 0.1Q2 = 2 and Q2 = 20

Since
∂ π ∂ π
2 2
= - 0.2 < 0 a n d = - 0.1 < 0
∂ Q12 ∂ Q2

the monopolist maximizes total profits by selling Q1 = 40 and Q2 = 20. Then

P1 = 12 - 0.1(40) = $8 and P2 = 6 - 0.05(20) = $5

and

π = 12(40) - 0.1(40)2 + 6(20) - 0.05(20)2 - 20 - 4(40) - 4(20) = $160

2. In the absence of price discrimination,

Q = Q1 + Q2 = 240 - 30P and P = 8 - 0.0333Q

TR = (P)(Q) = (8 - 0.0333Q)Q = 8Q - 0.0333Q2

π = 8Q - 0.0333Q2 - 120 - 4Q

dπ = 8 - 0.0667Q - 4 = 0
dQ

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 CHAPTER 12 PRICING PRACTICES

0.0667Q = 4, so that Q = 59.97 ≈ 60

Since

d2π = -0.667 < 0

d2Q

the monopolist maximizes profits at Q = 60 in the absence of price discrimination.

P = 8 - 0.0333Q = 8 - 0.0333(60) = 8 - 1.998 ≈ $6

π = 8(60) - 0.0333(60)2 - 20 - 4(60) = $20

251
 CHAPTER 13

REGULATION AND ANTITRUST: THE ROLE OF GOVERNMENT IN THE ECONOMY

13-1 GOVERNMENT REGULATION TO SUPPORT BUSINESS AND TO PROTECT

CONSUMERS, WORKERS, AND THE ENVIRONMENT
Government Regulations that Restrict Competition
Government Regulations to Protect Consumers, Workers, and the Environment
Case Study 13-1: Restrictions on Competition in the Pricing of Milk in New York City and
the Nation
Case Study 13-2: The FDA Steps Up Regulation of the Food and Drug Industry
Case Study 13-3: Regulation Greatly Reduced Air Pollution

13-2 EXTERNALITIES AND REGULATION

The Meaning and Importance of Externalities
Policies to Deal with Externalities
Case Study 13-4: The Market for Dumping Rights

13-3 PUBLIC UTILITY REGULATION

Public Utilities as Natural Monopolies
Difficulties in Public Utility Regulation
Case Study 13-5: Regulated Electricity Rate Increases for Con Edison

13-4 ANTITRUST: GOVERNMENT REGULATION OF MARKET STRUCTURE AND

CONDUCT
Sherman Act (1890)
Clayton Act (1914)
Federal trade Commission Act (1914)
Robinson-Patman Act (1936)
Wheeler-Lea Act (1938)
Celler-Kefauver Antimerger Act (1950)

13-5 ENFORCEMENT OF ANTITRUST LAWS AND THE DEREGULATION MOVEMENT

Enforcement of Antitrust Laws: Some General Observations
Enforcement of Antitrust Laws: Structure
Case Study 13-6: The IBM and AT&T Cases
Enforcement of Antitrust Laws: Conduct
Case Study 13-7: Antitrust and the New Merger Boom
The Deregulation Movement
Case Study 13-8: The Microsoft Antitrust Case
Case Study 13-9: Deregulation of the Airline Industry: An Assessment

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 CHAPTER 13 REGULATION AND ANTITRUST: THE ROLE OF GOVERNMENT IN THE ECONOMY

13-6 REGULATION OF INTERNATIONAL COMPETITION

Case Study 13-10: Voluntary Export Restraints on Japanese Automobiles to the United
States

13-7 THE EFFECT OF TAXATION ON BUSINESS DECISIONS

Box 13 – Managerial Economics at Work: Corporate tax Rates around the World and
Multinationals’ Behavior
Case Study 13-11: US Border Taxes and Export Subsidies

SUMMARY
DISCUSSION QUESTIONS
PROBLEMS
SPREASHSEET PROBLEMS
SUPPLEMENTARY READINGS
INTERNET SITE ADDRESSES
KEY TERMS (in order of their appearance)
_____________________________________________________________________________

Economic theory of regulation Clayton Act (1914)

Licensing Federal Trade Commission Act (1914)
Patent Robinson-Patman Act (1936)
Public interest theory of regulation Wheeler-Lea Act (1938)
Market failures Celler-Kefauver Antimerger Act (1950)
Externalities Dissolution and divestiture
External diseconomies of production Injunction
External economies of production Consent decree
External diseconomies of consumption Conscious parallelism
External economies of consumption Predatory pricing
Natural monopolies Import tariff
Public utilities Import quota
Averch-Johnson (A-J) effect Voluntary export restraint (VER)
Sherman Act (1980) Uruguay Round
Border taxes
Foreign Sales Corporation (FSC)

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PART FIVE REGULATION, RISK ANALYSIS, AND CAPITAL BUDGETING

ANSWERS TO DISCUSSION QUESTIONS

1. Two theories that seek to explain the rationale for government intervention in the economy are
the economic theory of regulation and the public interest theory. The economic theory of
regulation postulates that regulation is the result of pressures from business, consumers,
workers, and environmental groups brought to bear on the government to pass legislation to
protect them or their cause.

According to the public interest theory, on the other hand, regulation results from the desire
on the part of elected government officials to eliminate or correct market failures (i.e.,
situations where private and social benefits or costs diverge, or where efficient operation
requires a monopoly). This provided the traditional rationale for government intervention in
the economy. Today, however, the economic theory of regulation seems to be preferred by a
growing number of economists.

2. Licensing restricts entry and competition by limiting the number of franchises granted to enter
and/or to remain in a business, profession, or trade. A patent restricts entry and competition by
forbidding anyone but the inventor to make use of an invention for a period of 17 years. Tariffs
are taxes on imports and, as such, restrict competition that domestic firms face from abroad. A
quota is an even stronger restriction on competition from abroad which limits the quantity of a
product that is allowed to be imported into the nation.

3. Some of the direct restrictions on price competition resulting from government regulation
include government-guaranteed parity prices in agriculture, trucking freight rates and airfares
before deregulation, ocean shipping rates, and the requirement of the Robinson-Patman Act
forbidding firms to sell more cheaply to one buyer or in one market than others, or to sell at
“unreasonably low prices” with the intent of destroying competition or eliminating a
competitor.

4. It is difficult to justify on economic grounds the regulation of oil and natural gas prices. In the
absence of regulation, prices will provide the correct signals for consumers and producers, and
neither shortages nor surpluses will develop or persist over time. In fact, when the prices of oil
and natural gas were deregulated in the United States, production became more rational and
expanded, and prices declined.

Most of the arguments in favor of regulation revolve around the potential for abuse by the
large oil companies. The monopoly power of large oil companies is usually exaggerated,
however. There are also better methods than regulating prices, such as direct taxation, for
neutralizing monopoly power, since the former leads to production and consumption
disruptions.

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 CHAPTER 13 REGULATION AND ANTITRUST: THE ROLE OF GOVERNMENT IN THE ECONOMY

5. In a system of private education, there is likely to be underinvestment in education because the

social benefits of education exceed the private benefits. The reason for this is that, in general, a
more educated individual makes for a more responsible individual (an external benefit).

Since an individual decides how much to invest in education based only on the return that
he or she, as an individual, receives from education, he or she is likely to spend less on
education than is socially optimal. This provides the rationale for public support of private
education and for a public educational system.

6. (a) Even though the government collects the tax of $3 per hour for evening typing from
individual A, individual A is able to shift part of the burden of the tax onto those who
demand the typing services of individual A. From the left panel of Figure 13-2 in the
text, we can see that individual A receives $6 per hour for evening typing in the
absence of the tax and $8 per hour with the tax of $3 per hour.

Thus, with the tax, individual A receives a net payment of $5 per hour for evening
typing, as compared with $6 in the absence of the tax. Individual A is, thus, able to
shift two-thirds of the burden of the tax (i.e., $2) onto those who demand the typing
services, so that the actual burden or incidence of the tax on individual A is only one-
third or $1.

(b) The incidence or relative burden of a per-unit tax depends on the price elasticity of
demand for the product or service (the MPBA curve in the left panel of Figure 13-2).
The more inelastic is the demand curve, the greater is the relative burden of the tax on
those who demand the product or service.

At one extreme, when the price elasticity of demand is zero (i.e., when the demand
curve is vertical), the burden of the tax falls entirely on those demanding the product
or service (by having to pay a price that is higher than before the tax by the exact
amount of the tax).

At the opposite extreme (i.e., when the demand curve is infinitely elastic or
horizontal), the price of the product or service will remain the same after the
imposition of the tax. This means that the tax falls entirely on the supplier of the
product or service (who will receive an after-tax price that is lower than the price
before the imposition of the tax by the exact amount of the tax). The student can be
asked to draw a figure for each of these two extreme cases.

7. (a) Since individual A receives the benefit (i.e., the increase in the value of his or her
home) from tending the yard and also incurs the cost of such an activity, a per-unit
(hour) subsidy can be shown graphically either by an upward shift in the MPBA curve
or by a downward shift in the MPCA curve by the amount of the subsidy in the right
panel of Figure 13-2.

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PART FIVE REGULATION, RISK ANALYSIS, AND CAPITAL BUDGETING

(b) If the subsidy of $3 per hour is shown by shifting the MPCA curve down by $3 in the
right panel of Figure 12-2, the new MPCA + s curve would intersect the MPBA curve
so as to indicate that individual A will spend 10 hours per week tending his or her
yard. This is the socially optimal number of hours per week for individual A to tend
his or her yard (since MSB = MSC) and is the same result obtained by shifting the
MPBA curve up by $3 (shown in the right panel of Figure 13-2).

8. Even though either a subsidy to install antipollution equipment or a tax on polluters reduces the
level of pollution, they represent basically different approaches to pollution control because of
their different implications as to who owns the environment.

A subsidy implies that the firm has the right to pollute so that society must subsidize the
firm to install antipollution equipment. A tax implies that society has the right to a clean
environment and the tax is a penalty on polluters. Polluters must, thus, reimburse society
for the damages created by the pollution they generate. Most people prefer taxes to reduce
pollution because they recognize society’s right to a clean environment.

9. (a) A regulatory commission could induce a public utility to operate as a perfect

competitor in the long run by setting P = LMC. Since the price of the service (which
measures the value to society of an additional unit of the service) equals the extra cost
of producing the last unit of the service in the long run, the output at which P = LMC
is the best level of output of the service from society’s point of view in the long run.

(b) Since the LAC curve of the public utility company is declining at the output level at
which P = LMC, the LMC curve is below the LAC curve and the firm incurs a loss.
Therefore, the public utility company would not supply the service in the long run
unless it received a subsidy that would allow it to break even.

(c) The compromise usually adopted by the regulatory commission is to set P = LAC so
that the public utility breaks even (i.e., earns only a normal return on investment)
without the need for a subsidy. By doing so, the profits that a public utility would earn
if unregulated are eliminated.

10. Given the difficulties of regulating public utilities, many European countries have nationalized
the companies that supply electricity, gas, water, local telephone, and local transportation
services. The difficulty with this policy is that it removes, even more than regulation does, any
incentive for economic efficiency in the provision of these basic services.

Specifically, in the absence of any competition and facing even less scrutiny than the
managers of regulated public utility companies, the public servants who manage the
nationalized public utility companies have less incentive than the managers of regulated
public utilities to produce the best quality service at the lowest possible price.
Nationalization, therefore, does not seem to be the answer to the efficiency problems faced
by public utilities.

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11. If economies of scale are so pervasive that a single firm can supply a service to the entire
market much more efficiently than any number of smaller firms (as in the case of public
utilities), the government is likely to allow a single firm (a natural monopoly) to operate in the
market, subject to regulation of the price that the firm can charge for the service (so that the
firm earns only a normal return on investment) and of the type and quality of the service it
provides.

If, on the other hand, economies of scale are not so pervasive as to justify the operation of a
single firm in the market, the government is likely to apply antitrust laws to break up the
monopoly or restrain the firms supplying the service from anticompetitive behavior and
unfair business practices.

12. The basic antitrust laws are the Sherman Act of 1890 and the Clayton Act of 1914. They
prohibit “monopolization,” “restraints of trade,” and “unfair competition.” Being very broad in
nature, however, the Sherman and the Clayton Acts left a great deal to judicial interpretation
based on economic analysis, and led to the passage of the subsequent legislation to spell out
more precisely what business behavior was in fact prohibited by the antitrust laws, and the
closing of loopholes in the original legislation.

13. From the passage of the Sherman Act in 1890 until 1945, the Supreme Court held that size per
se was not illegal. The illegal use of monopoly power was required for successful prosecution.
Thus, while the Supreme Court ruled in 1911 that Standard Oil of New Jersey has acquired
monopoly power by illegal actions and ordered its dissolution into 30 independent firms, in
1920 the Court refused to order U.S. Steel to dissolve in the absence of conclusive proof of
illegal actions.

Starting with the 1945 Alcoa case, however, the Supreme Court ruled that size per se was
an offense, irrespective of illegal acts. However, in the 1982 IBM and AT&T cases, the
Court took an intermediate position and ruled that only size together with some anti-
competitive behavior was illegal. Thus, the Court ordered AT&T to divest itself of 22 local
telephone companies under a consent decree, but decided to drop its case against IBM.
Staring from the second half of the 1990s, the Court refused to approve mergers that
reduced competition and was likely to increase prices to consumers.

14. (a) The bad news for AT&T was that it had to divest itself of the 22 local Bell telephone
companies. These local telephone companies had total assets in excess of $80 billion,
which represented two-thirds of AT&T. Also bad news for AT&T was its loss of
monopoly on long-distance telephone service. The good news for AT&T was that it
could continue to operate Bell Laboratories and Western Electric (its manufacturing
unit). More importantly, AT&T was now allowed to enter the rapidly growing fields of
cable TV, electronic data transmission, video-text communications, and computers.

(b) The good news for AT&T customers was that now they could enjoy the benefits of
competition and lower prices in long-distance telephone service. The bad news was that
customers’ bills for local telephone service would increase (since AT&T would no longer
be there to subsidize lower local telephone rates from higher long-distance rates).

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15. (a) With an import tariff of $0.50 per unit, Px = $3.50 and consumers would consume
550X, or which 250X would be produced domestically and 300X imported. The
government would also collect $150 in revenues ($0.50 per unit for 300 units).

(b) With an import tariff of $2 per unit, Px = $5. At Px =$5, domestic production and
production would equal 400X, so that imports would be zero and the government would
collect no revenue tariff.

16. (a) Border taxes are rebates for internal indirect taxes given to exporters of a commodity
and imposed (in addition to the tariff) on importers of a commodity.

(b) Foreign Sales Corporation (FSC) Provisions of the US tax code used by US
corporations since 1971 to enjoy partial exemption from U. tax laws on income earned
from exports.

ANSWERS TO PROBLEMS

1. In Figure 1 on the next page, the equilibrium price is $600 and the equilibrium quantity is 4,000
units. These are given by point E, at which the D curve intersects the S curve. The socially
optimal price (which takes into consideration the external diseconomy of production resulting
from the pollution) is, however, $800 and the socially optimal quantity is 3,000 units. These are
given by point E', at which the D curve intersects the S' curve. The socially optimal price and
quantity cannot be reached, however, without government intervention.

2. Figure 2 on the next page shows that a corrective tax of $300 per unit collected from producers
will make S" the new industry supply curve. With S", P = $800 and Q = 3,000 (given by the
intersection of the D and S" curves at point E'). Producers now receive a net price of $500 (P =
$800 minus the $300 tax).

3. Figure 3 on the next page shows that the socially optimal price (which takes into consideration
the external economy of production) is $400 and the socially optimal quantity is 5,000 units.
These are given by point E', at which D intersects S'. Point E' cannot be reached, however,
without government intervention.

Figure 3 also shows that a corrective subsidy of $300 per unit given to producers will make
S" the new industry supply curve. With S", P = $400 and Q = 5,000 (given by the
intersection of D and S" at point E'). Producers now receive a net price of $700 (P = $400
plus the subsidy of $300 per unit).

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4. In Figure 4 on the next page, the equilibrium price is $1.20 and the equilibrium quantity is
6,000 cans. These are given by point E, at which the D and S curves intersect.

The socially optimal price (which takes into consideration the external diseconomy of
consumption resulting from the need to collect and recycle the empty cans) is, however,
$1.00 and the socially optimal quantity is 4,000 cans. These are given by point E', at which
the D' and S curves intersect. However, point E' cannot be reached without government
intervention.

5. Figure 5 shows that the corrective tax of $0.40 per can of soft drink imposed on consumers will
make D" the new market demand curve. With D", P = $1.00 and Q = 4,000 (given by the
intersection of D" and S at point E'). Consumers now pay $1.00 plus the $0.40 tax per can, or a
net price of $1.40 (as compared with the price of $1.20 before the tax).

6. Figure 6 shows that the socially optimal price (which takes into consideration the external
economy of consumption) is $1.40 and the socially optimal quantity is 8,000 cans. These are
given by point E', at which D' and S intersect. Point E' cannot be reached without government
intervention.

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Figure 6 also shows that a corrective subsidy of $0.40 per can of soft drink consumed given
to consumers will make D" the new market demand curve. With D", P = $1.40 and Q =
8,000 (given by the intersection of D" and S at point E'). Consumers now pay the net price
of $1.00 (P = $1.40 minus the subsidy of $0.40 per can on soft drink consumed).

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7. See Figure 7 on the next page.

In Figure 7, D and D' are, respectively, the original and new market demand curves. With
the new demand curve D' and the unchanged LAC curve, the regulatory commission would
set P' = LAC = $2 (point G') and the public utility company would supply 8 million units of
the service per time period (as compared with P = LAC = $3 with Q = 6 million units per
time period shown by point G on D). In either case, the public utility company breaks even.

8. See Figure 8 on the next page.

In Figure 8, D and D' are, respectively, the original and new market demand curves and
LAC and LAC' are the original and the new long-run average cost curves of the public
utility company. With D' and LAC', the public utility commission would set P" = LAC' = $4
(point G") and the public utility company would supply 6 million units of the service per
time period.

This is based on the assumption that the public utility commission does not realize that the
upward shift in the company's LAC curve is due to production inefficiencies rather than to
legitimate increases in costs of production.

9. (a) Sears could accuse the Pneumatic Tire Company and the company with which the
latter merged of unfair competition and to have broken the Federal Trade Commission
Act of 1914. It could also allege a conspiracy in restraint of trade or an attempt to
monopolize trade, which are illegal under the Sherman Act.

(b) In the first year after the Pneumatic Tire Company broke the contract, Sears’ tire sales
declined by 25 percent, or from $100 million to $75 million and net profits fell from
$30 million (30% of $100 million) to $22.5 million (30% of $75 million), or by $7.5
million. Discounting the $7.5 million of lost profits to the time that the Pneumatic Tire
Company broke the contract with Sears (i.e., for one year) at the annual rate of, say, 10
percent, Sears estimates its first year profit loss to be $6.8 million ($7.5 million
divided by 1.1).

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In the second year after the Pneumatic Tire Company broke the contract, Sears' tire sales
fell by another 25 percent from $100 million to $50 million so that net profits fell from $30
million (30% of $100 million) to $15 million (30% of $50 million), or by $15 million.
Discounting the $15 million of lost profits for two years at, say, 10 percent, to the time that

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the Pneumatic Tire Company broke the contract with Sears, Sears estimates its second year
net profit loss to be $12.4 million ($15 million divided by 1.1 squared, or by 1.21).

Thus, Sears estimates the present value of its net profit loss for the two years to be $19.2
million. If Sears succeeds in having the Pneumatic Tire Company convicted under the
Sherman Act, it could demand compensation of triple damages, or $57.6 million.

10. The best price that the public utility commission can allow the regulated public utility to charge
is $0.04 per KWH (the same as the lowest LAC of the public utility). The reason is that
LMC=LAC at the lowest point on the LAC curve. Thus, allowing a price equal to $0.04 per
KWH allows the firm to produce at the lowest LAC and just break even. This ideal situation
would occur only by change in the real world so that the public-utility commission faces and
more challenging choice in setting the electricity rate.

11. In the case of a monopoly which is not a natural monopoly, the LMC curve is rising and above
the corresponding LAC curve when the latter intersects the market demand curve. As a result,
setting P = LMC will not result in a loss for the monopolist and the need for a subsidy to induce
the monopolist to continue to supply the commodity or service. The economic profits that the
monopolist earns when P = LMC can then be entirely taxed away by an equal lump-sum tax.
Compare Figure 9-7 referring to a monopoly which is not a natural monopoly with Figure 13-3
which refers to a natural monopoly.

12. Before the merger, the Herfindahl index for the 10 equal-sized firms is 1,000. After the merger,
H=1,300 for the nine remaining firms. Since the post-merger index falls between 1,000 and
1,800 and the index increases by 300 points as a result of the merger, the Justice Department was
likely to challenge the merger based on its 1984 Herfindahl-index guideline only.

13. (a) Prior to the passage of the Motor Carrier Act of 1980, trucking in interstate commerce
was regulated by the Interstate Commerce Commission (ICC). The ICC was originally
set up in the nineteenth century to regulate railroads. In the early part of the twentieth
century, the ICC sought to protect railroads from the emerging trucking industry.

As the trucking industry grew and matured, the ICC introduced a maze of regulations to
protect large established trucking firms from the competition of smaller firms. These
regulations restricted entry into the industry and severely stifled competition. Because
regulation in the trucking industry resulted from pressure from large trucking firms and
restricted competition, it can be regarded as a good example of the capture theory of
regulation.

(b) The passage of the Motor Carrier Act of 1980 led to the removal of most restrictions to
entry into the trucking industry. Many geographical and commodity restrictions on
independent truckers were also abolished. The result was sharply increased competition
in the industry, lower shipping rates, improved service, and lower profits.

Since 1980–1982 were years of recession and high inflation and interest rates, however,
it is difficult or impossible to determine how much of the pressure on trucking firms
was the result of deregulation and how much was due to the poor economic climate.

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14. During the 1970s, entrance into the banking industry in the United States was highly restricted
and banks were not allowed to pay interest on checking deposits or higher than specified
interest rates on savings deposits (the so-called Regulation Q). Banks were also the only
financial institutions that could make commercial loans. In the face of such restrictions on
competition, the banking industry earned rates of return on stockholders' equity during the
1970s that were higher than the average rates of return (about 15 percent) in other industries.

During the 1980s, however, the reverse was the case. That is, the banking industry earned
rates of return that were consistently lower than for other US industries. One reason for this
was that the Depository Institutions and Monetary Control Act of 1980 deregulated many
aspects of banking in the United States and greatly increased the competition for business
loans.

Another reason was that many of the loans that large US commercial banks made in
developing countries (primarily to such Latin American countries as Brazil, Argentina, and
Venezuela) had to be written off as noncollectible.

15. (a) See Figure 9 on the next page.

The best level of output of the monopolist is 6 million units of the product or service
and is given by point E, at which the MC curve intersects the MR curve. The
monopolist sets P = $12 (point A on the D curve), faces AC = $8 (point B on the AC
curve), and thus earns a profit of $4 (AB) per unit and $24 million in total (the area of
rectangle ABCF).

(b) See Figure 10 on the next page.

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A lump-sum tax is like a fixed cost. As such, it shifts only the monopolist's AC curve
up. A lump-sum tax of $24 million would shift the AC curve up to AC', so that P = AC
= $12 at the best level of output of 6 million units (given by point E, at which MR =
MC) and the monopolist breaks even.

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(c) See Figure 11 on the previous page.

A per-unit tax of $3 is like a variable cost. As such, it shifts both the monopolist's AC
and MC curves up by $3. Thus, the best level of output of the monopolist is 5 million
units and is given by point E', at which the MC' curve intersects the MR curve. At Q =
5 million, P = $13 (point A' on the D curve), AC' = $13 (point A' on the AC' curve), so
that the monopolist earns a profit of $0 per unit and in total.

(d) See Figure 12 on the previous page.

If the government sets the price of the product or service that the monopolist sells at P =
$10, the market demand curve that the monopolist faces is given by GE"D and his or
her marginal revenue curve is given by GE"HNR. The monopolist would then behave
as a perfect competitor and produce 8 million units of the product or service, as
indicated by point E', at which P = MR = MC. At Q = 8 million units, AC = $7.5 (point
H on the AC curve), so that the firm would earn a profit of $2.5 (E"H) per unit and $20
million (the area of rectangle E"HTG) in total.

(e) The best method of controlling monopoly power is regulation that sets the price of the
product or service at the point at which the firm’s MC curve intersects the market
demand curve that the firm faces. At that point P = MC, the price is lower than with a
lump-sum tax or per-unit tax and the quantity produced and consumed is largest. The
firm, however, continues to earn a large profit.

Note that with a per-unit tax, the monopolist is able to shift part of the tax burden onto
the consumer. Thus, with a per-unit tax, the consumer pays the price of $13, as
compared with the price of $12 without any tax, and consumes 5 million units of the
product or service rather than the 6 million without any tax. In fact, the lower is the
price elasticity of demand, everything else being equal, the more of the burden of the
tax will the monopolist be able to pass on to consumers.

ANSWERS TO SPREADSHEET PROBLEMS

1. (a) The equilibrium price is $12 and the equilibrium quantity is 6.

(b) The socially optimal equilibrium price is $14 and the socially optimal equilibrium
quantity is 4.

(c) A corrective tax of $4 per-unit is required to bring production to the social optimum.

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2. (a) Since PD' is below PD, the marginal private benefit (MPB) exceeds the marginal
social benefit (MSB). Furthermore, since the divergence between marginal social and
private values are on the demand side, D' indicates the existence of external
diseconomies of consumption.

(b) The marginal external cost (MEC) at point E (the competitive equilibrium point) is $6
(the vertical distance between PD and PD' at Qx = 6) and MSB = MPB – MEC = $12 -
$6 = $6.

(c) The socially optimal price is PD = $10 and the socially optimal quantity is Q = 4 units
per time period (given by the point at which PD' intersects PS). However, P = $10 and
Q = 4 units may not be achieved under perfect competition without appropriate
government intervention.

(d) A corrective tax of $4 per unit imposed on the consumers of commodity X will make
PD'' = 14 – Q the new industry demand curve. With PD'', P = $10 and Q = 4 per time
period (where PD'' = PS). This is the socially optimal price and output. Consumers
would now pay P = $10 plus the $4 tax per unit or a net P = $14 (as compared with P
= $12 under the previous competitive equilibrium at point E).

(e) The total value of the economic gain resulting from the imposition of the corrective tax
is equal to $6. This is the excess of the MSC over MSB between Q = 4 and Q = 6 units.

A B C D E F G H I J
1
PD'
2 Q PD PS PD' '
3 1 17 7 16 13
4 2 16 8 14 12
5 3 15 9 12 11
6 4 14 10 10 10
7 5 13 11 8 MEC MPB 9
8 6 12 12 6 6 6 8
9 7 11 13 4 7
10 8 10 14 2 6
11 9 9 15 0 5
12 10 8 16 -2 4
13 11 7 17 -4 3
14
Economic
15 Gain
16 $6
17

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 CHAPTER 14

RISK ANALYSIS

14-1 RISK AND UNCERTAINTY IN MANAGERIAL DECISION MAKING

Case Study 14-1: The Risk Faced by Coca-Cola in Changing Its Secret Formula
Case Study 14-2: The Biggest Business Failures

14-2 MEASURING RISK WITH PROBABILITY DISTRIBUTIONS

Probability Distributions
An Absolute Measure of Risk: The Standard Deviation
Measuring Probabilities with the Normal Distribution
A Relative Measure of Risk: The Coefficient of Variation

14-3 UTILITY THEORY AND RISK AVERSION

Case Study 14-3: RiskMetrics: J. P. Morgan’s Method of Measuring Value at Risk
Case Study 14-4: The Purchase of Insurance and Gambling by the Same
Individual—A Seeming Contradiction

14-4 ADJUSTING THE VALUATION MODEL FOR RISK

Risk-Adjusted Discount Rates
Certainty-Equivalent Approach
Case Study 14-5: Adjusting the Valuation Model for Risk in the Real World

14-5 OTHER TECHNIQUES FOR INCORPORATING RISK IN DECISION-MAKING

Decision Trees
Simulation

14-6 DECISION-MAKING UNDER UNCERTAINTY

The Maximin Criterion
The Minimax Regret Criterion
Other Methods of Dealing with Uncertainty
Case Study 14-6: Spreading Risks in the Choice of a Portfolio

14-7 FOREIGN EXCHANGE RISKS AND HEDGING

Box 14 – Managerial Economics at Work: How Foreign Stocks Have Benefited a Domestic
Portfolio
Case Study 14-7: Information, Risk, and the Collapse of Long-Term Capital Management

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 CHAPTER 14 RISK ANALYSIS

14-8 INFORMATION AND RISK

Asymmetric Information and the Market for Lemons
The Insurance Market and Adverse Selection
The Problem of Moral Hazard
The Principal-Agent Problem
Case Study 14-9: Do Golden Parachutes Reward Failure?
Auctions
Case Study 14-9: Auctioning of the Airwaves

SUMMARY
DISCUSSION QUESTIONS
PROBLEMS
SPREADSHEET PROBLEMS
SUPPLEMENTARY READINGS
INTERNET SITE ADDRESSES
KEY TERMS (in the order of their appearance)
____________________________________________________________________________

Certainty Risk premium

Risk Certainty-equivalent coefficient (α)
Uncertainty Decision tree
State of nature Conditional probability
Probability Simulation
Probability distribution Sensitivity analysis
Expected profit Maximin criterion
Discrete probability distribution Minimax regret criterion
Continuous probability distribution Foreign-exchange rate
Standard deviation ( σ ) Hedging
Variance ( σ 2) Forward contract
Standard normal distribution Futures contract
Coefficient of variation (V) Asymmetric information
Risk seeker Adverse selection
Risk neutral Moral hazard
Risk averter Principal-agent problem
Diminishing marginal utility of money English auction
Util First-price sealed-bid auction
Expected utility Second-price sealed-bid auction
Risk-adjusted discount rate Dutch auction
Risk-return trade-off function Winner’s curse

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ANSWERS TO DISCUSSION QUESTIONS

1. Risk refers to the situation where there is more than one possible outcome to a decision and the
probability of each possible outcome is known or can be estimated.

Uncertainty is the case where there is more than one possible outcome to a decision and
where the probability of each specific outcome occurring is not known or even meaningful.

Probability distribution is the list of all possible outcomes of a decision or strategy and the
probability of occurrence attached to each.

Expected value is the sum of the product of each possible outcome of a decision or strategy
and the probability of its occurrence.

Standard deviation ( σ ) is a measure of the dispersion of possible outcomes from the

expected value; the square root of the variance.

n
Variance ( σ ) =Σ(Xi- X )2 • Pi, where Xi refers to outcome i, X is the expected value or mean
2

i=1
n
of all outcomes, Pi is the probability of outcome i, and Σ is the summation of outcomes iton.
i=1

The standard normal distribution is a bell-like distribution which is symmetrical about its
zero mean and with standard deviation equal to 1.

Coefficient of variation (v) is the standard deviation of the distribution divided by the
expected value or mean.

2. A discrete probability distribution can be represented by a step-like bar chart showing the
probability of occurrence of each outcome from a decision or strategy. On the other hand, a
continuous probability distribution can be represented by a smooth bell-like curve that can be
used to determine the probability that a particular outcome will fall within a given range of
outcomes.

The probability that a particular outcome will fall within a given range of outcomes is given
by the proportion of the area under the curve within the range of outcomes specified, to the
total area under the curve (set equal to 1 or 100 percent). If we assume that the distribution
of outcomes is approximately normally distributed, we can then use the table of the standard
normal distribution to find the areas (probabilities).

The tighter or less dispersed is the probability distribution about its expected value, the
smaller is the risk involved. A measure of the absolute dispersion of a probability
distribution (and risk of an investment decision) is given by the standard deviation.

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However, to compare the relative risk of investments with different expected values
(profits) we use the coefficient of variation. This is the ratio of the standard deviation of the
distribution divided by its expected value or mean.

3. If all the outcomes of a probability distribution are identical, the value of the standard deviation
and coefficient of variation are zero. The reason for this is that the deviation of each outcome
from the expected value or mean is zero. When the standard deviation and coefficient of
variation are zero, there is no risk. That is, we know with certainty the outcome of the strategy
or experiment.

Under uncertainty, the manager usually seeks to maximize profit. When risk is present, the
manager seeks to maximize expected profit, given the level of risk involved. That is, if two
projects have equal coefficients of variation, the manager will choose the project or
investment with the highest expected profit. Higher expected profits are required to balance
higher risks for risk-averse managers.

4. Diminishing marginal utility for money is reflected in a total utility for money curve that is
concave or faces down, so that its slope or marginal utility diminishes. This means that each
additional dollar of money income or wealth provides less extra utility to the individual. An
individual who faces diminishing marginal utility for money is risk averse and would not
accept a fair bet.

Constant marginal utility for money is reflected in a straight-line total utility for money
curve, so that its slope or marginal utility is constant. This means that each additional dollar
of money income or wealth provides the same extra utility to the individual. An individual
who faces constant marginal utility for money is risk neutral and would be indifferent to a
fair bet.

Finally, increasing marginal utility for money is reflected in a total utility for money curve
that is convex or faces up, so that its slope or marginal utility increases. This means that
each additional dollar of money income or wealth provides more and more utility to the
individual. An individual who faces increasing marginal utility for money is a risk seeker
and would accept even some unfair bets.

5. In managerial decision-making subject to risk, the manager seeks to maximize expected utility.
This is defined as the sum of the product of the utility associated with each possible outcome of
a decision or strategy and its probability of occurrence. Since most managers are risk averse
and face diminishing marginal utility for money income, a dollar earned provides less utility
than the utility loss associated with a dollar lost. Therefore, a risk averse manager will not
undertake a project with a positive expected monetary return if that corresponds to a negative
expected utility. Thus, in managerial decision-making subject to risk, the manager seeks to
maximize expected utility rather than expected monetary returns. Only if the manager is risk
neutral can the decision to undertake or not to undertake a project be based on the
maximization of expected monetary return. Indeed, in that case, the decision will be the same
whether it is based on the maximization of the expected monetary return or expected utility

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criterion. Since it is usually very difficult to come up with the actual utility function of a
manager or individual, this is a welcome situation. Most managers, however, are risk averse.

6. The expected utility of the project is

Expected utility of project = E(U) = 0.4(6 utils) + 0.6(-1 util) = 1.8

The manager should undertake the project if the expected utility per dollar of investment of
this project were higher than for any alternative project.

Under the alternative situation,

Expected utility of project = E(U) = 0.4(6 utils) + 0.6(-4 util) = 0

In this case, the manager would be indifferent as to whether or not to undertake the project.

7. A risk-adjusted discount rate refers to the higher rate of interest or discount used to calculate
the present value of a firm or the net cash flow (return) of a project in order to compensate for
risk. A risk-return trade-off function shows the various risk-return combinations among which
a manager or investor is indifferent. Risk premium is the excess in the expected or required rate
of return on a risky investment over the rate of return on a riskless asset in order to compensate
for risk.

The above concepts are useful in adjusting the valuation model of a firm or project for risk.
Specifically, a risk premium is added to the risk-free rate of interest or discount to calculate
the present value of a firm or the net cash flow (return) on a project in order to adjust for
risk.

8. The certainty-equivalent coefficient is the ratio of the certain sum equivalent to the expected
risky sum or net return from an investment that is used to adjust the valuation model for risk.

The certainty-equivalent coefficient reflects the decision maker's attitude toward risk. For a
risk averse decision-maker facing diminishing marginal utility from money, the value of the
certainty-equivalent coefficient ranges between zero and 1. The more risk averse is the
decision-maker, the smaller is the value of the certainty-equivalent coefficient that he or she
will attach to a particular investment project.

The certainty-equivalent coefficient is multiplied by the expected (risky) net cash flow or
returns from the investment in the numerator of the valuation model to determine their
certain sum equivalents, and using the risk-free discount rate in the denominator of the
valuation model.

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9. Each of the 5 different plant sizes that the firm can build can be associated with each of 4
possible ways that competitors may react. By themselves, these give (5)(4) = 20 possible
outcomes. Each of these 20 possible outcomes can then be associated with each of 3 different
economic conditions. Thus, we have an overall total of 60 possible outcomes.
That is, (5)(4)(3) = 60.

The probability of each possible outcome is obtained by multiplying the probability of

occurrence of each economic condition by the probability of each possible response by
competitors. Note that since the firm can decide or has control over which of the five plants
to build, no probability is attached to this decision or strategy.

10. Simulation refers to the use of a computer model of a managerial decision-making situation
involving risk that explicitly and simultaneously considers all the interactions among the
variables of the model and can be used to determine the probability distribution of the outcomes
or profit of a particular business strategy on the part of the firm. The probability distribution of
the firm’s profits can then be used to calculate the expected value of profits and the risk
involved. These can then be used by the firm to determine the optimal strategy.

Sensitivity analysis is a simulation procedure that is used to estimate the effect on the
output of the model or profit of the firm that results from changing the likely value or
estimate of one or more of the variables that are fed into the simulation model.

Simulation is used mostly to evaluate the outcomes of very complex business strategies
involving risk and millions of dollars of investments. Since the technique is usually very
expensive, it is not generally used to evaluate small and relatively simple investment
projects and possible business strategies.

11. Decision-making under uncertainty is necessarily subjective because the decision-maker does
not know and cannot estimate the probability associated with the possible outcomes of any
strategy. Therefore, he or she cannot estimate the expected payoff or return of any strategy and
risk involved.

The maximin criterion is a conservative and pessimistic decision rule because it considers
only the most pessimistic outcome of each strategy for the purpose of avoiding the worst of
all possible outcomes. For example, it would exclude any strategy which may have only a
slightly worse outcome than an alternative strategy even if the best outcome of the first
strategy might be very much larger than for the alternative strategy.
The maximin criterion or decision rule is appropriate when the firm has a very strong
aversion to risk, as for example, when the survival of a small firm depends on the avoidance
of losses. It might also be appropriate in oligopoly cases where there are few firms in the
market and the actions of one firm are likely to lead to retaliation by the others and lower
profits for all.

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12. The rationale behind the minimax regret decision rule is to minimize the maximum regret or
opportunity cost of making the wrong decision under each state of nature, after a particular state
of nature has actually occurred. The regret associated with each decision is measured by
subtracting the payoff from that decision from the maximum payoff under the same state of
nature. The decision-maker then chooses the strategy with the minimum of these maximum
regrets under any possible state of nature.

Some of the more informal and less precise methods of dealing with uncertainty are (1) the
acquisition of additional information (until the marginal benefit equals its marginal cost),
(2) referral to such authorities as the Internal Revenue Service, the Securities and Exchange
Commission, and the Labor Relations Board to remove the uncertainty about specific points
within their competence, (3) attempting to control the business environment in which the
firm operates by patents, copyrights, and exclusive franchises, (4) hedging (i.e., entering
into a contract to buy or sell a specific quantity of a commodity, security, foreign currency,
etc., for delivery at a future date, at a price agreed upon today), (5) diversification into
various product lines by a firm, different securities in a portfolio, and various lines of
business by a conglomerate corporation.

The minimax regret rule is useful when the decision-maker wants to minimize the
maximum regret or the opportunity cost of a decision under whatever state of nature occurs.
The other more informal and less precise methods of dealing with uncertainty are useful
under particular circumstances, and are often employed by experienced business executives.
Which of the more formal decision rules or more informal methods of dealing with
uncertainty are best depends on the circumstances, the firm's attitude toward uncertainty,
the type of investment decision that the firm faces, and so on.

13. An importer faces a foreign-exchange risk because he or she usually has to pay for imports
three months after receiving them, and in the meantime the foreign currency can appreciate
(which means that the importer will have to pay more in terms of the domestic currency than he
or she anticipated).

The importer can purchase now the amount of the foreign currency that he or she needs in
three months at today’s exchange rate and deposit it in a bank (and thus earn interest) until
the payment is due in three months. By doing this, the importer avoids the risk of a large
foreign-currency appreciation (domestic-currency depreciation).

Hedging usually takes place with a forward contract (in this case, a purchase of the amount
of the foreign currency due to coincide with the date of the foreign currency payment). The
reason for this is that the importer does not have to tie up his or her funds in foreign-
exchange deposits.

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14. An exporter faces a foreign-exchange risk because he or she usually receives payment for the
exports three months after shipping them, and in the meantime the foreign currency can
depreciate (which means that the exporter will receive less in terms of the domestic currency
than he or she anticipated).

The exporter can hedge the foreign exchange risk with a forward contract (in this case, a
sale of the amount of the foreign currency due to coincide with the date of the foreign
currency receipt).

15. Since credit-card companies must charge the same interest rate to all borrowers, they attract
more low- than high-quality borrowers (i.e., more borrowers who either do not repay their
debts or repay their debts late). This leads to an adverse selection problem and forces up the
interest rate charged, which increases even more the proportion of low-quality borrowers, until
interest rates would have to be so high that it would not pay even for low-quality borrowers to
borrow.

Credit-card companies reduce the adverse selection problem that they face by sharing the
credit histories of borrowers with other credit-card companies.

The sharing of borrowers’ credit histories by credit-card companies in order to reduce the
adverse selection problem that they face gives rise to complaints of invasion of privacy.
This is true, but without sharing credit histories, credit-card companies would have to
charge much higher credit rates, which might be unacceptable to most borrowers.

16. A principal-agent problem arises because the agents (managers) of a firm may seek to
maximize their own benefits (such as salaries) rather than the profits or value of the firm, which
is the owners’ or principals’ interest. The problem can be overcome by the firm offering big
bonuses its top managers based on the firm’s long-term performance and profitability.

17. There are four types of auctions: (1) the English or ascending bid (2) the first-price, sealed bid,
(3) the second-price, sealed-bid, and (4) the Dutch or descending bid. These differ on whether
the bidding is simultaneous or sequential, sealed or unsealed, and on the amount that the bidder
is required to pay. Auctions can give rise to the winner’s curve, or overpaying for an item by
placing the winning bid. This can be avoided by adopting a prudent bidding approach and not
overbid.

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ANSWERS TO PROBLEMS

1. (a) The expected value of investment I (RI) is

n
R I =Σ Ri Pi = ($4,000)(0.6) + ($6,000)(0.4) = $2,400 + $2,400 = $4,800
i=1

R II = ($3,000)(0.4) + ($5,000)(0.3) + ($7,000)(0.3)

$1,200 + $1,500 + $2,100 = $4,800

(b) See Figure 1 below.

(c) The calculation of the standard deviation of each investment is shown in Table 1 (on the
next page).

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(d) Since both projects have the same expected value or mean ($4,800) but the standard
deviation of investment I is lower than that of investment II, a risk averse manager
should choose investment I.

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2. (a) To determine that the area under the standard normal distribution within ± 1 σ is
68.26% we look up the value of z = 1.0 in Table C.1. This is 0.3413. This means that
the area to the right of the zero mean of the standard normal distribution to z = 1 is
0.3413 or 34.13%.

Because of symmetry, the area between the mean and z = -1 is also 0.3413 or 34.13%.
Therefore, the area between z = ±1 σ under the standard normal distribution is double
0.3413, which is 0.6826 or 68.26%.
From Table C.1, we get the value of 0.4772 for z = 2. Thus, the area under the
standard normal curve between z = ±2 σ is 2(0.4772), which equals 0.9544 or 95.44%.

From Table C.1, we get the value of 0.4987 for z=3. Thus, the area under the standard
normal curve between z ±3 σ is 0.9974 or 99.74%.

(b) For $650, z = $650-$500 = 2.12, which from Table C.1 gives 0.4830 or 48.30%.
$70.71
$300 - $500 $200
(c) For $300, z = = = 2.83, which from Table C.1 gives 0.4977.
$70.71
$70.71
This is the area between $300 and $500 (i.e., the probability that profit will fall
between $300 and $500). Therefore, the probability that profit will fall between $300
and $650 is equal to the probability that profit will fall between $300 and $500
(49.77%) plus the probability that profit will fall between $500 and $650 (found
earlier to be 48.30%), or 98.07.

The probability that profit will be lower than $300 is equal to 1.0 minus 0.9977, which
is 0.0023 or 0.23%. The probability that profit will be higher than $650 is 1.0 - 0.9830,
which is 0.017 or 1.7%.

3. (a) The expected value of Project A is

(0.4)(-$45) + (0.5)($35) + (0.1)($155) = -$18 + $17.50 + $15.50 = $15

The expected value of Project B is

0.4)(-$100) + (0.5)($60) + (0.1)($300) = -$40 + $30 + $3 = $20

Project B is preferred.

(b) The standard deviation is the square root of the variance.

The variance of Project A is

(0.4)(-$45 - $15)2 + (0.5)(-$35 - $15)2 + (0.1)($155 - $15) 2 =
(0.4)(-$602) + (0.5)($202) + (0.1)($1402) =
(0.4)($3,600) + (0.5)($400) + (0.1)($19,600) =
$1,400 + $200 + $1,960 = $3,600
So the standard deviation of the expected return to Project A is $60.

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The variance of Project B is

(0.4)(-$1202) + (0.5)($402) + (0.1)($2802) = $14,400
So the standard deviation of the expected to Project B is $120, which is larger than for A.

4. (a) To find the expected profit under each promotion strategy is shown in Table 2.

Table 2

Strategy Sales Profit Probability Expected Profit

(1) (2) (3) (4)=(2)(3)

A $ 8,000 $4,000 0.2 $ 800

10,000 5,000 0.3 1,500

12,000 6,000 0.3 1,800

14,000 7,000 0.2 1,400

Expected profit of strategy A = $ 5,500

B $ 8,000 $4,000 0.3 $1,200

12,000 6,000 0.4 2,400

16,000 8,000 0.3 2,400

Expected profit of Strategy B = $6,000

(b) The standard deviation of the distribution of profits under each promotion strategy is
calculated in Table 3 (on the next page).

(c) To determine which promotion strategy the firm should choose we must find the
coefficient of variation of the distribution of profits for each strategy. That is,

VA = σ A = $1,024.70 = 0.19
XA $5,500

VB = σ B = $1,549.19 = 0.26
XB $6,000

Since the coefficient of variation is higher for strategy B than for strategy A, strategy
B is more risky than strategy A.

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 CHAPTER 14 RISK ANALYSIS

(d) Strategy A is less risky than Strategy B, but it also has a lower expected profit. It is
not clear, therefore, from the information given which strategy is best. It depends on
whether the lower expected profit from strategy A is more than balanced by its lower
risk. This depends on the attitude of the manager toward risk.

5. (a) The expected monetary return of this investment (R) is

Expected Return = E(R) = 0.2($40,000) + 0.8(-$10,000) = $8,000 - $8,000 = 0

(b) The expected utility of the project for individuals A, B, and C are

E(U) of A = 0.2(10 utils) + 0.8(-5 utils) = 2 utils - 4 utils = -2 utils

E(U) of B = 0.2(20 utils) + 0.8(-5 utils) = 4 utils - 4 utils = 0 utils
E(U) of C = 0.2(30 utils) + 0.8(-5 utils) = 6 utils - 4 utils = 2 utils

Only individual C (the only individual for whom the marginal utility for money
increases) will invest in the venture because only for him or her the expected utility of
the project is positive. Because the marginal utility for money increases, individual C
is a risk seeker.

Individual B is indifferent to the venture because the expected utility of the project is
zero. For individual B, the marginal utility for money is constant, so that he or she is
risk neutral.

Individual A will not invest in the venture because the expected utility of the project is
negative. For individual A, the marginal utility for money is constant, so that he or she
is a risk averter.

6. (a) We can determine the manager’s attitude toward risk by substituting two dollar
amounts, one double the other, for M into the utility function and determining what
happens to the level of utility. For example, by substituting M = $10 and then M =
$20 into the manager’s utility function, we get

U = 100(10) - (10)2 = 1,000 - 100 = 900 utils

U = 100(20) - (20)2 = 2,000 - 400 = 1,600 utils

Since doubling M less than doubles U, the manager is risk averse.

(b) If the manager’s objective were to maximize profits, regardless of risk, he or she
would seek to maximize the expected monetary value of future net profits. The
expected profit of each project is calculated in Table 4 below. If the manager
disregarded risk, he or she would introduce product 1 because the expected profit from
product 1 ($20) exceeds the expected profit of product 2 ($18).

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PART FIVE REGULATION, RISK ANALYSIS, AND CAPITAL BUDGETING

Table 4

Project State Probability Profit Expected Profit

of (Pi) (π) (π)
Nature (1) (2) (3)=(1)(2)
1 Boom 0.2 $50 $10
Normal 0.5 20 10
Recession 0.3 0 0
Expected Profit from Product 1 = $20
2 Boom 0.2 $30 $6
Normal 0.4 20 8
Recession 0.4 10 4
Expected Profit from Product 2 = $18

(c) The risk per dollar of profit for product 1 and product 2 are

2 2 2
σ 1 = 0.2($50 - $20 ) + 0.5($20 - $20 ) + 0.3(0 - $20 )
= 0.2($900) + 0.5(0) + 0.3($400)
= $300
= $17.32
σ 1 = $23.87 = 1.19
V 1=
X1 $20
2 2 2
σ 2 = 0.2($30 - $18 ) + 0.4($20 - $18 ) + 0.4($10 - $18 )
= 0.2($144) + 0.4($1.60) + 0.4($64)
= $28.80 + $1.60 + $25.60
= $56
= $7.48
σ 2 = $7.48 = 0.42
V 2=
X2 $18

Since V1 (the coefficient of variation for product 1) is larger than V2, the introduction of
product 1 is more risky than the introduction of product 2.

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 CHAPTER 14 RISK ANALYSIS

(d) To determine which product to introduce we must calculate the expected utility
resulting from the introduction of each product. This is shown in Table 5. The utility
associated with each profit level shown in Table 5 is obtained by substituting the profit
level for M into the manager's utility function.

Table 5

State Probability Profit Associated Expected

of (Pi) (π) Utility Utility
Product Nature (1) (2) (3) (4)=(1)(3)
1 Boom 0.2 $50 2,500 500
Normal 0.5 20 1,600 800
Recession 0.3 0 0 0
Expected utility from Product 1 = 1,300 utils
2 Boom 0.2 $30 2,100 420
Normal 0.4 20 1,600 640
Recession 0.4 10 900 360
Expected utility from Product 2 = 1,420 utils

Since the expected utility from product 2 (1,420 utils) exceeds the expected utility
from product 1 (1,300 utils), the manager should introduce product 2.

7. (a) The net present value of project A and project B at the risk-free discount rate of 8
percent is

n
Rt -
NPV A = ∑ t C0
t=1 (1 + r )

$40,000 $60,000 $40,000

= + + - $110,000
1.08 (1.08 )2 (1.08 )3
$40,000 $60,000 $40,000
= + + - $110,000
1.08 1.1664 1.259712
= $37,037.04 + $51,440.33 + $31,753.29 - 110,000
= $10,230.66

$30,000 $80,000 $50,000

NPV B = + + - $104,000
1.08 (1.08 )2 (1.08 )3
= $27,777.78 + $68,587.11 + $39,691.61 - $104,000
= $32,056.50

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PART FIVE REGULATION, RISK ANALYSIS, AND CAPITAL BUDGETING

(b) With a risk premium of 2 percent for project A, the risk-adjusted discount rate is

$40,000 $60,000 $40,000

NPV A = + + - $110,000
1.10 (1.10 )2 (1.10 )3
$40,000 $60,000 $40,000
= + + - $110,000
1.10 1.21 1.331
= $36,363.64 + $49,586.78 + $30,052.59 - $110,000
= $6,003.01
8 + 2 = 10 percent. Thus,

On the other hand, with a risk premium of 6 percent for project B, the risk-adjusted
discount rate is 8 + 6 = 14 percent. Thus,

$30,000 $80,000 $50,000

NPV B = + + - $104,000
1.14 (1.14 )2 (1.14 )3
$30,000 $80,000 $50,000
= + + - $104,000
1.14 1.2996 1.481544
= $26,315.79 + $61,557.40 + $33,748.58 - $104,000
= $17,621.77

Even though project B is more risky than project A, it still gives a higher risk-adjusted
NPV than project A. Therefore, the manager should undertake project B rather than
project A.

8. To determine which of the two machines the Hotel should install, we must calculate the
expected value of the net cash flow in each year for each machine, the standard deviation as a
measure of risk, the risk-adjusted discount rate, and the net present value for each machine.
These are:

Expected net cash flow in each of four years:

Refreshing Machine = 0.25($6,000) + 0.50($5,000) + 0.25($4,000)

= $1,500 + $2,500 + $1,000

= $5,000

Cooling Machine = 0.25($7,000) + 0.5($5,000) + 0.25($3,000)

= $1,750 + $2,500 + $750

= $5,000

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 CHAPTER 14 RISK ANALYSIS

The standard deviation of the expected net cash flow for the Refreshing Machine is:

= 0.25($6,000 - $5,000 )2 + 0.50($5,000 - $5,000 )2 + 0.25($4,000 - $5,000 )2

= 0.25($1,000 )2 + 0.50(0 )2 + 0.25(-$1,000 )2
= $2,500,000 + 0 + $2,500,000
= $5,000,000
= $2236.07

The standard deviation of the expected net cash flow for the Cooling Machine is:

= 0.25($7,000 - $5,000 )2 + 0.50($5,000 - $5,000 )2 + 0.25($3,000 - $5,000 )2

= 0.25($2,000 )2 + 0.50(0 )2 + 0.25(-$2,000 )2
= $1,000,000 + 0 + $1,000,000
= $2,000,000
= $1,414.21

Since the standard deviation of the expected net cash flow from the Refreshing
Machine falls between $2,000 and $2,999, the Hotel should apply a risk premium of
10 percent. Thus, the risk-adjusted discount rate that the Hotel should use to calculate
the net present value of the Refreshing Machine is equal to the risk-free discount rate
of 10 percent plus the risk premium of 10 percent, or 20 percent.

On the other hand, since the standard deviation of the expected net cash flows from the
Cooling Machine falls between $1,000 and $1,999, the Hotel should apply the risk
premium of 4 percent, so that the risk-adjusted discount rate for the Cooling Machine
is 14 percent. Using these risk-adjusted discount rates, we get the net present value of
each machine as follows:

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PART FIVE REGULATION, RISK ANALYSIS, AND CAPITAL BUDGETING

For the Refreshing Machine,

n
NPV = ∑ Rt -
t C0
t=1 (1+ k )
4
$5,000
=∑ t
- $10,000
t=1 (1.20 )
n
1
= $5,000 ∑ - $10,000
t=1 (1.20 )t
= $5,000(2.5887) - $10,000
= $2,943.50

For the Cooling Machine,

4
$5,000
NPV = ∑ t
- $11,000
t=1 (1.14 )
n
1
= $5,000 ∑ - $11,000
t=1 (1.14 )t
= $5,000(2.9137) - $11,000
= $3,568.50

Since the NPV of the Cooling Machine is higher than the NPV of the Refreshing
Machine, the Hotel should install the former.

9. Multiplying the certainty-equivalent coefficient for each year (αt) by the expected cash flow for
each year ($5,000) for each machine, we get the certainty-equivalent value of the expected
return for each machine in each year shown below:

For Refreshing Machine For Cooling Machine

Year 1 0.90($5,000) = $4,500 0.96($5,000) = $4,800

Year 2 0.85($5,000) = $4,250 0.92($5,000) = $4,600

Year 3 0.75($5,000) = $3,750 0.90($5,000) = $4,500

Year 4 0.70($5,000) = $3,500 0.85($5,000) = $4,250

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 CHAPTER 14 RISK ANALYSIS

$4,500 $4,250 $3,750 $3,500

NPV = + + + - $10,000
1.10 (1.10 )2 (1.10 )3 (1.10 )4
$4,500 $4,250 $3,750 $3,500
= + + + - $10,000
1.10 1.21 1.331 1.4641
= $4,090.91 + $3,512.40 + $2,817.43 + $2,390.55 - $10,000
= $2,811.29
Using the certainty-equivalent returns for each machine for each year and the risk-free
discount rate of 10 percent, we get for Refreshing Machine:

This result is similar to the result obtained by the use of the risk-adjusted discount rate
of 20 percent in Problem 7.

$4,800 $4,600 $4,500 $4,250

NPV = + + + - $11,000
1.10 (1.10 )2 (1.10 )3 (1.10 )4
$4,800 $4,600 $4,500 $4,250
= + + + - $11,000
1.10 1.21 1.331 1.4641
= $4,363.64 + $3,801.65 + $3,380.92 + $2,902.80 - $11,000
= $3,449.02

For the Cooling Machine, we have:

This result is similar to the result obtained by the use of the risk-adjusted discount rate
of 14 percent in Problem 7. Thus, as in Problem 7, the Hotel should install the Cooling
Machine.

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PART FIVE REGULATION, RISK ANALYSIS, AND CAPITAL BUDGETING

10. The decision tree for the Fitness World Sporting Company to build either a large or a
small plant is given on the next page (Figure 2):

Being risk neutral, the Company should choose the strategy with the largest expected
present value. Thus, it should build the large plant. This results in the expected net present
value of $2,000,000 as compared with $1,000,000 for the small plant. The strategy of
building the small plant is then slashed off on the decision tree to indicate that it is
suboptimal.

11. The decision tree for the Beauty Company for the strategy of either introducing its new beauty
cream or investing in treasury bills is given in Figure 3 on the next page. Starting the analysis
of the decision tree from the right and moving to the left, we see that the firm’s strategy of a
low price leads to the highest expected value for the firm ($12,000). Thus, the firm’s strategy of
high and medium prices are slashed as suboptimal in section 3 of the figure. Finally, the firm’s
strategy of introducing the product leads to the expected value of

NPV = 0.8($12,000) + 0.2($40,000) = $17,600.

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 CHAPTER 14 RISK ANALYSIS

This compares with the certain return of $10,000 that the firm receives by investing an
equal sum in treasury bills. Whether the firm prefers the expected return of $17,600
resulting from the introduction of the new beauty cream to the $10,000 certain sum that it
would receive by investing the same amount of money in treasury bills depends on the
firm’s attitude toward risk (as examined earlier).

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PART FIVE REGULATION, RISK ANALYSIS, AND CAPITAL BUDGETING

12. (a) According to the maximin criterion, the firm should choose the project that provides the
best of the worst possible outcomes. This is project A, which has a payoff of $50
(indicated by the asterisk in the following table).

Table 6

Project State of Nature Maximin

Recession Normal Boom
A $50 $75 $ 85 $50*
B 40 80 100 40
C 30 70 70 30

(b) According to the minimax regret criterion, the firm should choose the project that
minimizes the maximum regret resulting from the wrong decision after the fact.
According to this criterion, this is project B, which has the minimum of the maximum
regrets of $10 (marked by the asterisk in the following table).

Table 7

Project State of Nature Regret Matrix Maximum

Regret
Recession Normal Boom Recession Normal Boom
A $50 $75 $ 85 $0 $5 $15 $15
B 40 80 100 10 0 0 10*
C 30 70 70 20 10 30 30

Note that while the best project of the firm is project A according to the maximin
criterion, it is project B according to the minimax regret criterion.

13. The US importer can hedge his foreign-exchange risk with a forward purchase of €100,000 for
$101,000 at today's three-month forward rate of $1.01/€1. In three months, the importer will
pay $101,000 and obtain the €100,000 with which to pay for his imports.

14. The US exporter can hedge his or her foreign-exchange risk with a forward sale of €100,000
for $101,000 at today’s three-month forward rate of $1.01/€1. In three months, the exporter will
receive $101,000 from the sale of the €100,000 that he or she received from the sale of his or
her exports.

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 CHAPTER 14 RISK ANALYSIS

15. The decision tree and the conditional probability of each outcome is shown in Figure 4, while
the calculations of the net present value of profits are presented in Figure 4A.

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PART FIVE REGULATION, RISK ANALYSIS, AND CAPITAL BUDGETING

As can be seen from column X of Figure 4A, the present value of net profits is
$451,389 for the $10 million plant and $1,772,509 for the $6 million plant. Therefore,
the Company should build the $6 million plant. The $10 million plant branch is thus
slashed off in section I of Figure 4 as suboptimal.

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 CHAPTER 14 RISK ANALYSIS

ANSWERS TO SPREADSHEET PROBLEMS

1. The expected value of investment A is ($4,000)(0.2) + ($5,000)(0.3) + ($6,000)(0.3) +

($7,000)(0.2) = $800 + $1,500 + $1,800 + $1,400 = $5,500.
The expected value of investment B is ($4,000)(0.3) + ($6,000)(0.4) + ($8,000)(0.3) = $1,200 +
$2,400 + $2,400 = $6,000.

(a) The standard deviation of investment A is $1,024.7. The standard deviation of

investment B is $1,549.19.

(b) Investment A is less risky than investment B, but it also provides a lower expected
income.

(c) It is not clear, therefore, from the information given which investment is best. It
depends on whether the lower expected income from investment A is more than
balanced by its lower risk. This depends on the attitude of the individual toward risk.

2.
A B C D
1
2 Conditions P(Condition) Project A Project B
3 Poor 0.40 $0 $2
4 Good 0.50 4 3
5 Excellent 0.10 8 4
6
7 Expected Value $2.80 $2.70
8
9 Expected Utility
10 Poor 0.0 1.8
11 Good 3.2 2.6
12 Excellent 4.8 3.2
13
14 Total Expected Utility 2.080 2.315
15

(a) From the spreadsheet, the expected value of Project A is higher, so it is preferred.

(b) Project B has a higher expected utility, however, so it is preferred under this criterion.

(c) The individual is risk averse because the utility function of profit increases at a
decreasing rate or faces down so that the marginal utility of profit diminishes.

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 CHAPTER 15

LONG-RUN INVESTMENT DECISIONS: CAPITAL BUDGETING

15-1 CAPITAL BUDGETING: AN OVERVIEW

Meaning and Importance of Capital Budgeting
Overview of the Capital Budgeting Process
Case Study 15-1: Cost-Benefit Analysis and the SST
Case Study 15-2: The Eurotunnel: Another Bad French-British Investment?

15-2 THE CAPITAL BUDGETING PROCESS

Projecting Cash Flows
Net Present Value (NPV)
Internal Rate of Return (IRR)
Comparison of NPV and IRR
Case Study 15-3: Pennzoil’s $3 Billion Capital Budgeting Challenge
Case Study 15-4: Capital Budgeting for Investments in Human Capital
Box 15 – Managerial Economics at Work: Is a College Education Still Worth It?

15-3 CAPITAL RATIONING AND THE PROFITABILITY INDEX

15-4 THE COST OF CAPITAL

The Cost of Debt
The Cost of Equity Capital: The Risk-Free Rate Plus Premium
The Cost of Equity Capital: The Dividend Valuation Model
The Cost of Equity Capital: The Capital Asset Pricing Model (CAPM)
The Weighted Cost of Capital
Case Study 15-5: The Choice between Equity and Debt
Case Study 15-6: Capital Budgeting Techniques of Major U.S. Firms

15-5 REVIEWING INVESTMENT PROJECTS AFTER IMPLEMENTATION

15-6 THE COST OF CAPITAL AND INTERNATIONAL COMPETITIVENESS

SUMMARY
DISCUSSION QUESTIONS
PROBLEMS
SPREADSHEET PROBLEMS

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SUPPLEMENTARY READINGS
INTERNET SITE ADDRESSES
INTEGRATING CASE STUDY 6: Deregulation, Risk, Capital Budgeting, and the Telecom
Crisis
KEY TERMS (in the order of their appearance)
__________________________________________________________________________________________

Capital budgeting Profitability index (PI)

Net cash flow from a project Cost of debt
Time value of money Dividend valuation model
Net present value (NPV) of a project Capital asset pricing model (CAPM)
Internal rate of return (IRR) on a project Beta Coefficient (ß)
Composite cost of capital

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ANSWERS TO DISCUSSION QUESTIONS

1. The theory of the firm postulates that in order to maximize total profits or the value of the firm,
a firm should expand production as long as the marginal revenue from the sale of the product
exceeds the marginal cost of producing it, and until marginal revenue exceeds marginal cost.

In a capital budgeting framework, this principle implies that the firm should undertake
additional investment projects as long as the return on the investment exceeds the cost of
raising the capital required to make the investment, and until the marginal return from the
project is equal to its marginal cost.

2. The general guidelines that a firm should follow in properly estimating the net cash flow from
an investment project are: (1) the net cash flow should be measured on an incremental basis
(i.e., by the difference between the stream of the firm’s net cash flow with and without the
project); (2) the net cash flow must be estimated on an after-tax basis, using the firm's marginal
tax rate, and (3) depreciation charges must be considered only in estimating the taxes that the
firm has to pay.

3. (a) The net cash flow exceeds the profit flow from a project by the amount of noncash
expenses that arise from the project. Noncash expenses are expenses that are
disbursed some time after they are actually incurred.

(b) Firms use the net cash flow rather than the profit flow from an investment project to
estimate the net present value of the project because noncash expenses are available to
and can be profitably invested by the firm until they are due to be actually disbursed.

4. (a) As noncash expenses, depreciation charges are subtracted from the sales revenues of
the firm in order to calculate the taxes that the firm has to pay, but they are then added
back to the firm's after-tax revenues to calculate the net cash flow from the project.

(b) The reason is that, while depreciation charges are tax deductible, they are available to
the firm over the economic life of the machinery and equipment (i.e., until the
machinery and equipment are actually replaced).

5. (a) The use of a higher risk-adjusted discount rate (k) reduces the net present value (NPV)
of a project and thus lowers the probability that the project will be undertaken by the
firm.

(b) The reason that the use of a higher k reduces the NPV of a project is that k appears in
the denominator of the formula (Equation 15-1 in the text) that is used to calculate the
NPV of a project.

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6. The NPV of a project is positive only when the IRR on a project exceeds the marginal cost of
capital to the firm (i.e., the risk-adjusted discount rate used by the firm). The NPV of a project
is zero when the IRR is equal to the marginal cost of capital, and negative when the IRR is
smaller than the marginal cost of capital to the firm.

Thus, the firm can use either the NPV or the IRR method in determining whether or not to
undertake a particular project. The conclusion would be the same when using either
method. That is, the firm should undertake a project only if the NPV of the project is
positive and the IRR on the project exceeds the marginal cost of capital to the firm.

The fact that the NPV of a project is positive indicates that the implicit rate of return on the
investment exceeds the cost of capital to the firm.

7. (a) Only when evaluating mutually exclusive investment projects can the NPV and the
IRR methods provide contradictory signals as to which investment project the firm
should undertake. For a single or independent project the two methods will always
give the same accept/reject investment signal.

(b) The NPV and IRR methods can provide contradictory investment signals because the
NPV method implicitly and conservatively assumes that the net cash flows generated
by the investment project are reinvested at the firm's cost of capital or risk-adjusted
discount rate, while the IRR method implicitly assumes that the net cash flows
generated by the investment project are reinvested at the same higher IRR earned on
the given project.

(c) When contradictory signals are provided by the NPV and the IRR methods, the former
should be used because the firm cannot assume that it can reinvest the net cash flows
from the project at the same higher IRR earned on the project.

8. (a) A firm might face capital rationing because of management's desire to avoid over-
expansion, overborrowing, and possibly losing control of the firm by selling more
stocks to raise additional capital.

(b) With capital rationing (i.e., when all the projects with positive NPV cannot be
undertaken) the firm should rank projects according to their profitability index (PI).
This is given by the ratio of the present value of the net cash flows from a project to its
cost.

(c) With capital rationing, the firm should rank and choose projects according to their
profitability indexes in order to avoid undertaking larger investment projects with
larger absolute NPVs but lower relative NPV or profitability per dollar invested.

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9. (a) The cost of debt capital is usually lower than the cost of equity capital to a firm for two
reasons. First, interest payments on borrowed funds (debt) are tax deductible while
dividends paid to the stockholders of the firm are not.

Secondly, the return (interest required to be paid) on bonds is usually lower than the
return on equity capital (dividend plus capital gains) because the firm must honor its
commitment to pay interest and principal on loans before paying dividends to
stockholders. Since lenders face a smaller risk than stockholders they naturally require
a smaller average return than stockholders.

(b) Firms do not rely exclusively on debt financing because they would probably be
unable to borrow as much funds as they need. Furthermore, the more the firm
borrows, the greater is the risk that lenders face and the higher is the rate of interest
that they require. At some point, the cost of debt will exceed the cost of equity capital.

In general, firms do not borrow up to the point where the interest rate that they must
pay on the marginal funds borrowed is equal to or larger than the cost of equity capital,
but raise debt and equity capital simultaneously and calculate the cost of funds as the
weighted average of the various types of funds that they utilize.

10. (a) A firm can raise equity capital internally by not paying out all profits of the firm in the
form of dividends.

(b) The cost to the firm of raising equity capital internally is the opportunity cost or
foregone return on these funds outside the firm that the firm must match. That is,
holders of the stock of the firm must receive a return on their stock holdings at least as
great as they could receive from similarly risky investments outside the firm.

(c) The firm need not pay dividends to raise equity capital internally or externally. Stock-
holders can receive a sufficiently large return on their investments from capital gains
(i.e., from the increase in the value of the firm’s stocks over time).

(d) Raising equity capital internally is generally less expensive than raising equity capital
externally because the former does not involve flotation costs (i.e., the cost of issuing
the stocks). These costs are sometimes not insignificant.

11. (a) Federal government securities are taken to be risk- free because of the almost complete
certainty that interest and principal payment obligations on these securities will be paid.
The risk-free rate usually used is the six-month treasury bill rate. Some practitioners,
however, prefer using the federal government bond rate.

(b) A firm’s stockholders face two additional types of risks in relation to holders of
government securities. The first is the greater risk that would result from holding
private bonds (on which payment obligations might not be made if the firm went
bankrupt) as opposed to government bonds. The second arises because obligations on
private bonds must be paid before stockholders can receive any dividends.

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12. Firms generally choose different debt/equity ratios depending on the relative stability of their
earnings over time. For example, public utilities generally have much higher debt/equity ratios
(financial leverage) than auto producers because the former have more secure and stable
earnings than the latter.

Facing much more secure and stable earnings, public utilities can absorb the greater risk
involved in having a much higher debt/equity ratio than automakers.

13. The marginal cost schedule of most firms slopes upwards because as the firm borrows more
and more funds it faces greater and greater risks that it will not be able to repay the loans. As a
result, lenders require higher and higher interest rates to compensate for the greater risk that
they face.

14. Calculation of the cost of the capital used by public utilities is crucial in determining the utility
rates that allow the public utility to earn a normal, and only a normal, return on its investment.
Sometimes minor differences in the method of estimating the cost of capital can result in
millions of extra dollars of profits or losses for the public utility.

15. Higher interest rates in the United States than abroad reduces the international competitiveness
of US firms in relation to foreign firms both at home and around the world in three ways.

First, it makes the cost of borrowing money higher for US than foreign firms. Second,
higher interest rates in the United States also require higher returns on stocks to attract
domestic and foreign equity capital, and so they further increase the cost of capital for
domestic firms in relation to foreign firms.

Third, higher interest rates in the United States than abroad increases the international value
of the dollar. This makes US exports more expensive and US imports cheaper than
otherwise and, thus, they further reduce the international competitiveness of US firms.

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ANSWERS TO PROBLEMS

1. See Figure 1 on the next page.

In Figure 1, the top of the lettered bars gives the firm’s demand for capital, while the step
MCC curve gives the marginal cost of capital to the firm.

From Figure 1, we can determine that the firm should undertake projects A, B, and C
because the rates of return expected from these projects exceed the marginal cost of raising
the capital required to undertake them.

On the other hand, the firm would not undertake projects D and E because the rates of
return that these projects are expected to generate are below the cost of capital.

2. (a) See Figure 2 on the next page.

(b) Smooth demand and MCC curves for capital are based on the condition that the firm
can make investments and raise funds in very small amounts in relation to the scale on
the horizontal axis.

(c) With the smooth demand for capital and MCC curves shown in Figure 2, the firm
would invest a total of $4.5 million and receive a return and incur a capital cost of 12
percent on the last dollar invested and raised. This is given by point F at the
intersection of the demand and MCC curves.

3. (a) If the firm uses the risk-adjusted discount rate (k) of 10 percent, the net present value
(NPV) of the project is

$290,000 $320,000 $353,000 $389,300 $779,230

NPV = 1
+ 2
+ 3
+ 4
+ - $1,000,000
(1.10 ) (1.10 ) (1.10 ) (1.10 ) (1.10 )5
$290,000 $320,000 $353,000 $389,300 $779,230
= + + + + - $1,000,000
1.1 1.21 1.331 1.4641 1.61051
= $263,636 + $264,462 + $265,214 + $265,897 + $483,841 - $1,000,000
= $1,543,051 - $1,000,000
= $543,051

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(b) If the firm uses instead the risk-adjusted discount rate (k) of 20 percent, the net present
value (NPV) of the project is:

$290,000 $320,000 $353,000 $389,300 $779,230

NPV = 1
+ 2
+ 3
+ 4
+ 5
- $1,000,000
(1.20 ) (1.20 ) (1.20 ) (1.20 ) (1.20 )
$290,000 $320,000 $353,000 $389,300 $779,230
= + + + + - $1,000,000
1.2 1.44 1.728 2.0736 2.48832
= $241,667 + $222,222 + $204,282 + $187,741 + $313,155 - $1,000,000
= $1,169,067 - $1,000,000
= $169,067
The same value could have been obtained more readily by multiplying the net cash
flow from the project in each year by the present value interest factor (PVIF) for i = k
= 20% and from n = t = 1 to n = t = 5 given in Table B.2 in Appendix B, as explained
in Appendix A at the end of the book.

(c) The value of the firm would increase by $543,051 (the net present value of the project)
if the firm used the risk-adjusted discount rate of 10 percent and would increase by
$169,067 if the firm used the risk-adjusted discount rate of 20 percent. Since the net
present value of the project is positive in either case, the firm should undertake the
project.

4. (a) The net cash flow from the project are summarized in Table 1.

Table 1

Estimated Cash Flow from Project

Year
1 2 3 4
Sales $10,000,000. $12,000,000. $14,400,000. $14,400,100.
Less: variable costs 4,000,000. 4,800,000. 5,760,000. 5,760,000.
Less: Fixed costs 1,000,000. 1,000,000. 1,000,000. 1,000,000.
Less: Depreciation 2,500,000. 2,500,000. 2,500,000. 2,500,000.
Profit before taxes $2,500,000. $3,700,000. $5,140,000. $5,140,000.
Less: Income tax 1,000,000. 1,480,000. 2,056,000. 2,056,000.
Profit after tax $1,500,000. $2,220,000. $3,084,000. $3,084,000.
Plus: Depreciation 2,500,000. 2,500,000. 2,500,000. 2,500,000.
Net cash flow $4,000,000. $4,720,000. $5,584,000. $5,584,000.
Plus: Recovery of working capital $1,500,000.
Net cash flow in year 4 $7,084,000.

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(b)

$4,000,000 $4,720,000 $5,584,000 $7,084,000

NPV = + + + - $10,000,000
(1.20 )1 (1.20 )2 (1.20 )3 (1.20 )4
= $13,258,842 - $10,000,000
= $3,258,842

(c) Since the NPV of the project is positive, the firm should undertake the project.
Undertaking the project would increase the value of the firm by the amount of the
NPV of the project (i.e., by $3,258,842).

5. The net present value of the project is obtained from

n
NPV = ∑ Rt -
t C0
t=1 (1+ k )
4
$5,000,000
=∑ t
- $10,000,000
t=1 (1 + 0.20 )

= $5,000,000( PVIFA20,4 ) - $10,000,000

= $5,000,000(2.5887) - $10,000,000
= $12,943,500 - $10,000,000
= $2,943,500

Since NPV > 0 the firm should undertake the project. Note that PVIFA20,4 refers to the
present value interest factor of an annuity of $1 for 4 years discounted at 20 percent (see
Section A4 of Appendix A at the end of the book).

6. The internal rate of return (IRR) is the rate of discount (k*) that equates the present value of the
net cash flow from the project to the initial $10 million cost of the project. We can do this by
trial-and-error. Starting with the arbitrary discount rate of 28 percent, we find that the present
value of the net cash flow from the project is:

$4,000,000 $4,720,000 $5,584,000 $7,084,000

+ + + = $11,307,529
(1.28 )1 (1.28 )2 (1.28 )3 (1.28 )4

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Since this exceeds the initial $10 million cost of the project, we have to use a larger
discount rate.

$4,000,000 $4,720,000 $5,584,000 $7,084,000

+ + + = $9,783,597
(1.36 )1 (1.36 )2 (1.36 )3 (1.36 )4

Using the discount rate of 36 percent, we get the present value of the net cash flow from the
project of:

Since this is smaller than the initial $10 million cost of the project, we have to use a
discount rate between 28 and 36 percent.

$4,000,000 $4,720,000 $5,584,000 $7,084,000

+ + + = $9,954,994
(1.35 )1 (1.35 )2 (1.35 )3 (1.35 )4

Using a discount rate of 35 percent, we get a present value of the net cash flow from the
project of Since this is very close to the initial $10 million cost of the project the discount
rate of 35 percent is the internal rate of return (IRR = k*) on this project.

7. (a) Using Table B.2 in Appendix B at the end of the book, the firm can find that the NPV
of project A is $1,137,210 and the NPV of project B is $1,216,904.

(b) By using trial-and-error and Table B.2, the firm can find that the IRR on project A lies
between 15 percent and 16 percent (it is actually 15.2%), while the IRR on project B
lies between 14 percent and 15 percent (it is actually 14.6%).

(c) Since investment projects A and B are mutually exclusive, and the NPV and the IRR
methods give contradictory results, the firm should undertake project B because its
NPV is higher than for project A. The reason is that the firm cannot assume that it can
reinvest the net cash flows generated by the project chosen at the same higher IRR that
it earns on the investment project chosen.

8. (a) The NPV of each project is obtained by subtracting from the present value of the net
cash flows (PVNCF) for each project the initial cost of the investment (C0).

Thus, NPV = $600,000 for project A, $450,000 for project B, and $300,000 for project C.
With capital rationing, the firm can undertake either project A only or projects B and C.
Ranking projects according to their NPV, the firm would undertake project A.

(b) Since the firm faces capital rationing, however, it should use the profitability index
(PI) as its investment criterion. The PI of each project is given by the ratio of the
PVNCF to the C0 of each project.
For project A, PI = $3,000,000/$2,400,000 = 1.25.
For project B, PI = $1,750,000/$1,300,000 = 1.35.
For project C, PI = $1,400,000/$1,100,000 = 1.27.

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Using the PI investment criterion indicates that the firm should undertake projects B
and C. The reason for this is that projects B and C provide a higher rate of return per
dollar invested than project A. Note that the sum of the NPV of projects B and C
exceeds the NPV for project A.

9. The cost of equity capital for the firm (ke) can be calculated by the risk-free rate or rate on
government securities (rf) plus the risk premium required to induce investors to buy the stock of
the firm (rp). That is,

ke = rf + rp

The value of rp is given by p1 plus p2, where p1 is equal to r - rf and p2 is the additional
premium required in order to induce investors to purchase the firm's stock as opposed to
purchasing the firm's bonds. Historically, the value of p2 has been about 4 percent. Thus,
the cost of equity capital to this firm is

ke = r f + p 1 + p 2

= 7% + (9%-7%) + 4%

= 13%

10. The cost of equity capital for this firm (ke) can be calculated with the dividend valuation model,
as follows

ke =D + g
P

where D is the amount of the yearly dividend paid per share of the common stock of the
firm, P is the price of a share of the common stock of the firm, and g is the expected annual
growth rate of dividend payments.

Since the company pays half of its expected $200 million in net after-tax earnings in
dividends and there are 100 million shares of common stock of the firm, the dividend per
share is $1. With a share of the common stock of the firm selling for eight times current
earnings, the price of a share of the common stock of the firm is $8.

With the expected annual growth of earnings and dividends of the firm of 7.5 percent, the
cost of equity capital for this firm is

ke =$1 + 0.075 = 0.125 + 0.075 = 0.20 or 20%

$8

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11. (a) The cost of debt (kd) is given by the interest rate that the firm must pay on its bonds (r)
times 1 minus the firm’s marginal income tax rate. That is,

kd = r(1 - t) = 11%(1 - 0.4) = 6.6%

(b) The cost of equity capital (ke) found by the capital asset pricing model (CAPM) is given
by

ke = rf + ß(km - rf)

where rf is the risk-free rate (i.e., the interest rate on government securities), km is the
return on the average stock of all firms in the market, and ß is the estimated beta
coefficient for the common stock of this firm.

With rf = 7.5%, km = 11.55%, and ß = 2, the cost of equity capital for this firm found
with the CAPM is

ke = 7.5% + 2(11.55% - 7.5%) = 15.6%

(c) The composite cost of capital (kc) is given by

kc = wdkd + weke

where wd and we are, respectively, the proportion of debt and equity capital in the firm's
capital structure.

With wd = 0.4, we = 0.6, kd=6.6%, and the cost of equity capital of ke=15.6%, the
composite cost of capital for this firm is

kc = 0.4(6.6%) + 0.6(15.6%) = 12.0%

This is the composite marginal cost of capital that we have used to evaluate the
investment projects open to the firm in Problems 1 and 2.

12. (a)
Investment Risks and Returns in the United States, 1926–2000
_________________________________________________________________
Real Rate of Risk
Asset Return (%) (Standard Deviation, %)
_________________________________________________________________
Common Stocks 9.8 20.2
Long-term Corporate Bonds 2.8 8.7
US Treasury Bills 0.7 3.2
_________________________________________________________________
Source: Ibbotson & Associates, Stocks, Bonds, Bills, and Inflation, 2001Yearbook.

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(b) The above table shows that riskier assets, such as common stocks or long-term
corporate bonds, have provided higher average real rates of return than more liquid and
less risky assets, such as US (three-month) Treasury Bills, in the United States over the
period = 1926 to 2000.

Common stocks involve a great deal of variability risk while long-term corporate bonds
involve a greater default risk and are less liquid (and therefore provide higher average
real returns) than US Treasury Bills. Clearly, risk-averse investors must balance
expected returns against risk in their investment decisions.

13. (a) The benefits that the United States received from foreign direct investments are more
jobs, higher wages, more taxes collected, better technology, and faster national growth.

(b) The possible harmful effects that might result for the United States from foreign
investments are the possibility of technological transfer to foreign nations, the reduced
return on domestic investments (as the total supply of investments increases), and the
possibility (remote) of foreign domination.

(c) Since a great deal of foreign investments in the United States during the past decade
went into capital formation rather than simply financing consumption, there is a strong
presumption that foreign investments were, on balance, beneficial to the United States.

14. (a) Foreign Direct Investment Flows to the United

States in Selected Years, 1980–2004 (billions of US dollars)
Year FDI Year FDI____
1980 $16.9 1995 $ 57.2
1981 25.2 1996 79.9
1982 12.6 1997 69.7
1983 10.4 1998 215.3
1984 24.5 1999 275.0
1985 19.7 2000 335.6
1986 35.4 2001 147.1
1987 58.5 2002 54.5
1988 57.7 2003 63.6
1989 68.3 2004 86.2
1990 48.5 2005 91.4
1991 23.2 2006 243.2
1992 15.3 2007 275.8
1993 26.2 2008 319.7
1994 45.6 2009 152.1
Source: Survey of Current Business, Various Issues

(b) Foreign direct investments in the United States are clearly cyclical, rising during
periods of of rapid growth and falling during periods of recession (1981–1982, 1991–
1992, and 2001).

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15. (a) The internal rate of return (IRR) on the project is obtained by solving the following
n

∑ (1+Rk * ) = C
t=1
t
t 0

equation for k*:

Substituting $32,000 for Rt, $100,000 for C0, and 5 for n into the above equation, we get
5
$32,000
∑ (1+ k * ) = $100,000
t=1
t

Using either Table B.2 or Table B.4, we find that the internal rate of return on this
project (k*) is 18 percent (i.e., with k* = 18%, the present value of $32,000 for five
years is equal to $100,070).

(b) The cost of debt (kd) is given by the interest rate that the corporation must pay on the
bonds (r) times 1 minus the corporation's marginal income tax rate. That is,

kd = r(1 - t) = 12%(1 - 0.4) = 7.2%

(c) The cost of equity capital for the firm (ke) is calculated by the risk-free rate or rate on
government securities (rf) plus the risk premium required to induce investors to buy the
stock of the corporation (rp). That is,

ke = rf + rp

The value of rp is given by p1 plus p2, where p1 is equal to r - rf and p2 is the additional
premium required in order to induce investors to purchase the corporation’s stock as
opposed to purchasing the corporation’s bonds. Historically, the value of p2 has been
about 4 percent. Thus, the cost of equity capital to this corporation using this method is

ke = rf + p1 + p2

= 10% + (12% -10%) + 4%

= 16%

(d) The cost of equity capital for this firm (ke) can be calculated with the dividend valuation
model, as follows:

ke = D + g
P

where D is the amount of the yearly dividend paid per share on the common stock of the
firm, P is the price of a share of the common stock of the firm, and g is the expected
annual growth rate in dividend payments.

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Since a share of the common stock of the firm sells for ten times current earnings or
dividend of $20 per share, the price of a share of the common stock of the firm is $200.

With the expected annual growth of earnings and dividends of the firm of 7 percent, the
cost of equity capital for this firm using this method is

ke = $1 + 0.07 = 0.10 + 0.07 = 0.17 or 17%

$10

(e) The cost of equity capital (ke) found by the capital asset pricing model (CAPM) is given
by

ke = rf + ß(km - rf)

where rf is the risk-free rate (i.e., the interest rate on government securities), km is the
return on the average stock of all firms in the market and ß is the estimated beta
coefficient for the common stock of this corporation.

With rf = 10%, km = 14%, and ß = 1.25, the cost of equity capital for this corporation
found by the CAPM is

ke = 10% + 1.25(14% - 10%) = 15%

(f) The composite cost of capital (kc) is given by

kc = wdkd + weke

where wd and we are, respectively, the proportion of debt and equity capital in the firm's
capital structure.

With wd = 0.3, we = 0.7, kd = 7.2%, and the average cost of equity capital found by the
three methods of ke = 16%, the composite cost of capital for this corporation is

kc = 0.3(7.2%) + 0.7(16%) = 13.36

(g) Since the internal rate of return (IRR) on the project is 18 percent, which exceeds the
composite cost of capital of 13.36 percent for this corporation, the corporation
shouldundertake the proposed project. By doing so, the profits and the value of the firm
will increase.

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PART FIVE REGULATION, RISK ANALYSIS, AND CAPITAL BUDGETING

ANSWER TO SPREADSHEET PROBLEMS

1.

A B C D E F G
1
Present
Investment Value Present
End of (Year 0) Net Coefficient Value of Net
2 Year and Cost Revenue Revenue 1/(1 + 0.05)n Revenue
3 0 $1,000 — -$1,000 — -$1,000
4 1 200 $600 400 0.952 381
5 2 300 800 500 0.907 454
6 3 300 800 500 0.864 432
7 4 400 800 400 0.823 329
8 4 … 200* 200 0.823 165/$761
9

2. The cost of equity capital for this firm (ke) can be calculated with the dividend model as follows

ke = D/P + g

where D is the amount of the yearly dividend paid per share of the common stock of the
firm, P is the price of a share of the common stock of the firm, and g is the expected annual
growth rate of dividend payments. Since the company pays half of its expected $200
million in net after-tax earnings in dividends and there are 100 million shares of common
stock of the firm, the dividend per share is $1. With a share of the common stock of the
firm selling for eight times current earnings, the price of a share of the common stock of the
firm is $8.

With the expected annual growth of earnings and dividends of the firm of 7.5%, the cost of
equity capital for this firm is

ke = $1/$8 + 0.075 = 0.125 + 0.075 = 0.20 or 20%

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