Managerial Economics Test 1

True or false and why: If consumers increase their willingness to pay then their demand increases, and so does the price.

A higher willingness to pay increases demand, but a higher willingness to pay does not necessarily increase the price. The increased demand may be fully accommodated by an increase in quantity supplied if supply is horizontal. In such case the price remains unchanged.

True or false and why: A higher demand for product x implies increased consumption or purchases of x.

A higher demand shifts demand to the right but does not necessarily increase consumption. Consumption is a result of the interaction of both demand and supply. If supply is fixed (supply is vertical), then an increase in demand does not increase consumption.

True or false and why: An organization that creates value for customers also generates profits.

A firm that creates value to customers is not necessarily able to appropriate that value.

True or false and why: Consumer expenditure does not change when the price elasticity equals one (in absolute value) over the whole range of a demand curve and the price changes.

True. A demand curve with constant price elasticity equal to one in absolute value keeps expenditure (E) constant. Why? If expenditure is defined as E=x*Px where E is expenditure, then x=E*Px-1. According to the definition of price elasticity, the price elasticity of demand is -1 in such demand equation.

True or false and why: "The increase in real income generated by a decrease in the price of a product is higher, the higher the share of the product in total expenditure."

True. A reduction in the price of a product that has a high share in total expenditure generates a relatively large "income effect." To understand this, suppose that a customer spends all his income of $100 in several products and buys 10 units of a given product priced at $5. The customer spends 50% in that product. If the price of that product falls to $4, then the customer will spend $40 for the same 10 units. The customer thus will spend $10 less. The reduction in the price of the product has thus increased the customer's real income. The customer may use the $10 saved to buy more of the product or more of other products. The higher the share of the product in expenditure, the higher the "savings." Note that the customer may not spend the "savings" in the product with the now lower price. Indeed, if the product is inferior, then the higher real income effect brought about by the reduction in the price of the product will reduce the demand for the product (because, by definition of "inferior," a product is inferior if the relationship between real income and demand is negative). In this last case, a reduction in the price leads the customer to increase the quantity of x but the increase in income (the "income effect") leads the customer to reduce the quantity of x. The income effect thus puts a brake to the increase in quantity brought about solely by the reduction in the price of the product.

True or false and why: It is impossible to increase the demand for x by acting on its substitute y.

False. If acting on y increases its demand and its price, then consumers of y will increase the demand for x.

True or false and why: There is a demand curve for a product whenever there is a "need" for the product.

False. A "need" is not sufficient to generate a demand curve. A customer may "need" a product but may be unable to buy it. A demand curve for a product or service is backed by the ability to buy the product. A demand curve or demand schedule that is backed by the ability to buy the product is sometimes called "effective demand."

When does an increase in the price of the product keep expenditure unchanged?

If the price elasticity of demand is equal to 1 (in absolute value), then an increase in the price will not change expenditure (x*Px).

What does it mean when someone says that "real income has increased from one year to the next"?

As in the case of the real price, real income is simply income divided by an index of prices. An increase in real income simply means that nominal income from one year to the next has increase by more than the increase in the price level. If a person had $1,000 in income last year and now income is $1,100, income has increased by 10%. If the index of prices went up by 3%, real income increased because 10%>3%. Again, that simple! (This is not even economics.)

After a sharp increase in the price of gas, a manager at a bus company revises costs upward. In a meeting, the manager says, "We will be hard hit by the increase in gas. A 20% increase in gas prices reduces our profit by about 50%. If this increase in the price of gas is here to stay, then this means millions of dollars of lost profit in the next five years alone." What would you say to the manager?

Assuming that the price of gas affects not only the bus company but also actual customers and potential customers who currently drive, the manager forgets the substitution effect of a higher price of gas. Drivers may now decide to take the bus instead of driving their cars. Demand for the bus company thus increases. Also, when projecting losses over the "next five years," the manager ignores the short and long run effects of a higher price of gas on buses. In the short run, the company is basically stuck with the buses it has. In the long run, it can buy more energy- efficient buses. It is even possible that the increase in the price of gas ends up benefiting the bus company as revenues from additional customers and rides may exceed the extra expenditure on gas. Also, the manager should consider the competitive position of the firm in relation to competitors. Competitors may be in worse situation, and raise their prices by a higher percentage, thus sending customers to the bus company.

Suppose that the quantity consumed of x increases when its price increases. Is the demand for x upward sloping?

At the same time the price increased, other variables may have changed. Demand has shifted. The higher quantity and higher price observed is still consistent with a negatively sloped demand curve.

Suppose that quantity demanded is 100 units when the price is $12 and 55 units when the price is $30. If all costs (including Marginal Cost) are zero for a profit maximizing producer, and demand is linear, what is the price that maximizes profits? Based on the price elasticity alone, should the price be higher than $12? Why?

Based on the information provided, a price equal to $12 does not maximize profits and the firm should increase the price. A price of $30 would generate profits of $1650 that exceed the profits when the price is $12. However, assuming a linear demand curve, the demand equation for the given price- quantity combinations ($12, 100) and ($30, 55) is x=130-2.50P or P=52-.4x (please confirm this by applying elementary mathematics -you should know how to derive the equation of a straight line from two data combinations). Profit maximization occurs where x=65 if Marginal Cost=0. In other words, Marginal Cost equals Marginal Revenue where x=65. In turn, the price is $26 for x=65. Thus revenues (equal to profits in this case) for the price-quantity combination ($26, 65) are $26*65=$1,690. Clearly, the profits when the price is $26 exceed the profits when the price is $12. They also exceed the profits when the price is $30. as profits when the price is $30 are $1650. Simply, $30 is too high a price if the producer wants to maximize profits. Alternatively, if demand is linear, the price-quantity combination ($30, 55) leads to more profits than the price-quantity combination ($12, 100), but the price-quantity combination ($26, 65) leads to even more profits than the price-quantity combination ($30, 55).

True or false and why: By definition, a product can only be substituted with another product.

False as a process may compete with a product, and a product can compete with a process. For example, the process of filtering water at home with the help of a water filter competes with bottled filtered water in some markets. Customers become "domestic bottlers" of filtered water and thus competitors of firms that produce bottled water. Another example is when a hospital adopts a unique surgical procedure but at the same time competes with pharmaceutical firms that produce medicinal products that lessen or eliminate the need for the surgical procedure. By taking the medicinal products, customers can compete with hospitals through their own process.

Heard in a meeting: "If two products x and y are complements in consumption and products y and z are also complements in consumption, then, logically, x and z are complements in consumption too." Do you agree? Why?

False. A counterexample kills the statement: Suppose that surgical procedure x is complemented by medicine y. Medicine y is in turn a complement for surgical procedure z. It doesn't follow that surgical procedures x and z are complements. Indeed, they may be substitutes. A surgeon may have to choose between performing surgical procedures x and z. You may have other examples.

True or false and why: If products x and y are complements, then they cannot be made mutually exclusive.

False. At a university, courses A and B may be scheduled at the same time, making it impossible to attend both (assuming that attendance is required and enforced), and thus are mutually exclusive at that point in time, but A and B may be complements (in the sense that one goes with the other, but not necessarily at the same time).

True, or false and why: Higher unit sales of a product imply a higher demand for the product.

False. Higher unit sales do not imply or necessarily lead to a higher demand. Indeed, demand may fall while unit sales rise. Why? At the same time that demand falls, supply may increase sufficiently to increase unit sales.

A product with price elasticity greater than one in absolute value has relatively few substitutes (low substitutability). True or false? Why?

False. If the price elasticity is greater than one, then a percentage increase in the price leads to a larger percentage reduction in quantity demanded. The product has relatively many substitutes (high substitutability).

True or false and why: Higher income increases the demand for a product.

False. If the product is "inferior," higher income reduces demand.

True or false and why: If x and y are substitutes, then the cross elasticity of x with respect to y is negative.

False. If x and y are substitutes, then an increase in the price of y increases the demand for x, as customers try to "escape" the higher price of y.

True or false and why: If the price elasticity in market A is 3 and the price elasticity in market B is 1, then the price elasticity in both markets A and B is 2.

False. It depends on the strength of the demand for x in each market. A weighted average has to be calculated.

True or false and why: If the income elasticity is negative, then an increase in the price reduces the revenues of the firm.

False. Read carefully. The statement refers to a change in price but relates the change in price to the income elasticity.

Heard in a meeting: "If both revenues and costs increase when more units are produced, then profits increase as long as the percentage increase in revenues exceeds the percentage increase in the cost per unit (average cost). For example, if revenues increase by 20% and cost per unit increases by 8%, then profits rise." Do you agree? Why?

False. Suppose that revenues increase by 20% from $500 to $600, and the cost per unit (average cost) increases by 8%, from $2 to $2.16 per unit, as production increases from 100 units to 150 units. Initially, revenue is $500 and total cost is 100*2 and thus profit is $500-$200=$300. Now revenue increases by 20% to $600 and cost per unit increases by 8%. Total cost is thus 150*$2.16=$324. The initial profit of $500-$200=$300 falls to $600-$324=$276. Profit is now 8% lower, despite an increase in 20% in revenue and just a 8% increase in cost per unit (average cost). Lesson: Do not directly compare percentage changes in revenues to percentage changes in cost per unit.

True or false and why: A linear downward-sloping demand curve has constant point price elasticity of demand.

False. The point price elasticity changes along a linear and downward-sloping demand curve. This is easy to see: If demand is x=c-e*P, where x is the quantity of product x and P is the price of x, and the price elasticity is PE=dx/dp*P/x, then PE=-e*(P/x) because dx/dp=-e. Clearly, the point price elasticity of demand is higher when the price-quantity combination on the straight demand curve is higher.

Heard in a meeting: "The decision to expand capacity at our plant depends on the income elasticity of demand, but not on the price elasticity of demand." Do you agree? Why?

False. The price elasticity also affects plant expansion (or reduction) decisions. For example, suppose that a firm faces a downward sloping demand curve for its product, and may be considering a reduction in the price as demand becomes more elastic. The price elasticity will allow the firm to know by how much a price reduction increases quantity demanded. Based on the price elasticity (and not just the price elasticity), managers can then evaluate if it will be profitable to change plant capacity in the long run (as plant expansions usually take time). Many other examples are possible.

True or false and why: Society is better off if the price of fish increases when the stock of fish falls and the value of the stock of fish is now higher at the now higher price of fish.

False. The statement says that the price of fish increases as the stock of fish decreases, and the now lower stock has a higher value (defined as the price of fish multiplied by the stock of fish). Social welfare does not depend on the value of fish. In this case, society has a lower stock of fish. The higher price of fish creates costs and benefits. It hurts customers while it benefits fishers. The effect on society is determined by the sum of all costs and benefits generated to all members of society.

True or false and why: It is impossible for workers to be potential competitors if by leaving they can't start their own firms.

False. Workers may still be potential competitors even when they cannot establish their own firms upon leaving as they may work for an existing or potential firm owned by others.

If the interest rate is 5% per year and the price index is expected to rise 3% per year, how much is $1 deposited a year ago worth today in real terms? What is the real rate of interest?

With interest, the dollar will grow to $1.05. The price index will grow from 1.00 to 1.03. After adjusting for the increase in the price index (the inflation for the period), $1.05 will be worth only $1.05/1.03=$1.0194 in real terms. The real rate of interest is then 1.94% as $1 becomes $1.0194 in real terms at the end of the period, and 1.94 real cents were earned on the initial $1. Summarizing, the real rate of interest is [(1.05/1.03)-1]*100, or 1.94%. Alternatively, consider a customer who deposits $100 today in an account earning 5% per period. At the end of the period, the customer can withdraw $105. However, prices have risen by 3% on that same period and thus the price index is 1.03. Thus $105 are only worth $105/1.03=$101.94 at the end of the period. The customer has earned $1.94 in real interest, or 1.94% on the $100 initial deposit. The real rate of interest is 1.94% per period. Confused? Reread as many times as necessary, and think!

True or false and why: A product with perfect substitutes has a price elasticity of zero.

False. When the product has perfect substitutes, an increase in its price leads to a switch to its substitutes.

When does an increase in income reduce demand?

If the product is inferior, then an increase in income will reduce demand.

Demand is determined by a product's attributes. What is the meaning of "convenience" in the product concept?

"Convenience" refers to how well a producer adjusts the organization's process to the customer's process, or how a producer pays the customer to adjust the customer's process to the organization's process. For example, pizza delivery is convenient (for some customers). Ikea's ready-for-assembly furniture is inconvenient for at least some customers, but customers are compensated for the inconvenience through a lower price. The lower price in turn is facilitated by the lower costs of producing unassembled furniture. The customer co-participates in Ikea's overall process and becomes an "informal employee" assembling furniture at home.

Why is the concept of "balance price" (defined as the price paid by the customer divided by the price received by the producer) useful for decision- making? Present an example.

A "balance price" relates the price paid by the customer (PPC) to the price received by the producer (PRP). The key is to understand the difference. It is presented as a ratio for easier analysis over time. However, the difference (PPC-PRP) is also quite useful. Useful for what? For example, firms have different customers and just focusing on the price paid by customers ignores many factors affecting profitability. For example, the final price paid by the customer is not necessarily received in full by the producer because of quantity discounts offered to wholesalers, rebates offered to customers and distributors, rewards paid out to distributors for prompt payment, bonuses for meeting sales quotas, advertising costs that are pooled with many distributors, shipping costs, insurance, and taxes, among many other costs that reduce the net price received by the producer. Thus calculating "balance prices" allows estimating customer profitability and the cost effectiveness of distribution, so as to balance the business relationship between the firm and its intermediate and final customers. The "balance price" thus strips the "price" of possible distortions and shows what producers actually pocket.

What is the difference between a "change in demand" and a "change in quantity demanded"?

A change in demand refers to a shift in the demand curve, while a change in quantity demanded refers to a movement along a given demand curve. A change in quantity demanded occurs because of changes in the price only. Changing factors other than price change (shift) the demand curve.

What is the difference between a change in consumption (or quantity consumed) and a change in demand?

A change in demand refers to the horizontal change in demand while consumption (or quantity consumed) refers to the horizontal change in the equilibrium quantities. For example, under downward demand (\) and upward supply (/) conditions, suppose that demand increases by 10 units at the original equilibrium price. However, the new consumption (quantity consumed) will not (in this case) increase by 10 units. Why? Consumption (quantity consumed) takes into account both demand and supply. A new demand-supply equilibrium will be established as demand increases. The increase in the price as a result of higher demand will put a "brake" on the now higher demand. Depending on the effect the higher demand has on the price, consumption will increase by less than the increase in demand (for example, 6 instead of 10 units).

A change in the price of a product generates a "real income effect" even if income does not change, and the change in "real income" is especially strong when the share of the product in income is high. What is meant by a change in the price generating a change in "real income"? Why is this change larger when the product has a high share in income?

A change in the price of a product generates a "real income effect" when the change in the price leaves more or less income for other products. For example, consider a person spending his whole income of $100 by buying 10 units of product x that sells for $3 per unit. Product x then explains 30% of the person's income or expenditure. Now suppose that the price increases to $4. For the same quantity, spending will now increase to $40, leaving $60 for other products. Thus the increase in the price of x for the same quantity of x has reduced "real income" as $100 now buys less. Of course, the person may well reduce the quantity of x purchased given the now higher price, but this reaction does not change the idea that $100 now buys less. This idea is important: Consider, for example, that spending on gasoline explains an important proportion of income for many people. If the price of gasoline increases, and the quantity does not decrease or doesn't decrease by much, then less income will be available for other products. As a result, firms offering other products may face a reduction in sales, even if their products are not directly related to gasoline.

Suppose that a company announces record profits but the price of its stock (or share price) goes down. Why?

A possible explanation is that investors bought shares before the announcement expecting even higher profits. The share price falls as relatively disappointing record profits are announced.

The demand curve (or schedule) faced by one producer among many producers is much more elastic than market demand when all producers produce the same product. Why?

A producer among many when all producers produce the same product faces a demand curve that is much more elastic than the market demand curve faced by all producers. In the extreme, with perfect substitutes, the demand facing each producer is infinitely elastic. Simply, this means that one producer among many does not have pricing power. If it charges more, customers escape to other producers producing the same product.

True or false and why: The demand for a product is a demand for all its attributes.

A product is a bundle of attributes and customers may value attributes differently.

A firm produces x, and another product y is a close substitute of x. If y is eliminated, will x face lower substitutability?

Although product y is a substitute for product x, product x may have equally strong substitutes like product z. Thus the elimination of product y may not affect or affect only negligibly the substitutability of product x. This case shows the importance the importance of distinguishing between substitutability and "substitution distance." "Substitution distance" refers to the second best alternative or substitute for a product. In the previous example, the "substitution distance" is extensive if y is a good substitute for x, but z is distant from y. The distance will be short if y and z are both good substitutes for x. This idea has important implications for competitive strategy. For example, consider a firm that eliminates a close substitute y and is now confident that its product x faces fewer threats. Simply, another product z can now take the place of product y, without any significant change in the degree of substitutability of x. Eliminating the firm that produces y may just strengthen a worse enemy, the firm that makes the other close substitute z. Indeed, the firm may have done its main enemy, the producer of product z, a big favor by eliminating the producer of y! Lesson: Distinguish between substitutability and "substitution distance."

When does an increase in income reduce the amount spent on a product while keeping the price unchanged?

An increase in income will reduce demand (shift demand to the left) when the product is inferior. The price will not change if supply is horizontal, and total expenditure (or total spending) on x (=x*Px) will fall as the quantity consumed is now lower.

Heard in a meeting: "If demand for wooden furniture increases, then trees grown in private lands will become scarcer as wooden furniture are ultimatelymade from trees. In the extreme, trees in private lands will become extinct as all trees are used for furniture." Do you agree? Why?

An increase in the demand for furniture will motivate private growers to increase the quantity of trees they grow. Trees in private lands will not become extinct as the higher price motivates growers to plant more trees.

Read in a report: "Data for the most recent quarter shows an increase in the volume sold of our main product. Thus demand has increased in the most recent quarter. We expect demand to continue to increase in the next quarter. To increase profits, we recommend an increase in the price because of the increased demand and the accompanying lower substitutability of our product." Comment.

Comments: An increase in volume sold is not necessarily due to an increase in demand. For example, instead of an increase (shift) in demand, the price may have been reduced, leading to a movement down the demand the demand curve. The expected increase (shift) in demand does not necessarily lead to an increase in price. The best strategy may be to increase quantity produced and keep the price unchanged. An increase in demand does not necessarily mean that the product is now less substitutable. The number of substitutes may have remained the same. There is no reason to consider reduced substitutability when demand facing the firm increases. All firms may be producing the same, equally substitutable product. Your turn!

What distinguishes "competitors" from complementors" or "collaborators"? Can "competitors" be "complementors" or collaborators at the same time?

Competitors may also be collaborators at the same or different times. Managers have to identify actual and potential rivalry and collaboration. Consider the following examples: Two producers of cars like GM and Ford may join forces to distribute parts to its dealers at the same time they compete in the production and sale of cars. Two brewers may jointly own a bottle-producing plant at the same time they compete in the production and sale of beer. Canon may collaborate with Hewlett Packard by providing toner cartridges for HP printers at the same time HP and Canon compete producing and selling printers. Similarly, Sony may supply Hewlett Packard with hard disks at the same time Hewlett Packard sells Sony's disk drives under the HP brand. Lesson: In business there are no enemies or friends, but just "interests."

Heard in a meeting: "Different customers are behind a demand curve. Customers are consumers of a product, and consumers are in turn buyers and payers of that product." Do you agree? Why?

Consumers are not necessarily payers or buyers. Different "customers" like payers, buyers, consumers, influencers and deciders are behind a demand curve.

Is "customer value" simply the difference between benefits and costs received by customers? Does the creation of "customer value" generate profits? Is the creation of customer value sufficient for profits?

Customer value is the incremental difference between the net benefit received by a product relative to its best feasible and comparable alternative. Customer value is not just the difference between customer benefits and the price paid. Customer value should be seen in relation to what competitors offer customers. Customer value is zero for a firm if customers pay the firm the same they pay anyone else and benefits are the same. Please note the importance of having comparable alternatives when estimating "customer value." For example, it is not correct to simply compare one unit of a product with one unit of another product if customers can have two units of a product for the same price as one unit of the other product. Managers should thus follow procedures to adequately compare alternatives. In addition, customer value is a subset of "value." Assuming customers and producers, "value" is composed of customer value (or consumer surplus) and producer value (producer surplus). Given that value is composed of customer value and producer value, value can be generated even if customer value is zero. Producer value is the difference between revenue and costs when costs consider the profits that a producer could make in the best alternative occupation. A firm is composed of a set of internal processes while it engages in transactions with external suppliers and customers. A firm's lower costs or higher revenues relative to competitors are related to the firm's processes. However, not all processes create equal value. Some processes just allow for survival. Also, some processes should not be performed by the organization itself and should rather be subcontracted. Also, given that a firm engages in transactions, it should also focus on influencing transaction costs like the costs of gathering information about the best prices for its supplies, the best places to sell its products, the costs of negotiating with suppliers and customers, the costs transporting the products, among other costs. For both the set of processes and the network of transactions, the key is to design processes and perform transactions that not only create customer value but also provide, communicate, and appropriate that value. The creation, provision and communication of customer value are not sufficient for profits because the firm may be unable to appropriate or capture that customer value.

Heard in a meeting: "It is clear that competitors can be also collaborators or complementors. It is also clear that customers and suppliers can only be complementors, because customers give us their money and suppliers allow us to create value to customers." Do you agree? Why?

Customers and suppliers may also be present competitors and potential competitors. Why? Some examples follow: After buying a product, a customer may learn how to make the same product and sell it to others. The customer then becomes a supplier after being a demander. Ironically, the original producer firm may have facilitated customer learning and thus induced some of the competition it now faces. By receiving sales information from a producer of leather shoes, a supplier of leather may more easily enter the market for leather shoes, bypassing the initial producer of leather shoes. Your turn!

Why does the point price elasticity of demand vary along a linear demand curve?

If demand is x=c-eP, where x is the quantity of product x and P is its price, then the point price elasticity is dx/dp*P/x= -e*(P/x). A higher price determines a higher point price elasticity in absolute value. When P=0, x=c, and thus in the demand's middle point, when x=c/2 , P=c/2e, and thus the point price elasticity in the demand's middle point is PE=- e*(c/2e)/(c/2) = -e*2c/2ec=-e/e=-1.

A consultant tells the manager at a firm that market demand for the product made by the firm is inelastic. In a meeting, the manager says: "Good, now we can increase the price, as revenues and profits will increase if demand is inelastic." What would you say to the manager? (Hint: How competitive is the market?)

Even if market demand is inelastic, a firm among many may not have the pricing power to increase the price without losing many customers. A firm competing with many other firms producing the same or a relatively easy to substitute product faces an elastic demand or, in the extreme, a perfectly elastic demand. Simply, as the firm tries to take advantage of an inelastic market demand, it risks losing its customers, as customers "escape" by buying from competitors. Of course, if the firm is the only producer in a certain market, then market demand is also the demand faced by the firm. In such a case, increasing the price increases revenues and profits, as a lower quantity also costs less to produce. Lesson: An inelastic market demand for a product does not imply an inelastic demand facing an individual firm among many operating in that market.

Present at least six examples of competitors acting as collaborators.

Examples: Some competitors join forces to establish common standards so as to act on producer firms that "ruin the industry." For example, producers of high quality purified water may join forces to pressure for standards for pure water and thus act against producers of low-quality water who damage the reputation of high quality purified water. Competitors A and B join forces to fight a much powerful and dangerous common competitor. Competitors A and B decide to establish plants close to a common supplier, thereby reducing the costs faced by the common supplier, who is in turn willing to reduce the price to both A and B. A firm invites a competitor to jointly serve a market, despite more competition for each of the firms, as the presence of more firms can possibly attract more customers. Two competitors may share the costs of delivering parts to the distributors of their products. The entry of a competitor increases the demand for an input and prompts suppliers to locate closer to producers, reducing costs for the firm and its competitor, while also allowing suppliers to reap cost economies. In the presence of a large and indivisible order placed by a customer, a firm may use a competitor as a supplier of the unfulfilled portion of the order. Your turn (finding many more should not be difficult)!

True or false and why: Demand increases when income increases, because customers have more money to buy products when their income rises.

Higher income does not necessarily increase demand, as it depends if the product is normal (positive relationship between demand and income), or inferior (negative relationship between demand and income). If the product is inferior, then income elasticity is negative: Higher income leads to a lower demand (that is, the demand curve shifts to the left), or lower income leads to a higher demand (the demand curve shifts to the right). By the way, if the income elasticity is positive and greater than one, products are referred to as "normal superior" or simply "superior." The terms "inferior" and "superior" are technical and do not imply that a product is inferior or superior in a judgmental sense.

True or false and why: A higher demand for legal guns cannot reduce the number of guns used in criminal activities.

If a higher demand for legal guns increases the price for guns overall, including those used for criminal activities, then the higher price of guns used for criminal activities reduce its quantity demanded, thereby reducing criminal activity.

Is a nominal interest rate of 4% per year paid on deposits when the price index rises by 2% better for customers than a nominal interest of 6% per year when the price index rises by 4% and taxes in both cases are 30% of the nominal interest earned on deposits? What is the real interest rate after taxes in each case?

If bank customers deposit $100 at the beginning of the year and the nominal interest rate is 4%, then customers will earn $4 in interest, but will have to pay 30% of it in taxes, for net after tax interest payment of $2.80 or 2.8%. Customers will have then $102.80 after tax a year later. Adjusted by the 2% increase in the price index, the deposit plus interest net of tax in real terms will be (102.80/1.02) or $100.78. Thus the real interest is .78%. If the nominal interest rate is instead 6% and the price index increases by 4% per year, then interest income after 30% taxes will be $4.2 and customers will have $104.20 a year later. Adjusted by the 4% increase in the price index, the deposit plus interest net of tax in real terms will be (104.20/1.04) or $100.19 a year later. Thus the real interest will be .19%. The real interest received by customers is lower in the second case. Customers will thus be worse off when the nominal rate is 6% per year and the price index increases by 4% per year, than when the nominal rate is 4% and the price index increases by 2%, and taxes remain the same.

Suppose that initially only two bottles of a unique wine exist. True or false: After one bottle of wine is withdrawn from the market, the remaining bottle of wine must be worth less than the two original bottles of wine.

If demand is inelastic, then the remaining bottle of wine will be worth more than two bottles of wine. For example, two bottles of wine may be worth $20, or $10 each, and if demand is inelastic and supply falls by one bottle, then the remaining bottle will be worth more than $20.

When does consumption (quantity consumed, quantity purchased) remain unchanged when demand increases?

If supply is fixed (vertical), then an increase in demand does not increase consumption (quantity consumed) of x. The quantity consumed cannot increase if only a fixed quantity of x is available, as consumption (quantity consumed) refers to the intersection between demand and supply. A change in demand will thus occur on the vertical supply and thus consumption (or quantity consumed) will remain unchanged.

If the income elasticity is 2 and the price elasticity is 1 (in absolute value), then by how much will the price increase when income increases by 1% if supply is vertical?

If the income elasticity is 2, then a 1% increase in income will increase demand by 2%. In turn, given that supply is vertical, if the price elasticity is 1 in absolute value, then the percentage change in quantity will equal the percentage change in price. Given that the percentage change in quantity is 2%, it follows that the percentage change in price will also be 2%. This is easy to see with the help of a graph. Draw a downward sloping demand and a vertical supply. Then shift demand by 2% at each price level, because the income elasticity is 2 and income increases by 1% according to the problem. Notice that quantity consumed will be the same given that supply is vertical. If the price elasticity is 1, then the percentage change in price will be 2% also.

If the nominal interest rate is 10% per year, and the price index increases by 4% why is the real interest not 10%/1.04?

If the interest rate is 10%, the real rate of interest with a 4% increase in prices is ((1.10/1.04)-1)*100. Why? Suppose that a person has an amount A and deposits it at a 10% rate. Thus, after the year the deposit will be worth A*(1.10) in nominal or absolute terms. However, prices will have risen by 4%. Thus the deposit is worth (A*1.10)/1.04 or A*(1.10/1.04) after a year in real dollars. In real terms, the increase is (1.10/1.04) or, in percent, ((1.10/1.04)-1)*100= 5.77%

A farmer is happy because a record crop is expected. Will the farmer increase his profits when all farmers have record crops?

If the price elasticity for the product is less than one in absolute value, then a record crop for all farmers will reduce revenues for all farmers, as the record crop reduces the market price.

Under downward demand and upward supply conditions, if income rises and the product is inferior, does demand increase or decrease? Does consumption (or quantity consumed) change by more or less than the change in demand?

If the product is inferior, then an increase in income reduces demand. Given that supply is upward sloping, lower demand reduces consumption or quantity consumed. The reduction in quantity consumed (determined by the new intersection of demand and supply curves) is less than the reduction in demand as the price changes when demand falls. If, instead, supply is horizontal (supply is infinitely elastic), then the decrease in demand equals the decrease in consumption when income increases. The new intersection of demand and supply would occur at the same price level. (If you wish, confirm these results with a downward-demand-and-an-upward- supply graph as a graph helps to see the situation.)

After observing a decrease in quantity demanded by 100% after an increase in the price by 100%, a manager says "The price elasticity of demand is thus -.5. Demand is inelastic! Thus, revenues should be higher!" What would you say to the manager? Specifically, will revenue (X*P) increase when quantity demanded decreases by 50% as the price increases by 100%? Is the price elasticity really -.5?

In this case, changes in price and quantity are large. An increase in the price by 100% and a reduction in quantity demanded by 50% leads to the same revenue (defined as price multiplied by quantity or P*X) as 2P*(.5X), where P is the original price and X is the original quantity, equals P*X, the original revenue. Now, the price elasticity formula would indicate that, indeed, the price elasticity is less than one. Why then doesn't revenue increase, as the manager says? The reason is that with the reported large changes in price and quantity, the manager should average the prices and the quantities to have a better estimate of the price elasticity. Suppose the price was originally $10 and the price increases by 100% to $20, while quantity demanded falls by 50% from 10 units to 5 units. Revenues would be $100 before and after the change in price and quantity. Using the average of prices and quantities the price elasticity would be dx/dp*(Average P/Average X) or (-5/10)*(15/7.5) or -1. This makes sense, as revenues do not change and the price elasticity is -1 (or "unitary elastic"). Lesson: Be careful when applying the price elasticity formula (or any similar elasticity formula for that matter). When changes are large (as a rule of thumb, when changes exceed 10%) use average prices and quantities! Also, it easy to find out if demand is elastic or inelastic within a demand segment by looking at the change in revenues (X*P). If revenue (X*P) increases when the price increases, then demand is inelastic, and if revenue decreases, demand is elastic. Analogously, if revenue (X*P) increases when the price decreases, then demand is elastic, and if revenue decreases, demand is inelastic.

Heard in a meeting: "We buy 80% of an input from one single supplier firm. However, our purchases only represent 1% of the supplier's overall sales of this input. The dependence on this supplier is unacceptable. We are vulnerable to supplier's actions." Comment. Specifically, based on the percentages mentioned, is the firm dependent on the supplier?

It is important for a firm to know how much it purchases from a supplier firm relative to overall purchases and how much the supplier sells to the firm relative to its overall sales. However, a high level of purchases relative to total purchases does not necessarily indicate (imply) high vulnerability as the buyer firm may still be able to switch easily to other suppliers if conditions so warrant. The same is true for the supplier. In the extreme, a supplier that sells mostly to one buyer may appear to be highly vulnerable to buyer action. Even so, the supplier may still be able to switch to other buyers without incurring significant costs. Lesson: Managers should identify the degree of supplier substitutability behind the proportion of purchases made from a given supplier, or the degree of buyer substitutability behind the proportion of sales made to a given buyer.

When quantity demanded changes after a change in price, the price elasticity can be calculated as the change in expenditure due to a change in quantity [change in quantity (dx) multiplied by the average price] divided by the change in expenditure due to a change in price [change in price multiplied by average quantity] Why? (Suppose the price falls from $10 to $9 and the quantity demanded increases from 10 to 12 units. What is the price elasticity?)

It should not come as a surprise that the price elasticity (PE) is also the change in expenditure due to a change in quantity divided by the change in expenditure due a change in price. It's based on the formula for PE. Why? The formula for PE is (dx/dp)*(P/x) or (dx*P)/(dP*x). The numerator (dx*P) is the change in expenditure due to a change in quantity, while the numerator (dP*x) is the change in expenditure due to a change in price. In both cases averages of x and P can be used to better estimate the price elasticity. Thus for the numbers provided, and using averages for a better estimate, the price elasticity in the demand arc or segment bounded by ($10, 10) and ($9, 12) is PE= (2/-1)*(9.5/11) =-1.73, or 1.73 in absolute value. Using changes in expenditure instead, the estimated price elasticity is - (2*$9.5)/(11*$1)=-1.73 or 1.73 in absolute value. Obviously it is the same result. Using average quantity and average price for better approximation for the price elasticity in the demand arc or segment bounded by ($10, 10) and ($9, 12), customer expenditure increases by $19 because of an increase in quantity (2 units) and expenditure falls by $11 because of a reduction in price ($1). Thinking in terms of changes in expenditure may be useful when applying the concept of price elasticity.

True or false and why: If the price elasticity is less than one, then an increase in the price reduces revenues.

Just the opposite. When demand is inelastic (or less than one in absolute value) over the relevant range, then the percentage change in price exceeds the percentage change in quantity, and Px*X (customer expenditure or producer revenues) increases.

Suppose a firm faces a downward sloping demand curve and currently produces 10 units for total revenue of $100. If total revenue is $105 when it produces 11 units, is the price of the 11th unit $5?

Marginal revenue is not necessarily equal to price. According to the problem, the firm collects $100 in revenue when it produces 10 units and $105 when it produces 11 units. It is wrong to conclude that the price of the eleventh unit is then $5, the marginal revenue. Consider that the firm is selling 10 units at a price of $10 per unit, but to sell 11 units it has to reduce the price for all units to $9.55 per unit. Clearly, the price of the eleventh unit will be $9.55 in such case. Simply, to sell 11 units instead of 10 units, the firm may have to reduce the price of all units. Now, when is marginal revenue equal to the price of the additional unit sold (MR=P) even when a firm faces a downward sloping demand curve? Consider that a firm may be able to sell an additional unit at a lower price without affecting the price charged for the previous units. The firm may be able to sell 10 units for $10 per unit and sell an additional unit (the eleventh unit) for $5 without affecting the price of the previous 100 units. Such a case is possible when a firm discriminates on the basis of price.

What is the difference between "individual demand" and "market demand"?

Market demand is the (horizontal) sum of individual demands. For example, suppose that at price of $2 per unit, 100 customers buy 5 units each and 300 customers buy 8 units each. If the market is composed of the aforementioned 400 customers, then market demand is 100*5+300*8=2,900 units. Thus market demand is 2,900 units at a price of $2.

Heard in a meeting: "A substitute cannot be made a complement. That is implicit when we define a product as a substitute or a complement. Obviously, a product cannot be both a substitute and a complement." Do you agree? Why?

Orange juice and coffee may be complements at some times but substitutes at other times. Also, a manager can influence substitutability. For example, if meat is a substitute for pasta, a manager of pasta may suggest that customers eat pasta with meat. Or consider milk: Some consumers may combine milk and coffee while others may drink milk instead of coffee. A consumer may have coffee with milk in the morning but have a glass of milk instead of coffee in the afternoon.

True or false and why: Only positive benefits explain the demand for a product.

Positive benefits explain the demand for a product, but so do cost reductions and loss avoidance. Not all three types of benefit have to be necessarily present for customers to have a demand for a product. For some customers, cost reduction may be more important than positive benefits. For example, some customers may have a demand for energy saving light bulbs mainly because of cost reduction attributes of energy saving light bulbs.

A consultant visits a city routinely and notices that prices increase by about 5% at the end of each month before falling again when the new month starts. Also, lines form in front to restaurants and at cash registers of supermarkets, leading to wasted time and aggravation. The consultant learns that capacity is constrained during the last days of each month as demand increases. He suspects that demand increases because of increases in income. The consultant tells the manager of a local firm, "You can increase the real income of your workers without giving them any extra penny. Indeed, you may be able to save on labor costs too. However, don't tell anyone. If many know how to do it, the effect is diluted." Puzzled, the manager asks, "What? Are you a magician? How can we increase the real income of our workers if we don't increase their pay?" Can you provide an answer?

Possible answer: Prices in the city may be going up at the end of the month because demand increases, given capacity constrains. Demand may in turn increase because most workers living and working in the city are paid at the end of the month. The firm may be able to increase the purchasing power of the income received by its workers by paying them before the end of the month. The firm may thus be able to increase endogenously the real income receive by its workers. ("Endogenously" means "from within.") Indeed, the firm may even be able to reduce pay given that workers gain as they increase their real income and purchasing power by receiving their pay before prices rise. Analogously, the firm may change the work schedule of its workers so workers waste less time commuting. Notice that the effect will be diluted if all firms do the same.

A purchasing manager is planning to buy an input y next month. Given an expected lower overall demand for the input next month, the purchasing manager feels less urgency to secure the input today. However, to the surprise of the purchasing manager, when the order is made, the input is as difficult to find, despite lower demand. What may have happened? Provide an explanation.

Possible explanation: The producer of the input also may have expected a lower demand for the input and decided to produce less. Both demand and supply fell (or shifted to the left). Expectations played a role in the final outcome.

A change in the price of a product generates an "income" and a "substitution" effect. For example, the substitution effect of an increase in the price of product x motivates customers to demand more of the substitute. The income effect from an increase in the price reduces real income or purchasing power as customers can buy less of the product at the new higher price. Depending on the type of product (normal, inferior or neutral), the reduction in real income may increase, decrease or not affect demand. Now the question: If the share of the product is small in total income or expenditure, will the income effect be large or small?

Real income is nominal or absolute income divided by the price level or price index. When the price of a product increases, real income falls. The effect on real income of an increase in the price of a product is labeled "income effect." The "substitution effect" refers to the reduction in quantity demanded brought about by a change in price (an increase in the price, in this case). The change in the quantity of the product is the combined result of the substitution and income effects. Some products have low substitution effects and low income effects. For example, take salt. The proportion of salt in total expenditure or spending is small. Thus, the income effect is low. Also, salt has few, if any, substitutes. Other products, like housing, have high income effects. The share of housing in total expenditure or spending is high, thus making the income effect important. A higher price of housing has an important effect on real income. It leaves people with much lower real income.

Heard in a meeting: "Some analysts are warning that demand will remain weak. Well, not so in our case, as the latest report shows a robust increase in sales or quantity sold. When sales are up, demand is strong!" Comment. Specifically, is demand strong when sales increase?

Sales (or quantity sold) may go up even if demand remains unchanged or demand decreases. Sales result from both demand and supply interactions. For example, quantity sold may increase when the increase in supply more than compensates a decrease in demand. A manager should not conclude that demand has increased when sales or quantity sold is now higher.

Salt has a very low price elasticity of demand. Why? (Present at least two reasons.)

Salt does not have many substitutes, and the share of salt in customer expenditure is low, so that the "income effect" of a change in the price is low. Both make for a highly inelastic demand for salt.

Generally speaking, what is behind the concept of "elasticity" independently of its specific use in business economics?

Simply, the concept of "elasticity" refers to the percentage change in one variable when another variable changes in a given percentage. Specifically, if A and B are two variables, then the elasticity of A with respect to B is simply the percentage change in A when the other variable changes in a given percentage. For example, an elasticity of A with respect to B equal to 2 means that a 1% change in B changes A by 2%. Notice that the elasticity is just a number, and not a percentage.

What factors or variables affect supply? How does the price of the product affect quantity supplied? How does the price of inputs increases? How does a complement in production affect supply? How does a substitute in production affect supply? How do expectations affect supply?

Supply is affected by the price of the product (the firm's output), the price of complements in production, the price of substitutes in production, the number of firms, technology, expectations and other variables. Typically, a higher price increases quantity supplied. A higher number of firms increases supply. A higher price of a complement in production increases supply (as happens, for example, when a product is a by-product of the other, as in the case of chicken meat and feathers -a higher price of chicken leads to produce more chicken and thus more feathers). A higher price of a substitute in production reduces supply (for example, a higher price of potatoes leads to produce more potatoes and fewer tomatoes). An increase in the price of inputs reduces supply as it increases costs. Technology increases supply as more can be produced at the same cost. Expectations of future higher prices reduce supply today, as producers prefer to wait and sell their output for a higher price tomorrow.

Heard in a meeting as the CEO of a recently established firm discusses its strategy: "As a start-up, we will beat the existing players in the market, but it will not be easy. They will fight us, but we will fight back. There is so much to gain, so it is worth it. Long live our grand strategy! Let one thousand flowers bloom as we get rich!" A manager attending the meeting says, "This is not a 'grand strategy' but a naïve strategy. We can have more than thousand flowers bloom too. I don't think we should fight. Rather, let's go to competitors and shake their hands." Surprised, the CEO says, "Shake hands with the same ones who want to hurt us?" Please defend the manager.

The CEO apparently ignores a possible better option of joining forces with competitors. Instead of fighting, it may be more profitable to sell the idea to one or several competitors or sell the whole start-up to a competitor who wants to "crush" it (using the CEO's words). Simply, collaboration may be more profitable than confrontation.

Given low demand for travel, a vacationer is in no hurry to buy a ticket today and thus decides to wait longer before buying a ticket. The vacationer tells a friend, "The planes will anyway be empty," However, the vacationer finds tickets difficult to buy shortly before the vacation. After being able to buy a ticket, the vacationer is surprised to see the plane full. What happened? Present a possible scenario.

The airline may have also expected low demand and adjusted capacity (the number of planes in use). The airline may have cancelled flights and rerouted passengers to their destinations through other flights (including flights run by competitors).

An art collector owns 20 paintings out of 30 paintings of a famous deceased artist. A painting recently sold for $10,000. In a meeting with friends, the collector says, "Well, if a painting sold for $10,000 then my collection of paintings is worth $200,000. In other words, If I sell them tomorrow I would get $200,000." What would you say to the collector, assuming that his paintings are similar to the one recently sold?

The collector will not get $200,000 if 20 paintings are offered in the market. One painting may fetch $10,000 if one painting is sold, but the 20 paintings owned by the collector represent 67% of all paintings. Selling so many paintings at once will have an important effect on the price of paintings. The price of each painting will then be less than $10,000.

The CEO at a firm says to a manager after an increase in the payroll tax paid by firms and employees, "This is terrible for business. Higher payroll taxes reduce disposable or discretionary income and that in turn lowers demand." The manager replies "Well, given the circumstances, we might benefit!" Make sense of the manager's words. Specifically, why may a payroll tax benefit the firm?

The income elasticity may be negative for the firm's products. Thus a reduction in income because of the increase in the payroll tax that decreases disposable or discretionary income may lead to higher demand for the firm's products. Consider that the firm may attract lower income customers and now becomes more appealing to customers with lower income.

A report reveals that sales of new houses increased by 12% after a 10% reduction in the price of new houses. In a meeting, a manager says, "Based on this information, we can conclude that the price elasticity for new houses is -1.2 (or 1.2 in absolute value). What would you say to the manager? Specifically, is the price elasticity 1.2 "based on this information" as the manager says?

The manager concludes that the price elasticity is 1.2 in absolute value if sales of houses increased by 12% when the price of new houses fell by 10%. However, the price elasticity is defined for a given demand curve. Both demand curve and the supply curve may have shifted. The information provided then reflects the new equilibrium between demand and supply. Instead of being on the same demand curve, the old and new prices and the old and new quantities reflect old and new intersection of demand and supply.

A firm is considering donating 10% of its total revenues to a charitable organization. A manager opposes the idea and says, "If we have to donate 10% of our total revenues to charity, then the price has to increase by at least that much for our profit to remain unchanged. Given the present condition in the market, we just cannot raise prices. The charity will have to wait. We can't afford it. Look, we are not just considering donating 10% of additional revenues here, but 10% of total revenues. Although I am sympathetic to the needs of this charitable organization, donating 10% of total revenue is simply a crazy idea. After donating 10% of revenues, it is us who will need a donation to keep afloat, ha-ha." Comment. Specifically, can the firm increase its profits by donating 10% of total revenues to a charity if the price remains unchanged?

The manager ignores that the donation may shift demand. Profit for the firm after donating 10% of total revenues to charity may increase. For example, suppose that the firm currently produces 100 units and charges a price of $5 per unit, and makes a $2 profit per unit, for a total profit of $200. Suppose that positive publicity when the firm donates 10% to charity increases (shifts) demand by 40%, so that the firm can now sell 140 units. Total revenue increases from $500 to $700 while its profit before donating 10% of revenues to charity increases to $280. The profit is $210 after transferring 10% of revenues to charity. Even after donating 10% of total revenues to the firm, profit for the firm is higher by $10, or 5%. In this case, donating 10% of total revenue increases profits by 5%. As a parallel exercise, consider a case where the firm donates 10% of incremental revenues. By how much does profit increase if instead of donating 10% of total revenues, the firm donates 10% of incremental revenues? Assuming the same increase of 40% in revenues, the firm will now donate $20 as revenues increase from $500 to $700. Its profit after donating to charity will be higher by $60. Thus donating 10% of incremental revenues to charity increases profit by 30%

A firm sells ready-made meals that require additional cooking time and plans to introduce a cooking appliance that will more easily cook the ready-made meals and also will allow users to cook meals from ingredients they can buy from the supermarket. In a meeting, the manager says, "Well, we should expect more sales of ready-made meals as we sell more of the appliance because ready -made meals and the cooking appliance are complements. One helps to sell the other." What would you say to the marketing manager?

The marketing manager should be cautious. It appears that the cooking appliance and ready-made meals are complements, as the appliance can more easily and quickly cook the ready-made. However, the cooking appliance may lead customers to prepare more meals at home, reducing the demand for ready- made meals. Thus demand for the ready-made meals may fall because of the cooking appliance that the marketing manager considers to be a complement. A similar case is when a player-recorder can play both special on-demand shows and record regular TV shows. It appears that a player-recorder can only increase the demand for on-demand shows as the player-recorder plays the on-demand shows. However, the player-recorder may lead customers to record more regular TV shows and thus reduce the demand for on-demand shows.

The price elasticity is defined as the percentage change in quantity due to a percentage change in price. Translate this definition into a mathematical formula.

The price elasticity of demand is defined as a percentage change in quantity over a percentage change in the price. The percentage change in quantity is (dx/x)*100, while a percentage change in price is (dPx /Px)*100, where dx is the change in x, and dPx is the change in the price of x. For example, if quantity demanded is 100 units and it increases by 2 units when the price changes from $10 to $9.90, then the percentage change in quantity is (2/100)*100=2%, while the percentage change in the price is (.10/10)*100=1%. Thus the price elasticity of demand is (dx/x)/(dPx /Px)=2%/-1%=-2, or just 2 in absolute value. (Note: A better estimate of the price elasticity is obtained when percentage changes in quantity and price are large (higher than 10% in practical application) by averaging quantity and price levels. The average quantity when quantity increases from 100 to 102 is (100+102)/2=101 and the average price when the price falls from $10 to $9.90 is ($10+$9.90)/2=9.95. In this case, the use of 101 units and $9.95 instead of 100 units and $10 when applying the formula does not add much value because quantity and price changes are small anyway.) By rearranging terms, the price elasticity (dx/x)/(dPx /Px) is equivalent to (dx/dPx)/(x/Px), and to (dx/dPx)*(Px/x), or to (dlogx/dlog Px). (Check an elementary mathematics book if the previous derivation confuses you, because the various ways to present the price elasticity are more about elementary mathematics than about economics.)

What is the problem when defining industry as "collection of firms producing products that are substitutes in consumption"?

The problem with defining an industry composed of firm producing products that are close substitutes in consumption is that it ignores some potential competitors. Suppose that firm A produces x and another firm B produces y, and x and y are substitutes in consumption. The industry is thus composed of A and B. However, a firm C presently producing a product z unrelated to x and y in consumption may use a similar process used to produce z to produce x. If the price charged by A and B is increased beyond a certain threshold level, C may decide to enter A and B's market and produce x. Thus A, the producer of x, is continuously contested or kept in check by C, despite C presently not producing x. Firm C is a potential competitor as it produces z with a process that enables production of x if so warranted by conditions in the market (like the price of x). Thus managers should be careful with bureaucratic definitions of "industry" and consider potential competitors that are able to quickly enter and produce the same or a similar product if external conditions become are sufficiently attractive.

In a meeting, a sales manager presents a pessimistic profit outlook, and predicts higher unit sales for the next quarter. The production manager attending the meeting says, "Aha, this means that demand will increase and remain strong, and if demand is strong, we should not be that pessimistic!" What would you say to the production manager?

The production manager incorrectly concludes that "demand will increase and remain strong" by looking at unit sales only. However, unit sales can increase even if demand falls. The firm may increase unit sales by reducing the price. Unit sales may increase despite weaker demand as the price falls. (The production manager should take the course.)

If the price of a product was $1 a year ago and is $1.20 now, has the real price increased if the price index increased by 5% in the same period? If so, by how much did the real price increase?

The real price increased because the percentage increase in the price (20%) exceeded the percentage increase in the price index (5%). The real price is $1.20/1.05 or $1.14 today.

Heard in a restaurant: "A reduction in the sales tax paid by drinks in restaurants will increase the price of drinks, and not reduce it, because a lower sales tax will induce consumers to demand more drinks, and a higher demand for drinks will then increase the price." Do you agree? Why?

The reduction in the sales tax reduces the price of drinks and leads basically to a change in the quantity demanded of drinks, not to a shift in demand.

Heard in a meeting: "A higher demand for oil recently increased the price of oil. However, the increase is not sustainable because a higher price of oil will reduce demand as the price oil reduces real income and the reduced demand will then again reduce the price of oil." Do you agree?

The statement confuses a change in demand with a change in quantity demanded. The price of oil increases because of an increase or shift in the demand for oil. The higher price of oil is a consequence of a higher demand for oil.

True or false and why: If demand is downward- sloping and supply is upward-sloping, then, if demand falls, the price falls, but when the price falls, demand increases. Hence, a decrease in demand does not reduce the price.

The statement confuses a shift in demand (a change in demand) with a movement along the demand curve (a change in quantity demanded). Assuming a downward-sloping demand curve and an upward sloping supply curve, a decrease (shift) in demand reduces the price, but the lower price does not shift demand again to the right.

If the table below shows a demand schedule for a firm, what is total revenue and marginal revenue (the change in revenue when an additional unit of x is produced)? Is demand elastic in the $30-$40 arc or segment? P X 10 10 20 9 30 8 40 7 50 6 60 5

The table with total revenue (TR) and marginal revenue (MR) added is P 10 20 30 40 50 60 x 10 9 8 7 6 5 TR 100 180 240 280 300 300 MR 80 60 40 20 0 When applying the price elasticity formula, the estimate for the price elasticity in the $30-$40 arc or segment is -1/10*(35/7.5) =-.47. Demand is inelastic in this arc. This makes sense, as the firm's total revenue increases when the price increases. Another way of knowing that the price elasticity is less than one is by analyzing the change in revenues. Revenues are $280 when the price is $40, while revenues are $240 when the price is $30. Revenues increase as the price increases from $30 to $40, and thus demand is inelastic in this segment. The price elasticity is less than one in absolute value.

If in market A the price elasticity is -4 and in market B the price elasticity is -7, and market A represents two thirds of the total market, what is the price elasticity for the whole market?

This problem has more to do with elementary algebra than with economics. For simplicity, suppose that the total quantity in markets A and B is 300 units, and thus the quantity in A is 200 units (that is, two thirds of the total). If the price falls by 10%, then quantity in A increases by 40% to 280 and the quantity in B increases by 70% to 170, for a new total of 450, an increase of 50%. Thus the price elasticity of the whole market is 5. Of course, this is the same as if the price elasticity in each market is weighted by the participation of each market in the total market, or (2/3)*(-4) + (1/3)*(-7)=-15/3, or -5. Easy!

The term "industry" often means "collection of firms producing similar products." Does this mean that all manufacturers of cars belong to the "car industry"? Does this mean that producers of mystery novels produce books in the "book industry" while producers of mystery films operate in the "movie industry"?

The term "industry" is often used ambiguously. In a business context, the use of the term typically relates to the degree of substitutability (in consumption) among products. The economic interpretation of industry is not necessarily the bureaucratic meaning of industry (based on the Standard Industrial Classification -SIC- or its successor since 1997, the North American Industry Classification System - NAICS-). The idea is simple: If a book is a good substitute for a movie, then producers of books and producers of movies can be considered to belong to the same "industry." If a BMW is not a close substitute to a Hyundai, then producers of Hyundai cars can reasonably considered to belong to a different "industry." If BMWs and leisure boats are close substitutes, then producers of BMWs and producers of boats can be judged to be in the same "industry." If wood, ceramic tile and linoleum are used for flooring, then a producer of wood, ceramic tile and linoleum flooring are in the same industry. This is not the case when using the SIC or NAICS. Other problems relate to the international and geographical scope of industries. The car industry competes globally, while a paper mainly competes locally. There may be many producers of cement, but a local producer of cement enjoys less competition given the high transportation costs of cement. There are thousands of bakeries producing fresh bread but there may be just one in a small town, and fresh bread is costly to transport. This shows the relativity of the "industries" listed in standard "bureaucratic" classifications. The practical use of the term "industry" in business and economics thus extends beyond a bureaucratic interpretation. Remember product substitutability in consumption as the main determinant of an "industry." This explains also the use of the concept of "strategic groups." For example, BMW, Lexus, Mercedes, Cadillac and other producers or divisions producing luxury cars can easily be included in one strategic group, while Toyota, Nissan, Honda and Mazda, and other producers of more utilitarian cars can be included in another strategic group. Cars are simply not just cars.

If the cross elasticity of complements like steak sauce and meat is negative, how can the quantity of steak sauce increase when the demand for meat increases? Does a negative cross elasticity of steak sauce and meat contradict the observation that an increase in the demand for meat increases the demand for steak sauce (its complement)? Why?There is no contradiction. If the price of meat increases on the same demand curve for meat (for example, because the costs of producing meat increase), then the quantity demanded for meat decreases and the demand for steak sauce decreases also as steak sauce complements meat. Thus an increase in the price of meat reduces the demand for steak sauce, as reflected by the negative cross elasticity of steak sauce with respect to the price of meat. Now, when demand for meat increases because, for example, more people prefer meat, then the demand for steak sauce increases also, as more steak sauce is consumed with more meat.

There is no contradiction. If the price of meat increases on the same demand curve for meat (for example, because the costs of producing meat increase), then the quantity demanded for meat decreases and the demand for steak sauce decreases also as steak sauce complements meat. Thus an increase in the price of meat reduces the demand for steak sauce, as reflected by the negative cross elasticity of steak sauce with respect to the price of meat. Now, when demand for meat increases because, for example, more people prefer meat, then the demand for steak sauce increases also, as more steak sauce is consumed with more meat.

True or false and why: If the point price elasticity of demand equals 1 in absolute value, then expenditure does not change or changes minimally when the price changes. Hint: Take any price and any quantity and change the quantity by a small percentage (for example, .1%) when the price changes also by that same small percentage (.1%), as the price elasticity equals one in absolute.value.

True. Intuitively, it is easy to see that when PE=-1, expenditure does not change. If the price elasticity is greater than one in absolute value and the price increases, expenditure decreases. If the price elasticity is less than one in absolute price and the price increases, expenditure increases. A price elasticity equal to one in absolute value can then be seen as the borderline between the case when price elasticity is greater than one and the case when price elasticity is lower than one. Alternatively, consider a price of $10 and a quantity of 10,000 units. Expenditure is thus $100,000. Suppose that the price increases by .01% and if the price elasticity equals one in absolute value quantity then decreases by the same .1%. Thus the price is now $10.01 and the quantity is now 99990 for a expenditure equal to $9999.99, or practically $10,000. Remember that the point price elasticity is calculated at a point and a point considers infinitesimally small changes. Thus expenditure remains at $10,000. Optional demonstration: Applying the chain rule, d(xP)/dx equals dx/dx (P) + x (dP/dx) which in turn is equal to P + x (dP/dx), which in turn equals P [1+(x/P)*(dP/dx)]. Given that the price elasticity is defined as PE=-(dx/dP)* (P/x), the change in expenditure equals d(xP)/dP= P*[1- (1/PE)]. Thus d(xP)/dx=0 (that is, expenditure does not change) when PE=-1 (the elasticity is one in absolute value).

A customer currently buys 100 units of a product at the current price of $2. When asked, the customer says that the maximum willingness to pay for one unit is $6. Based on this information alone, can you roughly estimate the customer's point price elasticity when the price is $2 and quantity demanded is 100 units? Based on this rough estimate, should the producer experiment and increase the price?

Two quite disperse price/quantity combinations are available: ($2, 100) and ($6, 1). For a rough estimate of the point price elasticity, let's assume a linear demand relationship. The demand equation is x=149.5-24.75P for the previous price/quantity combinations. As a quick note, you should know how to derive a linear equation from two combinations of points. Check any basic or elementary mathematics book if you don't know how to do this. Confirm that x=100 if the price is $2, and x=1 if the price is $6 when using this linear demand equation just derived. Continuing, the slope of this linear demand curve is dp/dx=4/99. Using the price elasticity formula PE=dx/dp*p/x, and replacing P and x by the current price ($2) and current quantity (100), the point price elasticity (PE) at this price/quantity combination is (- 99/4)*(2/100) =-.495 or simply .50 in absolute value. Based on this rough estimate, the producer should experiment and increase the price. For example, suppose the price increases by 4% to $2.08. Using the previously derived linear demand equation, quantity demanded will then be x=149.5-24.75*2.08=98. The producer's revenue will then increase from 100*$2=$200 to 98*$2.08=$203.84 while costs will decrease as less is produced. Profits will thus increase.

A producer estimates demand as x=200-P (equivalent to an indirect demand equation P=200-x), where P is the price of product x and x is the quantity of x. What is the price elasticity of x? Would your result change if instead the demand equation is Log x=200-Log P?

Using the formula, the point price elasticity would be P/X, because dx/dP=-1. Why is dx/dp=-1. Easy: The demand equation is x=200-P and if, for example, P=50, x=150, and if P=49, x=151. Or, for example, if P=20, x=180 and if P=21, x=179. Clearly, a $1 decrease in price leads to a one unit increase in quantity demanded, and thus dx=dp=-1. Of course, P is the price and x is the quantity associated with that price according to the estimated demand equation. The price elasticity will then be dx/dp*P/x or - 1*(P/x). For example, if P=20, then x=200-20=180, and thus the point price elasticity would equal 2/18 or 1/9 in absolute value when P=20 and x=180. Now, if the demand equation is Log x=200-LogP, then the price elasticity would be 1 in absolute value, as the price elasticity is defined as dLogx/dLogP (which is exactly equivalent to dx/dP*P/x, where again P is the price of product x and x is the quantity of x).

Why are producers of complements for a product x both collaborators and competitors of the producer of x?

When the price of the complement increases, the demand for product x falls. This is equivalent to an increase in production of x by competitors. In this sense, the producer of a complement acts as a competitor. Of course, the producer of a complement also acts as a collaborator when that producer helps the producer of x sell more units of x.

Under downward demand and upward supply, if demand increases and supply decreases, may customer expenditures fall?

Yes, as the next examples shows: Suppose that initially the price is $5 and quantity consumed is 10 units. Expenditure is thus $5*10=$50. Suppose that the demand increases and supply falls, pushing the price to $8 and reducing the quantity consumed to 5 units. Thus, expenditure is now $8*5=$40. The increase in demand and the reduction in supply reduced expenditure in this case.

Are a firm's customers indirect and potential competitors too?

Yes, they should be included. For example, customers are competitors when they imitate a product, or negotiate a lower price due to their buying power. Also, consider that customers include intermediate customers like distributors and firms that tie a product to their own products. Customers can be potential competitors when they turn into suppliers after learning how the product works or is made. Also, customers can be competitors when...your turn!

If a total demand schedule or curve is defined as the sum of individual demand schedules at each price level, does the total demand curve include the demand curve of potential customers who currently do not buy the product at the prevailing price?

Yes. At the current price level, some people do not buy, as their willingness to pay is below the prevailing price. However, the total demand curve, as the horizontal sum of all individual demand curves, includes them. If the price falls sufficiently, people currently not buying will be tempted to buy, and the total demand curve will reflect it.

A store sells each a product it buys for $15 for $18. At that price it sells 50 units per week. A manager says, "I was considering raising the price to $19. My feeling is that this reduces sales by 2 units." Based on this information, should the store increase the price of the product to $19?

Yes. Demand is inelastic. Revenue is now 19*48=$912, higher than the revenue of $900 selling 20 units. Profit is now $192 instead of $150.

Are producers of utilitarian cars (like Hyundai or Kia) competitors of producers of symbolic cars (like BMW or Lexus) when luxury and symbolic cars are unrelated in demand? Why?

Yes. Even if utilitarian cars and symbolic cars are unrelated in demand, both use similar resources. Thus they compete when they demand resources or inputs like steel, glass and tires. Also, producers of utilitarian cars are potential competitors. They may later produce symbolic cars by using the production of utilitarian cars as an initial platform.

Can firms in an industry that use the same resources collaborate with a firm operating in a different and completely unrelated industry?

Yes. When firms in an industry demand more resources like a common input, then producers of the input may enjoy economies of scale, or reduced average costs of production due to larger scale or size of plants, and the price of the input may fall with greater production. The lower price benefits the firm using the same input and operating in an unrelated industry.