CHAPTER 3

DEMAND ANALYSIS AND OPTIMAL PRICING

The following table shows the four topic sections of this chapter and the associated study
guide problems that pertain to each topic section.
Section Topic
1 Determinants of Demand
Problems M1-M6, S1-S2
2 Elasticity of Demand
Problems M7-M13, S3-S5, L1-L2
3 Demand Analysis and Optimal Pricing
Problems M14-M22, S6-S10, L3-L9

Multiple Choice

M1 Which of the following best describes “yield management” as practiced by airlines?

a. Tracking the percentage of seats occupied on a flight.
b. Flight-by-flight management to maximize revenue.
c. Seat-by-seat pricing to maximize profit.
d. Day-by-day costing to minimize expenses.
e. City-by-city management to optimize flight schedules.

M2 Typically, what main economic factor(s) affect demand?

a. Price is the overriding factor.
b. Advertising is the overriding factor.
c. Demographic and population shifts.
d. Multiple factors including price and income.
e. Primarily growth in consumer income.

M3 If the price of a substitute good increases significantly, demand for the competing good
will
a. Increase
b. Remain unchanged.
c. Decrease
d. Increase or decrease, depending on the difference between the two prices.
e. The effect is uncertain. It depends on the price elasticity of demand.

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M4 When the price of smart phones decreases, the demand for data plans will
a. Increase.
b. Remain unchanged.
c. Decrease.
d. Increase or decrease, depending on the difference between the two prices.
e. The effect is uncertain. It depends on the price elasticity of demand.

M5 Which of the following is the best description of a normal good?

a. An increase in income lowers the price of the product.
b. An increase in the price of a rival good increases its demand.
c. An increase in income increases its unit sales.
d. A decrease in income spurs greater advertising on the good.
e. A decrease in price raises its unit sales.

M6 Which of the following pairs of goods are complements?

a. Hot dogs and hamburgers.
b. Coffee and tea.
c. Coffee and soft drinks.
d. Airline seats and train seats.
e. Coffee and sugar.

M7 A good’s price is $15 and its sales are 400 units. When the price is increased to $18, sales
fall to 350 units. The point elasticity at P = $15 is
a. -1.25.
b. -1.00.
c. -.625.
d. -.50.
e. -.22.

M8 A good’s demand is given by: Q = 500 - 50P. At P = $5, the point price elasticity is
a. -8.0
b. -5.0
c. -1.5
d. -1.0
e. -.5

M9 Suppose that the current price for a good is $20 and quantity sold is 400 units. If the price
elasticity is -2.5, and price is raised to $21, what is the new quantity sold?
a. 360
b. 300
c. 280
d. 350
e. 450

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M10 Which of the following best describes the meaning of “inelastic demand”?
a. Demand is relatively unresponsive to price.
b. Demand is completely unresponsive to price.
c. Demand is fairly responsive to price.
d. Demand is highly responsive to price.
e. The percentage change in quantity is equal (and opposite) to the percentage
change in price.

M11 In which case is demand likely to be more elastic, the long run or the short run?
a. The long run, because there are fewer chances to find substitutes.
b. The short run, because buyers are able to adjust quickly to changes.
c. The long run, because buyers can find more numerous substitutes.
d. The short run, because in the long run there are fewer substitutes
e. The long run because income increases will tend to outweigh price changes.

M12 If the cross price elasticity between two goods is -2.5, how are the two goods related?
a. The goods are strong substitutes.
b. The goods are unrelated.
c. The goods are strong complements.
d. The goods are weak substitutes.
e. The goods are weak complements.

M13 For a particular good, EP = -2 and EY = 1.5. If price increases by 15% and income
increases by 5%, the predicted change in unit sales is
a. -30%.
b. -22.5%.
c. -7.5%.
d. 0%.
e. 7.5%.

M14 If the price of a good is in the inelastic range and the firm raises price,
a. Quantity will be unchanged and revenue will increase.
b. Quantity will fall just enough to leave revenue unchanged.
c. Quantity will fall, but revenue will increase.
d. Quantity will fall, but the revenue change cannot be determined without more
information.
e. None of the above answers is correct.

M15 In a pure selling problem,

a. Fixed costs are so low they can be ignored.
b. Sunk costs, whatever their magnitude, can be ignored.
c. Variable costs are zero or so low they can be ignored.
d. Inelastic demand allows the firm to set a high price markup.
e. Marginal cost is positive and constant.

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M16 A firm produces a good at a marginal cost of $20 per unit and sells it for $40 per unit. It
currently has an inventory of 500 units, and P = 30 - .05Q describes its current demand
curve. In these circumstances, what is the firm’s optimal price?
a. $25.
b. $20.
c. $15.
d. $10.
e. $5.

M17 A firms produces a good with MC = $60 per unit and EP = -5. The firm’s optimal price is
a. $120.
b. $75.
c. $90.
d. There is not enough information to provide an answer.
e. None of the answers is correct.

M18 For a profit-maximizing markup,

a. The more elastic is demand, the higher the price.
b. The more elastic is demand, the lower the price.
c. The more elastic is demand, the higher the markup.
d. The greater is demand, the higher is the price.
e. The lower is marginal cost, the higher the price.

M19 Price discrimination occurs when

a. A buyer chooses sellers based on nonprice characteristics.
b. A seller raises prices when demand surges.
c. A seller charges different buyers the same price.
d. A seller charges different prices based on different costs of service.
e. A seller charges different prices for the same good or service.

M20 Suppose a firm sells a good in three different markets. In market A, management thinks
that demand elasticity is -1.1. In market B, management thinks elasticity is -3.5. In market
C, management thinks elasticity is -8. In which market will a profit-maximizing firm set
the highest price?
a. Market A
b. Market B
c. Market C
d. Profitable price discrimination is not possible in this instance.
e. One cannot say for sure from the information given.

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M21 Information goods and services are characterized by:

a. Higher value added and very inelastic demand.
b. Positive network externalities.
c. High fixed cost and negligible marginal cost.
d. Limited opportunities for price discrimination.
e. Answers b and c are both correct.

M22 In the case of an airline pricing business seats and pleasure seats, what rule should the
profit-maximizing airline follow?
a. Set prices so that marginal revenue from the last business seat equals marginal
revenue from the last pleasure seat.
b. Set prices so that marginal cost of the last business seat equals the marginal cost
of the last pleasure seat.
c. Set prices so that the demand elasticities are the same for each class of seat.
d. Cut back on pleasure seats to increase business seats.
e. Expand seating in the section with less elastic demand at the current price;
contract seating in the section with more elastic demand.

Short Problems and Questions

S1 Distinguish between a movement along the firm’s demand curve and a shift in the
demand curve. Explain what kind of variables induces a move along the curve, and what
variables induce a shift in the demand curve.

S2 Cola Bottlers, Inc. sells bottled soft drinks from vending machines in a variety of
locations. Management has determined that sales at a typical machine depend on price
(in dollars) according to the demand equation:
Q = 1,200 - 800P
a. Determine the number of bottles that will be sold at a price of $1.00.
b. If the price is raised to $1.25, how many bottles will be sold?

S3 Sandy Wiches sells fresh sandwiches at a beach location. Management has determined
that on a typical day, demand can be described by the following demand equation:
Q = 1,200 - 200P.
a. If P = $3.00, determine the number of sandwiches sold and the elasticity of
demand at this price.
b. If price is increased to $4.00, determine the elasticity of demand at this new price.
Is demand more or less elastic after the price increase?

S4 What factors affect price elasticity?

S5 a. A firm faces the demand curve: P = 800 - 25Q. What is the firm’s revenue
maximizing price?
b. Demand changes to: P = 960 - 40Q. Now, what price maximizes revenue?

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S6 A firm is selling a good with a marginal cost of $70. Management thinks that demand
elasticity is -2.75. What price should the firm set in order to maximize profit?

S7 Suppose that you are manager of the sporting goods department in a large department
store. The store’s top management follows a standard 100% markup over the wholesale
price it pays for all items in the store. (So if the store pays a wholesale price of $50 for an
item, it sets its retail price at $100.) In your experience, the elasticity of demand for most
sporting goods items is in the neighborhood of -3. Is top management’s pricing strategy
appropriate for sporting goods?

S8 A firm is considering whether to increase advertising. Market conditions dictate a sales

price of $27.50 per unit, and the firm’s marginal cost is $17.50 per unit. Quantity sold
depends on advertising according to the formula:
Q = .3A - .001A2
where A measures advertising expenditure (in dollars). Determine the firm’s optimal
level of advertising spending.

S9 A college admissions office has hired a consultant in an effort to help predict student
enrollment. After detailed surveys are conducted, the consultant reports that point
elasticities are as follows: EP = -1.75, EY =.6, and EN = .75, where N denotes the tuition
of a nearby university. Current tuition at the college is $11,000 per semester.
a. The college is considering raising tuition charges by 7.5%, income is expected to
rise by 1.5%, and the rival college has announced a tuition increase of 4.5%.
Predict the change in the college’s enrollment.
b. Suppose that the vice president for Financial Affairs would like to see tuition set
in order to build up a fund in case of a future drop in student enrollment. If the
marginal cost of a student is $6,000 per semester, what is the college’s optimal
tuition price?

S10 An up-scale hair salon normally charges $100 for a hair cut (including wash and blow
dry) and sells about 400 per week. Under a deal with Groupon, the salon is offering a
limited number of cuts for $75 (with the salon netting $50 after Groupon’s $25 fee). The
salon has found that the offer brought in 50 new customers, while 50 of its current
customers took advantage of the Groupon deal. Was the Groupon offer a success for the
salon? Explain.

Longer Problems and Discussion Questions

L1. Biopharm has a patent protected monopoly on a drug that fights migraine head aches.
a. Because the drug is so effective, one manager argues that the firm can set a price
twice as high as other drugs on the market. Do you agree?

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b. A rival firm has come out with a comparable drug. At first, it has set a price
comparable to Biopharm’s and the firms split the market about equally. Now the
rival has lowered its price by 10%. Biopharm estimates its price elasticity to be
-1.5 and the cross price elasticity to be .8. What will be the effect on its sales if
Biopharm does nothing? What if it matches its rival’s price cut? What strategy
would you recommend?

L2 The Sioux Valley Parakeets, a minor league baseball team, has hired you as a consultant
to predict ticket sales for the upcoming season, and to advise on changes in ticket prices.
a. The elasticity of ticket sales with respect to the local population is estimated to be
about .9. If the local population increases from 130,000 to 140,000, what is the
predicted change in ticket sales?
b. The current price is $7.50. If EP is -.85, predict the percentage change in tickets if
price is raised to $8.50. Will revenue rise or fall? How does your answer change if
elasticity is -1.1?
c. You have estimated income elasticity to be: EY = .75. Explain what this means,
and why it is important for management.

L3 Firm X sells its main product in the domestic market at P* = $100 and produces it at a
marginal cost of $50. It is considering selling the product in a foreign market. It has
estimated the elasticity of demand in the foreign market to be EP = -3.5, and the extra cost
of serving the foreign market (shipping and so on) comes to about $10 per unit. One
executive advises setting the foreign price at $110 to cover the shipping cost. Another
suggests discounting the price to $90 because foreign demand is so elastic. What is your
price recommendation?

L4 Small State Air serves several airports in the Rocky Mountain States, flying customers to
the larger airports for connecting flights. Recent data for a particular route reveals that the
one daily flight has had 10 business customers and 20 coach class customers. The plane
seats 42. The charge for business class is $250, and the charge for coach is $165.
The airline is considering a temporary price cut to boost bookings on the flight, but is
uncertain about which class to discount, and by how much. You have been called in as a
consultant to the airline. What would you advise and why?

L5 Major University is a premier institution that draws students from all over the world to its
campus. Although it is state funded, it aspires to world-class quality and reputation,
which are enhanced when out-of-state residents enroll. Data suggest that in-state
enrollment can be described by the equation:
QI = 25,000 - PI,
where QI = in-state enrollment and PI = in-state tuition. Out-of-state enrollment is given
by: QN = 13,500 - .5PN.
a. If tuition for in-state students is $14,000 and for out-of-state students is $19,000,
what is total enrollment and demand elasticity for each type of student?
b. Suppose that the marginal cost to the university of an additional student is $7,000.
Is Major University maximizing profit at its current tuition charges? Explain.

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c. Because of major funding cuts, the university is expecting to reduce its total
enrollment to 11,000 students next year. The university is free to set any tuition
charges it wishes. If the goal is to maximize total tuition revenue, what should in-
state tuition, out-of-state tuition, and respective enrollments be?

L6 Pic Pens sells Basic pens, which can be produced at constant marginal cost of $500 per
thousand. Management thinks that annual demand for Basic pens can be approximated by:
PB = 2,500 - 10QB
where PB = price of 1,000 Basic pens in dollars, and QB denotes Basic pens (in thousands).
a. Determine the optimal quantity and price of Basic pens for Pic.
b. Pic is considering bringing out a new line of Nice pens. These are identical to
Basic pens, except for the color of the plastic barrel and the packaging, and can be
produced at the same cost as Basic pens. If the new pen is introduced, the
marketing department thinks that the relevant demand curves will be:
PB = 2,000 - 10QB and PN = 1,500 - 10QN
where PN = price of 1,000 Nice pens in dollars, and QN = units of Nice pens in
thousands. Pic is free to charge different prices for the pens.
What are the optimal prices and quantities for the two pens? Is it profitable to
sell the second type of pen?

L7 Hula Products has reintroduced the hula hoop to the world and faces a growing demand
for its product in two distinct markets: the United States and Europe. Demand in these
markets is:
PU = 20 - .1QU
and PE = 10 - .05QE.,
where all quantities are expressed in thousands of units (i.e. QU = 50 means 50 thousand
units). Hula can produce hoops at a marginal cost of $1.50 per unit.
a. What are the profit-maximizing prices and quantities in the two markets?
b. Hula has a capacity constraint and can produce a maximum of 200 thousand
hoops. How does this affect the firm’s output and prices in part a?

L8 Carefully define price discrimination. What condition(s) must exist for discrimination to
be profitable? What are the different types of discrimination? Give an example of each to
illustrate your answer.

L9 You are the economic consultant to the largest media company in a local market. Their
share of the market is over 70%, because of its highly regarded news team. You have
discovered that demand for advertising on their station is price inelastic. What advice
regarding pricing would you give to the company?

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SOLUTIONS

Multiple Choice

M1 c See discussion in text.

M2 d
M3 a
M4 a These goods are complements.
M5 c For an inferior good, an increase in income will decrease demand for the good.
M6 e
M7 c Use the formula for point elasticity: EP = [Q/Q]/[P/P] =
[(-50)/(400)]/[(3)/(15)] = -.125/.2 = -.625.
M8 d First, compute Q at a price of $5: Q = 500 – (50(5) = 250. Next use the formula
for point elasticity: EP = (dQ/dP)(P/Q) = (-50)(5/250) = -250/250 = -1.
M9 d The change in price is $1. From the original price, this is a 5% change. Multiply
the percentage change in price by the elasticity of demand to obtain the change in
quantity: %Q = (-2.5)(5%) = -12.5%. The new Q is: (.875)(400) = 350.
M10 a
M11 c See discussion in text.
M12 c
M13 b Q/Q = EP(P/P) + EY(Y/Y) = (-2)(15%) + (1.5)(5%) = -22.5%.
M14 c
M15 c See discussion in text
M16 c Set MR = 0 (this is a pure selling problem). MR = 30 - .1Q = 0, implies Q = 300
and P = $15.
M17 b According to the markup rule P = [-5 /(1 + -5)][60] = $75
M18 b The markup rule, P = [Ep /(1 + Ep)][MC], implies this result.
M19 e See discussion in text.
M20 a Price discriminators maximize profit by setting the highest price where demand is
least elastic.
M21 e
M22 a

Short Problems and Questions

S1 A shift in demand occurs when an explanatory variable in the demand equation – other
than price – changes. For example, an increase in income will cause the demand curve to
shift to the right (in the usual case of a normal good). By contrast, a change in quantity
demanded due to a change in price represents a movement along the demand curve.
The distinction is important because it allows management to determine why unit
sales of a good or service are changing. Management has some control over what price to
charge, but changes in non-price variables are usually beyond the control of management.

S2 a. Q = 1,200 – (800)(1.00) = 400.

b. Q = 1,200 – (800)(1.25) = 200.

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S3 a. Q = 1,200 – (200)(3.00) = 600.

EP = (dQ/dP)(P/Q) = (-200)(3.00/600) = -1.0.
b. Q = 1,200 – (200)(4.00) = 400.
EP = (dQ/dP)(P/Q) = (-200)(4.00/400) = -2.0.
Moving to a higher price along a linear demand curve increases demand elasticity.

S4 One factor is the degree to which a good is a necessity. If the buyer can do without the
good, demand is generally more elastic. Second is the availability of substitutes. The
greater the number of substitutes, the more elastic demand becomes. The third factor is
the proportion of income spent on the good or service. If a large portion is spent on the
good, buyers become more price sensitive. Last is the time of adjustment. If buyers have
more time to adjust to a change in price, then demand tends to be more elastic.

S5 a. Compute: R = PQ = 800Q - 25Q2, implying MR = 800 - 50Q.

Set MR = 0, implying: 50Q = 800. Therefore, Q = 16, P = $400,
and R = $6,400.
b. Compute the new revenue function: R = PQ = 960Q - 40Q2:
Set MR = 960 - 80QD = 0, implying Q = 12, P = $480, and R = $5,760.

S6 The optimal markup rule is: P = [EP/(l + EP)]MC.

Therefore, P = [(-2.75)/(1 - 2.75)][70] = $110.

S7 According to the markup rule, a sporting goods item (costing $50) should be priced at:
P = [(-3)/(1 - 3)][50] = $75. Because demand is relatively elastic, the right markup is 50%
above wholesale cost. A blanket 100% markup policy is too high and suboptimal for
sporting goods.

S8 Gross profit per unit of sales is $27.50 - $17.50 = $10. Thus, the firm’s net profit is:
 = 10Q – A = 10(.3A - .001A2) - A
= 2A - .01A2.
Setting marginal profit equal to zero implies: d/dA = 2 - .02A = 0
Therefore, A = $100 is the optimal level of advertising spending.

S9 a. Q/Q = (-1.75)(7.5%) + (.6)(1.5%) + (.75)(4.5%) = -8.85%.

b. P = [(EP)/(1 + EP)]MC = [(-1.75)/(1 - 1.75)][$6,000] = $14,000.
The college maximizes its net contribution by raising tuition substantially, from
$12,000 per semester to $14,000.

S10 Before Groupon, the salon was generating $40,000 in revenue per week. Now it’s total
revenue is: (100)($50) + (350)($100) = $40,000. So, the effect on immediate revenue is a
“wash.” Because of the cost associated with supplying 50 additional haircuts, its
immediate profit has decreased. The Groupon initiative will prove to be a good deal for
the salon only if it succeeds in converting appreciable number of new customers into
permanent customers.

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Longer Problems and Discussion Questions

L1 a. Despite the drug’s utility and the protective patent, setting a price twice as high is
an extreme strategy. If demand becomes much more elastic at very high prices,
such a markup could prove to be too high to be profit maximizing.

b. If the firm holds its price, its sales will fall by (.8)(10) = 8%. If it matches the
price cut, its sales will increase by: (-1.5)(-10) + (.8)(-10) = 7%. Typically, the
best price response lies between these two extremes – that is, a partial price cut.
The rival’s price cut has shifted inward Biopharm’s demand curve and
presumably made its demand slightly more elastic. Thus, Biopharm should try a
partial price cut (say 5%), estimate the resulting price elasticity and see if its new
price is in now in rough accord with the optimal markup rule.

L2 a. The population change is 10,000. The % change is: 10,000/130,000 = 7.69%.

The percentage change in quantity is: %Q = (.9)(7.69%) = 6.92%.
b. The change in price is $1, implying a percentage change of 1/7.50 = 13.33%.
For price elasticity EP = -.85, the percentage change in quantity is:
%Q = (-.85)(13.33%) = -11.33% decrease in ticket sales.
Revenue will increase, because demand is inelastic. If elasticity is -1.1, the
percentage change in quantity is: %Q = (-1.1)(13.33%) = -14.67% (a larger
decrease in ticket sales). Revenue will decrease, because demand is elastic.
c. Income elasticity is the percentage change in unit sales, all other factors held
constant, for a given percentage change in consumer income. In this context, an
economic boom will increase unit sales, while a recession will decrease unit sales.
To the extent that management has advance information about economic
conditions, it may be able to adjust ticket prices as the economy moves through
the (local) business cycle.

L3 Neither executive is correct. According to the markup rule, demand elasticity and
marginal cost both matter. Specifically, the targeted optimal price is computed according
to: P* = [-3.5/-2.5][$60] = $84. This is the preferred price point for the foreign market.

L4 This is a pure selling problem. As long as the airline is committed to making one flight
per day, the fixed costs are given. In this case, the variable cost of an additional passenger
is low enough to ignore. There is excess capacity on the flight; therefore, a fare cut would
boost bookings, and there is space available. One need not worry that additional bookings
cannot be accommodated.
The key to the solution is to determine which set of customers is most likely to
respond to the fare cut (that is, in which segment is more elastic). The most likely answer
is that business traffic is price inelastic (businessmen must travel for sales or staff
meetings on a tight schedule), while coach customers are likely to have alternative travel
options (bus, car), which take longer but may cost less. More substitutes for a good or
service tend to increase demand elasticity.

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If demand is elastic, a price cut will raise unit sales and total revenue. If demand is
inelastic, a price cut will raise unit sales, but not total revenue. Therefore, the choice most
likely to raise total revenue (and profit) is a fare cut in coach class.

L5 a. QI = 25,000 – 14,000 = 11,000.

EI = (dQ/dP)(P/Q) = (-1)(11,000/14,000) = -.786.
QN = 13,5000 – (.5)(19,000) = 4,000.
EN = (dQ/dP)(P/Q) = (-.5)(19,000/4,000) = -2.375.
b. Compute inverse demand functions for each group of students.
For in-state students: QI = 25,000 - PI implies: PI = 25,000 - QI.
R= PIQI = 25,000QI - Q2I. Setting MR = MC implies: 25,000 - 2QI = 7,000.
Thus, QI = 9,000. In turn, PI = $16,000.
For out-of-state students: QN = 13,500 - .5PN implies: PN = 27,000 - 2QN
Therefore, MR = 27,000 - 4QN. Setting MR = MC, we have:
27,000 - 4QN = 7,000. Therefore, QN = 5,000 and PN = $17,000.
No, the university is not maximizing its net profit. Tuition should be raised by
$2,000 (from $14,000 to $16,000) for in-state students, and lowered by $2,000
(from $19,000 to $17,000) for out-of-state students. The new enrollment would be
14,000 students (down from the current level of 15,000).
c. The university seeks to maximize its total tuition revenue subject to a total
enrollment of 11,000 students. Thus, the key maximization condition is to equate
marginal revenues across student types: MRI = MRN. This implies that:
25,000 - 2QI = 27,000 - 4QN. In turn, we know that: QI + QN = 11,000. Solving
these 2 equations simultaneously implies: 25,000 – (2)(11,000 - QN) =27,000 -
4QN, or after simplifying: 6QN = 24,000. Thus, QN = 4,000 and QI = 7,000. In
turn, PI = $18,000 and PN = $19,000.
For Major University, the appropriate course of action is to increase tuition for
both types of students. Note the profit-maximizing plan calls for enrolling only
7,000 in-state students, down 4,000 students from current levels. (However, this
strategy might not be acceptable at state schools. State policy makers may opt for
large cuts in out-of-state students instead.)

L6 a. Pic’s profit is:  = R - C = (2,500 - 10QB)QB - 500QB

= 2,000QB - 10Q2B
Setting M = 0 implies: d/dQB = 2,000 - 20QB = 0, or QB = 100 thousand.
In turn, PB = 2,500 – (10)(100) = $1,500 per thousand pens.
Finally, total profit is:  = $100,000.
b. The new profit function for Pic is:
 = (2,000 - 10QB)(QB) + (1,500 - 10QN)(QN)- 500QB - 500QN
Setting M = 0 for each type of pen implies:
(Basic) M = 2,000 - 20QB - 500 = 0. Therefore, QB = 75 and PB = $1,250.
(Nice) M = 1,500 - 20QN - 500 = 0. Therefore, QN= 50 and PN = $1,000.
Total profit is: (1,250 – 500)(75) + (1,000 – 500)(50) = $81,250.

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If it introduces the new pen, the firm will seize the opportunity to charge different
wholesale prices: $1,250 and $1,000 per thousand. The problem is that the new
pen cannibalizes (cuts into) the sale of the firm’s basic pens. (The demand curve
shifts down.) With two pen lines, the firm’s total profit actually drops. Thus, the
firm should stick with its single pen.

L7 Hula practices profitable price discrimination across the two markets.

a. Compute marginal revenue in each market and equate to marginal cost.
In the United States, PU = 20 - .1QU. Setting MR = MC, we find 20 - .2QU = 1.5,
implying QU = 92.5 thousand units and PU = 20 – (.1)(92.5) = $10.75.
In Europe, PE = 10 - .05QE. Setting MR = MC, we have: 10 - .1QE = 1.5,
implying QE = 85 thousand units and PE = 10 – (.05)(85) = $5.75.
b. No. Total sales in the two markets come to 177.5 thousand, so Hula has more than
enough capacity (200 thousand) to fulfill its production plan.

L8 Price discrimination occurs when a firm sells the same good or service to different buyers
at different prices. Generally speaking, discrimination also includes the provision that the
difference in price is not based upon a difference in cost.
For discrimination to be profitable, two conditions must be met. First, the firm must
be able to identify market segments that differ with respect to price elasticity of demand.
Second, it must be able to “enforce” the different prices paid by different segments. This
means that resale, or arbitrage, from the lower-price market to the higher-price market
must be impossible or extremely limited.
Third-degree discrimination consists of charging different prices to different market
segments, but charging the same price within a given segment. Examples include airline
pricing of seats and movie ticket pricing for children and adults.
First-degree, or perfect, price discrimination occurs when a firm sets a different price
for each customer and by doing so extracts the maximum possible sales revenue. Examples
include auto dealers with many cars for sale and plenty of serious buyers. If the dealer is an
exceptionally good judge of character, he can guess the maximum each is willing to pay and
set that price. In practice, first-degree discrimination is difficult to achieve.
Second-degree discrimination occurs when the firm offers different schedules of
prices. An example is a quantity discount for large volumes. Included would be taxi
service, photocopy rental agreements, telephone service, electricity, and residential gas
service.

L9 The media company is not currently maximizing profit. Because demand is inelastic, the
firm can raise total revenue and profit by increasing advertising rates. A small increase in
rates is not likely to move the media company into the elastic portion of the curve. The
popularity of the firm indicates that there are few good substitutes for advertisers
(assuming that they want to reach a large number of viewers), so that quantity demanded
will not likely drop substantially from a price increase.

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