Demand Analysis and Estimation 103

Chapter 5

DEMAND ANALYSIS AND ESTIMATION

QUESTIONS & ANSWERS

Q5.1 "The utility derived from consumption is intangible and unobservable. Therefore, the
utility concept has no practical value.” Discuss this statement.

Q5.1 ANSWER

The utility derived from consumption is intangible, and therefore unobservable.

However, when goods and services provide utility to consumers, there is a direct and
measurable influence on their purchase decisions. Through their revealed
preferences, consumers convey their evaluation of the value, or worth, of individual
products. While the value derived through consumption is intangible, it leads to
purchase decisions that can be monitored and responded to by firms.

Q5.2 Is an increase in total utility or satisfaction following an increase in income

consistent with the law of diminishing marginal utility?

Q5.2 ANSWER

Yes, the law of diminishing marginal utility states that the marginal utility derived
from consumption will eventually diminish as consumption increases during a given
time period. This means that the addition to total utility per dollar of income will
tend to fall as total income rises. Despite the fact that total utility, or well-being,
tends to rise with income, it is typical that the marginal utility derived per dollar of
income tends to fall as income rises -- as is predicted by the law of diminishing
marginal utility.

Q5.3 Prospective car buyers are sometimes confronted by sales representatives who argue
that they can offer a vehicle that is “just as good as a BMW, but at one-half the
price.” Use the indifference concept to explain why the claims of the sales
representative are not credible.

Q5.3 ANSWER

If two products provide the same amount of satisfaction or utility, the consumer is
said to display indifference between the two. Indifference implies equivalence in the
104 Chapter 5

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

Q5.4 Following a price change for Diet Coke, explain how retailers use sales information
to learn if Doritos snack chips represent a complement or substitute for Diet Coke.

Q5.4 ANSWER

Following a price change, companies use sales information to distinguish

complements from substitutes by noting the size and direction of effects on demand
for related products. Demand curves are downward sloping. As a result, when the
price of a product is decreased, sales of that product rise. At the same time, sales of
substitutes fall as customers switch to the now lower-priced alternative. When the
price of a product rises, sales of that product fall but sales of substitute products rise
as customers switch to the substitute’s relative bargain price. There is a positive
correlation between price changes and units sold when two products are substitutes.
Sales of substitutes change in the same direction of the price change for substitute
products.
Conversely, when the price of a product is decreased, sales of that product and
complements both rise. When the price of a product rises, sales of that product fall
as do sales of complementary products. There is an inverse correlation between price
changes and units sold when two products are complements.

Q5.5 During the past 40 years the average price of a new single-family home has risen by
a factor of ten, making the cost of housing prohibitive for many Americans. Over the
same time frame, however, the number of units sold per year has more than doubled.
Are these data inconsistent with the idea of a downward-sloping demand curve for
new housing?
Demand Analysis and Estimation 105

Q5.5 ANSWER

No, these data are consistent with a downward-sloping demand curve for new
housing. For most goods and services, the price charged is the most important
determinant of sales. Quantity demanded falls with a price increase, and rises with a
price decrease. In the case of housing, the quantity demanded would have fallen as
prices rose except for the overwhelming influence of rising incomes over time.
Housing is a normal good. Housing demand rises sharply during economic
expansions and contracts during recessions. Over long periods of time, housing
demand rises slowly and steadily as economic growth raises disposable income. It is
vital that students separate out price and income effects when considering the
demand for housing and other products.

Q5.6 What would an upward-sloping demand curve imply about the marginal utility
derived from consumption? Why aren't upward sloping demand curves observed in
the real world?

Q5.6 ANSWER

The law of diminishing marginal utility states that the marginal utility derived will
fall as the consumption of a given product increases during a given time interval.
This gives rise to a downward sloping demand curve for all goods and services. For
a given demand curve to be upward sloping, an increasing marginal utility of
consumption would have to be operative. This is counter to human nature. Despite
myths that sometimes arise concerning the pricing of some luxury goods, like
perfume, there is no real-world evidence of upward sloping demand curves.
In this regard, it is worth emphasizing the fact that an upward sloping demand
curve implies that higher prices lead to an increase in quantity demanded. Under
such a wonderful circumstance, firms would have an incentive to charge higher and
higher prices (“to infinity and beyond!”). Nothing would limit the firm’s ability to
gain revenues by raising prices. In the real world, higher prices eventually result in
some buyers being priced out of the market and to an eventual downturn in revenues.

Q5.7 How is a price-consumption curve related to a demand curve?

Q5.7 ANSWER

If income and the prices of other goods and services are held constant, a reduction in
the price of a given consumption item causes consumers to choose different market
baskets. The various market baskets that maximize utility at different prices for a
given item trace out the consumer’s price-consumption curve. For example, the
price-consumption curve shows how the optimal consumption of both goods and
106 Chapter 5

services are affected by changing prices for services. A similar price-consumption

curve could be used to illustrate how the optimal consumption of both goods and
services are affected by changing prices for goods. On the other hand, the demand
curve for services shows how the quantity demanded of services rises in a response
to a fall in the price for services. A similar individual demand curve could be used to
illustrate how the quantity demanded of goods rises in a response to a fall in prices
for goods.

Q5.8 An estimated 80% increase in the retail price of cigarettes is necessary to cause a
30% drop in the number of cigarettes sold. Would such a price increase help or hurt
tobacco industry profits? What would be the likely effect on industry profits if this
price boost was simply caused by a $1.50 per pack increase in cigarette excise
taxes?

Q5.8 ANSWER

The price elasticity of demand for cigarettes is highly inelastic if an 80% increase in
retail prices would cause only a 30% drop in the number of cigarettes sold. An arc
price elasticity for cigarettes on the order of E P = -0.375 (= -30%/80%) implies that
tobacco industry revenues would rise sharply following a big price increase. Since
the variable costs of producing and selling cigarettes would fall with a 30% drop in
the number of cigarettes sold, a significant industry-wide increase in cigarette prices
could cause industry profits to explode on the upside.
It is less certain what would happen to tobacco industry profits if the price
increase described above were the simple result of an increase in excise taxes on each
pack of cigarettes sold. For example, a new $1.50 tax on a pack of cigarettes would
increase typical retail prices from $1.88 to $3.38 per pack, or by roughly 80%. If all
new revenues went to the government in the form of taxes, then industry revenues
and variable costs would both fall by 30% following a 30% drop in unit sales.
Unless the tobacco industry cut fixed expenses, industry profits would fall in the long
run. On the other hand, with such inelastic demand and government-sanctioned price
increases, the tobacco industry might be expected to lobby hard for further profit-
enhancing price increases in the post tax-increase era.

Q5.9 Individual consumer demand declines for inferior goods as personal income
increases because consumers replace them with more desirable alternatives. Is an
inverse relation between demand and national income likely for such products?

Q5.9 ANSWER

No, not usually. Theoretically, it is plausible that the aggregate demand for some
goods and services might be counter-cyclical, actually rising during a business
recession and falling during an economic boom. After all, if individual consumers
Demand Analysis and Estimation 107

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

Q5.10 In the United States, high-wage workers shun public transit and drive cars to work.
These same high-income individuals often support massive subsidies for public
transit. Use the concept of revealed preference to explain the public demand for
108 Chapter 5

transportation. Can you explain this consumer behavior by high-income

individuals?

Q5.10 ANSWER

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

SELF-TEST PROBLEMS AND SOLUTIONS

ST5.1 Individual Demand Curve. Alex P. Keaton is an ardent baseball fan. The following
table shows the relation between the number of games he attends per month during
the season and the total utility he derives from baseball game consumption:

Number of Baseball Games per Month Total Utility

0 0
1 50
2 90
3 120
4 140
5 150

A. Construct a table showing Keaton's marginal utility derived from baseball

game consumption.
Demand Analysis and Estimation 109

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

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

D. Plot Keaton's baseball game demand curve.

ST5.1 SOLUTION

A.
Number of Baseball Total Marginal
Games Per Month Utility Utility
0 0 --
1 50 50
2 90 40
3 120 30
4 140 20
5 150 10

B. At one baseball game per month, MU = 50. Thus, at a $25 price per baseball game,
the cost per unit of marginal utility derived from baseball game consumption is
P/MU = $25/50 = $0.50 or 50¢ per util.

C. At a maximum acceptable price of 50¢ per util, Keaton's maximum acceptable price
for baseball game tickets varies according to the following schedule:

Maximum
Number Marginal Acceptable
of Games Utility price
Per Month Total Utility MU = ΔU/ΔG at 50¢ per MU
0 0 -- --
1 50 50 $25.00
2 90 40 20.00
110 Chapter 5

3 120 30 15.00
4 140 20 10.00
5 150 10 5.00

D. Keaton's baseball ticket demand curve is:

Keaton's B aseball Ticket Demand C urve

$35

$30

Demand cur ve
$25

$20

$15

$10

$5

$0
0 1 2 3 4 5

Number of games

ST5.2 Elasticity Estimation. Distinctive Designs, Inc., imports and distributes dress and
sports watches. At the end of the company's fiscal year, brand manager Charlie
Pace has asked you to evaluate sales of the sports watch line using the following
data:
Number of Sports Watch
Sports Watches Advertising Sports Watch Dress Watch
Month Sold Expenditures Price, P Price, PD
July 4,500 $10,000 26 50
August 5,500 10,000 24 50
Septembe 4,500 9,200 24 50
r
October 3,500 9,200 24 46
November 5,000 9,750 25 50
December 15,000 9,750 20 50
January 5,000 8,350 25 50
February 4,000 7,850 25 50
March 5,500 9,500 25 55
April 6,000 8,500 24 51
Demand Analysis and Estimation 111

Number of Sports Watch

Sports Watches Advertising Sports Watch Dress Watch
Month Sold Expenditures Price, P Price, PD
May 4,000 8,500 26 51
June 5,000 8,500 26 57

In particular, Pace has asked you to estimate relevant demand elasticities.

Remember that to estimate the required elasticities, you should consider months only
when the other important factors considered in the preceding table have not
changed. Also note that by restricting your analysis to consecutive months, changes
in any additional factors not explicitly included in the analysis are less likely to
affect estimated elasticities. Finally, the average arc elasticity of demand for each
factor is simply the average of monthly elasticities calculated during the past year.

A. Indicate whether there was or was not a change in each respective independent
variable for each month pair during the past year.

Sports Watch
Advertising Sports Watch Dress Watch
Month-Pair Expenditures, A Price, P Price, PD
July-August ____________ ____________ ____________
August-September ____________ ____________ ____________
September-October ____________ ____________ ____________
October-November ____________ ____________ ____________
November- ____________ ____________ ____________
December
December-January ____________ ____________ ____________
January-February ____________ ____________ ____________
February-March ____________ ____________ ____________
March-April ____________ ____________ ____________
April-May ____________ ____________ ____________
May-June ____________ ____________ ____________

B. Calculate and interpret the average advertising arc elasticity of demand for
sports watches.

C. Calculate and interpret the average arc price elasticity of demand for sports
watches.
 112 Chapter 5

D. Calculate and interpret the average arc cross-price elasticity of demand

between sports and dress watches.

ST5.2 SOLUTION

A.

Sports Watch
Advertising Sports Watch Dress Watch
Month-Pair Expenditures, A Price, P Price, PD
July-August No change Change No change
August-September Change No change No change
September-October No change No change Change
October-November Change Change Change
November-December No change Change No change
December-January Change Change No change
January-February Change No change No change
February-March Change No change Change
March-April Change Change Change
April-May No change Change No change
May-June No change No change Change

B. In calculating the arc advertising elasticity of demand, only consider consecutive

months when there was a change in advertising but no change in the prices of sports
and dress watches:

August-September

 Q A 2 + A1
EA = 
 A Q2 + Q1
4,500 - 5,500 $9,200 + $10,000
= 
$9,200 - $10,000 4,500 + 5,500
= 2.4

January-February
Demand Analysis and Estimation 113

 Q A 2 + A1
EA = 
 A Q2 + Q1
4,000 - 5,000 $7,850 + $8,350
= 
$7,850 - $8,350 4,000 + 5,000
= 3.6
On average, EA = (2.4 + 3.6)/2 = 3 and demand will rise 3%, with a 1%
increase in advertising. Thus, demand appears quite sensitive to advertising.

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

July-August

 Q P 2 + P1
EP = 
 P Q 2 + Q1
5,500 - 4,500 $24 + $26
= 
$24 - $26 5,500 + 4,500
= - 2.5

November-December

 Q P 2 + P1
EP = 
 P Q 2 + Q1
15,000 - 5,000 $20 + $25
= 
$20 - $25 15,000 + 5,000
= - 4.5

April-May

 Q P 2 + P1
EP = x
 P Q2 + Q1
4,000 - 6,000 $26 + $24
= x
$26 - $24 4,000 + 6,000
= -5
On average, EP = [(-2.5) + (-4.5) + (-5)]/3 = -4. A 1% increase (decrease) in
price will lead to a 4% decrease (increase) in the quantity demanded. The demand
for sports watches is, therefore, elastic with respect to price.
114 Chapter 5

D. In calculating the arc cross-price elasticity of demand, we only consider consecutive

months when there was a change in the price of dress watches, but no change in
advertising nor the price of sports watches:

September-October

 Q PX 2 + PX 1
E PX = 
 PX Q 2 + Q1
3,500 - 4,500 $46 + $50
= 
$46 - $50 3,500 + 4,500
=3

May-June

 Q PX 2 + PX 1
E PX = 
 PX Q 2 + Q1
5,000 - 4,000 $57 + $51
= 
$57 - $51 5,000 + 4,000
=2
On average, EPX = (3 + 2)/2 = 2.5. Since E PX > 0, sports and dress watches are
substitutes.

PROBLEMS & SOLUTIONS

P5.1 Utility Theory. Determine whether each of the following statements is true or false.
Explain why.

A. According to the theory of consumer behavior, more is always better.

B. Consumers must understand how much one product is preferred over another
in order to rank-order consumption alternatives.

C. A market basket is a descriptive statement that relates satisfaction or

well-being to the consumption of goods and services.

D. The nonsatiation principle abstracts from time and place considerations.

E. Marginal utility measures the consumer's overall level of satisfaction derived

from consumption activities

P5.1 SOLUTION
Demand Analysis and Estimation 115

A. True. Consumer behavior theory rests upon the “more is better” assumption
regarding the utility tied to consumption. All goods and services are desirable in the
sense of being able to satisfy consumer wants. As a result, consumers will always
prefer more to less of any good or service.

B. False. The consumer’s understanding of ordinal utility makes possible a rank

ordering of preferred goods and services. Notice that knowledge concerning
complete consumer preferences does not necessarily include understanding about
how much one product is preferred over another.

C. False. A utility function is a descriptive statement that relates satisfaction or

well-being to the consumption of goods and services.

D. True. At any specific place and time, consumers do become sated. Therefore, the
nonsatiation principle involves a certain amount of abstraction from time and place
considerations. It is best considered within the context of money income where more
money brings additional satisfaction or well-being.

E. False. Whereas total utility measures the consumer's overall level of satisfaction
derived from consumption activities, marginal utility measures the added satisfaction
derived from a one-unit increase in consumption of a particular good or service,
holding consumption of other goods and services constant.

P5.2 Law of Diminishing Marginal Utility. Indicate whether each of the following
statements is true or false. Explain why.

A. The law of diminishing marginal utility states that as an individual increases

consumption of a given product within a set period of time, the utility gained
from consumption eventually declines.

B. When prices are held constant, a diminishing marginal utility for consumption
decreases the cost of each marginal unit of satisfaction.

C. Marginal utility measures the added satisfaction derived from a one-unit

increase in consumption, holding consumption of other goods and services
constant.

D. When goods are relatively scarce, the law of diminishing marginal utility
means that the added value of another unit of goods will be small in relation to
the added value of another unit of services.

E. The law of diminishing marginal utility gives rise to a downward- sloping

demand curve for all goods and services.
116 Chapter 5

P5.2 SOLUTION

A. False. In general, the law of diminishing marginal utility states that as an individual
increases consumption of a given product within a set period of time, the marginal
utility gained from consumption eventually declines.

B. False. When prices are held constant, a diminishing marginal utility for consumption
increases the cost of each marginal unit of satisfaction.

C. True. Whereas total utility measures the consumer's overall level of satisfaction
derived from consumption activities, marginal utility measures the added satisfaction
derived from a one-unit increase in consumption of a particular good or service,
holding consumption of other goods and services constant.

D. False. When goods are relatively scarce, the law of diminishing marginal utility
means that the added value of another unit of goods will be large in relation to the
added value of another unit of services.

E. True. This law gives rise to a downward-sloping demand curve for all goods and
services.

P5.3 Indifference Curves. Suggest briefly whether each of the following statements about
indifference curves that show preferences between goods and services is true or false
and defend your answer.

A. Consumers prefer higher indifference curves that represent greater

combinations of goods and services to lower indifference curves that represent
smaller combinations of goods and services.

B. Indifference curves slope downward because if the quantity of one consumer

product is reduced, the quantity of the other must also decrease to maintain the
same degree of utility.

C. The slope of an indifference curve shows the rate at which consumers are
willing to tradeoff goods and services.

D. The fact that indifference curves do not intersect stems from the “more is
better” principle.

E. Indifference curves bend inward (are convex to the origin) because if goods are
relatively abundant, the added value of another unit of goods will be small in
relation to the added value of another unit of services.
Demand Analysis and Estimation 117

P5.3 SOLUTION

A. True. Consumers prefer more to less, so they prefer higher indifference curves that
represent greater combinations of goods and services to lower indifference curves
that represent smaller combinations of goods and services.

B. False. Indifference curves slope downward. This stems from the fact that the slope
of an indifference curve shows the tradeoff involved between goods and services.
Because consumers like both goods and services, if the quantity of one is reduced,
the quantity of the other must increase to maintain the same degree of utility.

C. True. The slope of an indifference curve shows the rate at which consumers are
willing to tradeoff goods and services. For example, when goods are relatively
scarce, the law of diminishing marginal utility means that the added value of another
unit of goods will be large in relation to the added value of another unit of services.
Conversely, when goods are relatively abundant, the added value of another unit of
goods will be small in relation to the added value of another unit of services.

D. True. Indifference curves do not intersect. Holding goods constant, an indifference

curve involving a greater amount of services must give greater satisfaction.
Similarly, holding services constant, an indifference curve involving a greater
amount of goods must give greater satisfaction. This stems from the fact that goods
and services both provide consumer benefits, and reflects the “more is better”
principle.

E. True. Indifference curves bend inward (are convex to the origin). For example,
when goods are relatively scarce, the law of diminishing marginal utility means that
the added value of another unit of goods will be large in relation to the added value
of another unit of services. Conversely, when goods are relatively abundant, the
added value of another unit of goods will be small in relation to the added value of
another unit of services.

P5.4 Budget Constraints. Holding all else equal, indicate how each of the following
changes would affect a budget constraint that limits consumption of goods (Y) and
services (X). Explain your answer.

A. Deflation that uniformly drops the price of all goods and services.

B. Inflation that consistently increases the price of all goods and services.

C. Technical change that reduces the price of goods, but leaves the price of
services unchanged.
118 Chapter 5

D. Economic growth that boosts the level of disposable income.

E. Government-mandated health care coverage for workers that boosts the price
of goods by 3% and increases the price of services by 5%.

P5.4 SOLUTION

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

B. Inflation that increases the price of all goods and services results in a parallel
leftward (inward) shift in the budget constraint. Holding income constant, higher
prices reduce the amount of goods and services that consumers can buy with a fixed
amount of spending. This harmful impact on consumption is similar to that
following a decrease in income.
C. Technical change that reduces the price of goods, but leaves the price of services
unchanged results in an outward rotation of the budget constraint along the goods
(Y) axis. After such a change, the budget line intersects the Y axis at a higher point,
indicating that a greater amount of goods can be purchased with a fixed budget. The
amount of services that can be purchased for a fixed amount is unaffected by such a
change, and the X intercept (services axis) of the budget constraint is unaffected by
such a change.

D. Economic growth that boosts the level of disposable income results in a parallel
rightward (outward) shift in the budget constraint. Holding prices constant, growing
income makes it possible for consumers to buy more goods and services with the
same total amount of spending. This beneficial impact on consumption is similar to
that following deflation that drops the price of all goods and services.

E. Government-mandated health care coverage for workers that boosts the price of
goods by 3% and increases the price of services by 5% will have a negative impact
on consumption of both goods and services, but the negative impact will be worse
in the case of services. Following such a change, the relative price of services will
rise relative to the price of goods. The new budget line will move inward 3% along
the X axis reflecting the fact that a fixed budget will only be able to buy 97% of the
previously affordable goods. The new budget line will move inward 5% along the
Y axis reflecting the fact that a fixed budget will only be able to buy 95% of the
previously affordable services. The net effect is similar to a decrease in income
followed by a unilateral increase in the price of services.

P5.5 Elasticity. The demand for personal computers can be characterized by the
following point elasticities: price elasticity = -5, cross-price elasticity with
software = -4, and income elasticity = 2.5. Indicate whether each of the following
statements is true or false, and explain your answer.

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

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

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

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

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

computers and software.

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

decline in income.
P5.5 SOLUTION

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

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

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

D. False. Negative cross-price elasticity indicates that personal computers and

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

E. False. A 2% reduction in price will cause a 10% increase in the quantity of personal
computers demanded. A 1% decline in income will cause a 2.5% fall in demand.
These changes will not be mutually offsetting.

P5.6 Optimal Pricing. In an effort to reduce excess end-of-the-model-year inventory,

Harrison Ford offered a 1% discount off the average price of 4WD Escape Gas-
Electric Hybrid SUVs sold during the month of August. Customer response was
wildly enthusiastic, with unit sales rising by 10% over the previous month's level.

A. Calculate the point price elasticity of demand for Harrison Ford 4WD Escape
Limited SUVs sold during the month of August.

B. Calculate the profit-maximizing price per unit if Harrison Ford has an

average wholesale (invoice) cost of $23,500 and incurs marginal selling costs
of $350 per unit.

P5.6 SOLUTION

VVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVVV
εP = ΔQ/Q ÷ ΔP/P

= 10%/-1%

= -10 (Highly elastic)

WWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWW Th
e profit-maximizing price can be found using the optimal price formula:

P* = MC/(1 + 1/εP)

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

= $26,500

P5.7 Cross-Price Elasticity. The South Beach Cafe recently reduced appetizer prices
from $12 to $10 for afternoon “early bird” customers and enjoyed a resulting
increase in sales from 90 to 150 orders per day. Beverage sales also increased from
300 to 600 units per day.

A. Calculate the arc price elasticity of demand for appetizers.

B. Calculate the arc cross-price elasticity of demand between beverage sales and
appetizer prices.

XXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXX
Holding all else equal, would you expect an additional appetizer price decrease to
$8 to cause both appetizer and beverage revenues to rise? Explain

P5.7 SOLUTION

A.
 Q P2 + P1 (150 - 90) ($10 + $12)
EP =  =  = - 2.75
 P Q2 + Q1 ($10 - $12) (150 + 90)

B.

 Q P X 2 + P X 1 (600 - 300) ($10 + $12)

E PX =  =  = - 3.67
 PX Q2 + Q1 ($10 - $12) (600 + 300)

YYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYYY
Yes, the |EP| = 2.75 > 1 calculated in part A implies an elastic demand for appetizers and that an
additional price reduction will increase appetizer revenues. EPX = -3.67 < 0 indicates
that beverages and appetizers are complements. Therefore, a further decrease in
appetizer prices will cause a continued growth in beverage unit sales and revenues.
Alternatively, If P = a + bQ, then $12 = a + b(90) and $10 = a + b(150). Solving
for the demand curve gives P = $15 - $0.033Q. At P = $12, total revenue is $1,080 (=
$12 × 90). If P = $10, total revenue is $1,500 (= $10 × 150). At P = $8, total revenue
is $1,680 (= $8 × 210). In any case, to determine the profit effects of appetizer price
changes it is necessary to consider revenue and cost implications of both appetizer
 and beverage sales.

P5.8 Income Elasticity. Ironside Industries, Inc., is a leading manufacturer of tufted

carpeting under the Ironside brand. Demand for Ironside's products is closely tied
to the overall pace of building and remodeling activity and, therefore, is highly
sensitive to changes in national income. The carpet manufacturing industry is
highly competitive, so Ironside's demand is also very price-sensitive.
During the past year, Ironside sold 30 million square yards (units) of
carpeting at an average wholesale price of $15.50 per unit. This year, household
income is expected to ssurge from $55,500 to $58,500 per year in a booming
economic recovery.

A. Without any price change, Ironside's marketing director expects current-year

sales to soar to 50 million units because of rising income. Calculate the
implied income arc elasticity of demand.

B. Given the projected rise in income, the marketing director believes that a
volume of 30 million units could be maintained despite an increase in price of
$1 per unit. On this basis, calculate the implied arc price elasticity of demand.

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

P5.8 SOLUTION

A.
Q I +I
EI =  2 1
 I Q2 + Q1
50 - 30 $58,500 + $55,500
= 
$58,500 - $55,500 50 + 30
= 9.5

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

30 - 50 $16.50 + $15.50
= 
$16.50 - $15.50 30 + 50
= - 8 (Elastic)

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

P5.9 Cross-Price Elasticity. B. B. Lean is a catalog retailer of a wide variety of sporting

goods and recreational products. Although the market response to the company's
spring catalog was generally good, sales of B. B. Lean's $140 deluxe garment bag
declined from 10,000 to 4,800 units. During this period, a competitor offered a
whopping $52 off their regular $137 price on deluxe garment bags.

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

garment bag.

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

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

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

P5.9 SOLUTION
Q Y 2-Q Y1 PX 2+PX1
A. EPX = 
P X 2-P X1 QY 2+QY1

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

= 
$85 - $137 4,800 + 10,000

= 1.5 (Substitutes)

Q 2-Q1 P 2 + P1
B. EP = 
P 2-P1 Q 2 +Q1
 6,000 - 4,800 $130 + $140
= 
$130 - $140 6,000 + 4,800

= -3 (Elastic)

Q 2-Q1 P 2 + P1
C. EP = 
P 2-P1 Q 2 +Q1

10,000 - 6,000 + $130

-3 = x P2
P 2 - $130 10,000 + 6,000

P 2 + $130
-3 =
4( P 2 - $130)

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

13P2 = $1,430

P2 = $110

This implies a further price reduction of $20 because:

ΔP = $130 - $110 = $20

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

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

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

C. In light of the price reduction associated with the coupon promotion and
assuming no change in the price elasticity of demand, calculate
Enchantment's arc advertising elasticity.
 D. Why might the true arc advertising elasticity differ from that calculated in part
C?

P5.10 SOLUTION
Q P 2 + P1
A. EP = 
P Q 2 + Q1

9,000 - 16,200 $12 + $9

= 
$12 - $9 9,000 + 16,200

= -2

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

ΔP = -$5(0.4) or P2 = $12 - $5(0.4)

= -$2 = $10

ΔP = $10 - $12

= -$2

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

Q* - Q 1 P 2 + P1
EP = 
P 2-P1 Q* + Q 1

Q* - 9,000 $10 + $12

-2 = 
$10 - $12 Q* + 9,000

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

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

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

9Q* = 117,000

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

Q 2 - Q* A 2 +A1
EA = 
A 2-A1 Q 2 + Q*

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

= 
$3,750 - $3,250 15,000 + 13,000

= 1

D. It is important to recognize that a coupon promotion can involve more than just the
independent effects of a price cut plus an increase in advertising as is implied in Part
C. Synergistic or interactive effects may increase advertising effectiveness when the
promotion is accompanied by a price cut. Similarly, price reductions can have a
much larger impact when advertised. In addition, a coupon is a price cut for only
the most price sensitive (coupon-using) customers, and may spur sales by much
more than a dollar equivalent across-the-board price cut.
Synergy between advertising and the implicit price reduction that accompanies
a coupon promotion can cause the estimate in Part C to overstate the true advertising
elasticity. Similarly, this advertising elasticity will be overstated to the extent that
targeted price cuts have a bigger influence on the quantity demanded than similar
across-the-board price reductions, as seems likely.
CASE STUDY FOR CHAPTER 5

Demand Estimation for Mrs. Smyth’s Pies

Demand estimation for brand-name consumer products is made difficult by the fact that
managers must rely on proprietary data. There simply is not any publicly available data which
can be used to estimate demand elasticities for brand-name orange juice, frozen entrees, pies,
and the like--and with good reason. Competitors would be delighted to know profit margins
across a broad array of competing products so that advertising, pricing policy, and product
development strategy could all be targeted for maximum benefit. Product demand information
is valuable and jealously guarded.
To see the process that might be undertaken to develop a better understanding of
product demand conditions, consider the hypothetical example of Mrs. Smyth's Inc., a
Chicago-based food company. In early 2008, Mrs. Smyth's initiated an empirical estimation of
demand for its gourmet frozen fruit pies. The firm is formulating pricing and promotional plans
for the coming year, and management is interested in learning how pricing and promotional
decisions might affect sales. Mrs. Smyth's has been marketing frozen fruit pies for several
years, and its market research department has collected quarterly data over two years for six
important marketing areas, including sales quantity, the retail price charged for the pies, local
advertising and promotional expenditures, and the price charged by a major competing brand
of frozen pies. Statistical data published by the U.S. Census Bureau (http://www.census.gov) on
population and disposable income in each of the six Metropolitan Statistical Areas were also
available for analysis. It was therefore possible to include a wide range of hypothesized
demand determinants in an empirical estimation of fruit pie demand. These data appear in
Table 5.9.

The following regression equation was fit to these data:

Qit = b0 + b1Pit + b2Ait + b3PXit + b4Yit + b5Popit + b6Tit + uit

Q is the quantity of pies sold during the tth quarter; P is the retail price in dollars of Mrs.
Smyth's frozen pies; A represents the dollars spent for advertising; PX is the price, measured in
dollars, charged for competing premium-quality frozen fruit pies; Y is the median dollars of
disposable income per household; Pop is the population of the market area; T is the trend
factor (2006-1 = 1, . . . , 2007- 4 = 8); and uit is a residual (or disturbance) term. The subscript
i indicates the regional market from which the observation was taken, whereas the subscript t
represents the quarter during which the observation occurred. Least squares estimation of the
regression equation on the basis of the 48 data observations (eight quarters of data for each of
six areas) resulted in the estimated regression coefficients and other statistics given in Table
5.10.
A. Describe the economic meaning and statistical significance of each individual
independent variable included in the Mrs. Smyth's frozen fruit pie demand equation.

B. Interpret the coefficient of determination (R2) for the Mrs. Smyth's frozen fruit pie
demand equation.

ZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZ
Use the regression model and 2007-4 data to estimate 2008-1 unit sales in the Washington-
Arlington-Alexandria market.

AAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAA
To illustrate use of the standard error of the estimate statistic, derive the 95 percent and 99
percent confidence intervals for 2008-1 unit sales in the Washington-Arlington-
Alexandria market.

CASE STUDY SOLUTION

A. The individual coefficients for the Mrs. Smyth's pie demand regression equation can be
interpreted as follows. The intercept term, 529,774, has no economic meaning in
this instance; it lies far outside the range of observed data and obviously cannot be
interpreted as the demand for Mrs. Smyth's frozen fruit pies when all the
independent variables take on zero values. The coefficient for each independent
variable indicates the marginal relation between that variable and sales of pies,
holding constant the effect of all the other variables in the demand function. For
example, the -122,607 coefficient for P, the price charged for Mrs. Smyth's pies,
indicates that when the effects of all other demand variables are held constant, each
$1 increase in price causes quarterly sales to decline by roughly 122,607 pies.
Similarly, the 5.838 coefficient for A, the advertising and promotion variable,
indicates that for each $1 increase in advertising during the quarter, roughly 5.838
additional pies are sold. Demand for Mrs. Smyth's pies rises by roughly 29,867 pies
with every $1 increase in competitor prices, and a $1 increase in the median
disposable income per household leads to roughly a 2.043-unit increase in quarterly
pie demand. Similarly, a one person increase in the population of a given market
area leads to a small 0.030-unit increase in quarterly pie demand. Finally, the
coefficient for the trend variable indicates that pie demand is growing in a typical
market by roughly 2,815 units per quarter. Mrs. Smyth's is enjoying secular growth
in pie demand.
Individual coefficients provide useful estimates of the expected marginal
influence on demand following a one-unit change in each respective variable.
However, they are only estimates. For example, it would be very unusual for a $1
increase in price to cause exactly a -122,607-unit change in the quantity demanded.
The actual effect could be more or less. For decision-making purposes, it would be
helpful to know if the marginal influences suggested by the regression model are
stable or instead tend to vary widely over the sample analyzed. In general, if it were
known with certainty that Y = a + bX, then a one-unit change in X would always
 lead to a b-unit change in Y. If b > 0, X and Y are directly related; if b < 0, X and Y
are inversely related. If no relation at all holds between X and Y, then b = 0.
Although the true parameter b is unobservable, its value is projected by the
coefficient estimate. To be statistically reliable, the coefficient estimate must be
large relative to its standard deviation over the sample.
In Mrs. Smyth's frozen fruit pie demand equation, the coefficient estimates for
price (P), advertising (A), competitor price (PX) and population (Pop) are all more
than twice as large as their respective standard errors. Therefore, it is possible to
reject the hypothesis that each of these independent variables is unrelated to pie
demand with 95 percent confidence. These coefficient estimates suggest an
especially strong relation between pie demand and the P, A, and Pop variables. Each
of these coefficient estimates is over three times as large as its underlying standard
error and therefore is statistically significant at the 99 percent confidence level.
Once the effects of these independent variables have been constrained, there is no
additional independent influence noted for income (Y) or the time trend variable (T).

B. The coefficient of determination R2 = 0.871 or 87.1 percent indicates that the regression
model has explained 87.1 per cent of the total variation in pie demand. This is a very
satisfactory level of explanation for the model as a whole. The corrected coefficient
of determination R 2 = 0.852 or 85.2 per cent is a relatively modest downward
adjustment from R2; it suggests that the high level of explanatory power achieved by
the regression model cannot be attributed to an overly small sample size. Finally, the
F statistic is used to indicate whether a significant share of variation in the dependent
variable has been explained by the regression model. The hypothesis actually tested
is that the dependent Y variable is statistically unrelated to all the independent X
variables included in the model. If this hypothesis cannot be rejected, variation
explained by the regression is small. The critical value for F is denoted as F f 1 , f 2 ,
where f1, the degrees of freedom for the numerator, equals k - 1, and f2, the degrees of
freedom for the denominator, equals n - k. For example, the F statistic for this
example involves f1 = k - 1 = 7 - 1 = 6, and f2 = n - k = 48 - 7 = 41 degrees of
freedom. Also note that the calculated F 6,41 = 45.16 > 3.29, the critical F6,40 value for
the α = 0.01 or 99% confidence level shown in Appendix B. This means there is less
than a 1% chance of observing such a high F statistic when there is no link between
the dependent Y variable and the entire group of X variables. Given the ability to
reject the hypothesis of no relation at the 99% confidence level, it will always be
possible to reject this hypothesis at the lower, 95% and 90%, confidence levels.

C. To project the next quarter's sales of frozen fruit pies in the Washington, DC-Arlington-
Alexandria market, the company must simply enter expected values for each
independent variable in the estimated demand equation. Mrs. Smyth's expects an
average price for its pies of $7.95, advertising expenditures of $30,487. The prices
of competing pies are expected to be $5.69; median disposable income per
household is $53,235; population in the market area is 5,445,382 persons; and the
quarter for which demand is being forecast is the ninth quarter in the model.
 Inserting the appropriate unit values into the demand equation results in an estimated
demand of:

Q = 529,774 – 122,607(7.95) + 5.838(30,487) + 29,867(5.69) + 2.043(53,235)

+ 0.030(5,445,382) + 2,815(9)

= 200,430 pies.

Mrs. Smyth's could forecast the total demand for its pies by forecasting sales in each
of the six market areas, then summing these area forecasts to obtain an estimate of
total pie demand. Using the results from the demand estimation model and data
from each individual market, it would also be possible to construct a confidence
interval for total pie demand based on the standard error of the estimate. (Note: Be
sure to remember that 2008-1 is time period T = 9!)

D. Although 200,430 is the best estimate of pie demand for the Washington, DC-Arlington-
Alexandria market during the 2008-1 period, it is highly unlikely that precisely this
number of pies will be sold. Either more or less may be sold, depending on the
effects of other factors not explicitly accounted for in our pie demand estimation
model. The standard error of the estimate is a very useful statistic because it allows
us to construct a range or confidence interval within which actual sales are likely to
fall. For example, sales can be projected to fall within a range of ± 2 standard errors
of the 200,430 expected sales level with a confidence level of 95 per cent. There is
only a 5 per cent chance that actual sales in the Washington, DC-Arlington-
Alexandria market during the coming period will fall outside this range. Similarly,
there is a 99 per cent chance that actual sales will fall in the range of 200,430 ±
3(67,584), and only a 1 per cent chance that actual sales will fall outside this range.