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# Let G be (achieved points)/10+1.5. Round G exactly to quarters of a grade to get your grade.

## Solution to Homework Set 3

Managerial Economics Fall 2011

## Conceptual and Computational Questions

6 points
2. The demand curve for a product is given by Qd x = 1, 000 2Px + .02Pz , where Pz = \$400. (a) What is the own price elasticity of demand when Px = \$154? Is demand elastic or inelastic at this price? What would happen to the rms revenue if it decided to charge a price below \$154? At the given prices, quantity demanded is 700 units: Qd x = 1000 2 154+ .02 400 = 700. Substituting the relevant information into Px 1 point the elasticity formula gives: EQx ,Px = 2 Q = 308 700 = 0.44. x Since this is less than one in absolute value, demand is inelastic at this price. If the rm charged a lower price, total revenue would 1 point decrease. (b) What is the own price elasticity of demand when Px = \$354? Is demand elastic or inelastic at this price? What would happen to the rms revenue if it decided to charge a price below \$354? At the given prices, quantity demanded is 300 units: Qd x = 1000 2 354+ .02 400 = 300. Substituting the relevant information into Px 1 point the elasticity formula gives: EQx ,Px = 2 Q = 708 300 = 2.36. x Since this is greater than one in absolute value, demand is elastic at this price. If the rm increased its price, total revenue would 1 point decrease. (c) What is the cross-price elasticity of demand between good X and good Z when Px = \$154? Are goods X and Z substitutes or complements? At the given prices, quantity demanded is 700 units. Substituting the relevant information into the elasticity formula gives: 1 point Pz EQx ,Pz = .02 Q = .02 400 700 = 0.011. Since this number is positive, x goods X and Z are substitutes.

1 point

7 points

3. Suppose the demand function for a rms product is given by ln Qd x = 3 0.5 ln Px 2.5 ln Py + ln M + 2 ln A where Px = \$10, Py = \$4, M = \$20, 000, and A = \$250.

(a) Determine the own price elasticity of demand, and state whether demand is elastic, inelastic, or unitary elastic. The own price elasticity of demand is simply the coecient of 1 point ln Px , which is 0.5. Since this number is less than one in absolute value, demand is inelastic. 1 point (b) Determine the cross-price elasticity of demand between good X and good Y, and state whether these two goods are substitutes or complements. The cross-price elasticity of demand is simply the coecient of ln Py , which is -2.5. Since this number is negative, goods X and as in a) 2 points Y are complements. (c) Determine the income elasticity of demand, and state whether good X is a normal or inferior good. The income elasticity of demand is simply the coecient of ln M , which is 1. Since this number is positive, good X is a normal as in a) 2 points good. (d) Determine the own advertising elasticity of demand. The advertising elasticity of demand is simply the coecient of 1 point ln A, which is 2.

2 points

8. Suppose the true inverse demand relation for good X is P = a + bQ + e, and you estimated the parameters to be a = 10, b = 2.5, a = 1, and b = 0.5. Find the approximate 95 percent condence interval for the true values of a and b. The approximate 95 percent condence interval for a is a 2a = 102. 1 point Thus, you can be 95 percent condent that a is within the range of 8 and 12. The approximate 95 percent condence interval for b is 1 point b 2 b = 2.5 1. Thus, you can be 95 percent condent that b is within the range of -3.5 and -1.5.
d = a + bP + cM + e, where 9. The demand function for good X is qx x Px is the price of good X and M is income. Least squares regression

7 points

## This should be -1.36/0.56

reveals that a = 5.25, b = 1.36, c = 0.14, a = 6.19, b = 0.56, and c = 0 . 05 . The R -square is 0.24. (a) Compute the t-statistic for each of the estimated coecients. 9369.45 1.36 The t-statistics are as follows: ta = 11067.07 = 0.848; t b = 0.56 = each t one point 0.14 2.429; and tc = 0.05 = 2.80. (b) Determine which (if any) of the estimated coecients are statistically dierent from zero. Since |ta , is not statistically dier | < 2 the coecient estimate, a ent from zero. However, since |t | > 2 and |tc | > 2, the coecient b estimates b and c are statistically dierent from zero. (c) Explain, in plain words, what the R-square in this regression indicates. The R-square and adjusted R-square tell us the proportion of variation explained by the regression. The R-square tells us that 24 percent of the variability in the dependent variable is explained by price and income. The adjusted R-square conrms that fact and the R-square is not the result of estimating too many coecients (i.e. few degrees of freedom).

## Problems and Applications

3 points
15. You are a division manager at Toyota. If your marketing department estimates that the semiannual demand for the Highlander is Q = 100, 000 1.25P , what price should you charge in order to maximize revenues from sales of the Highlander? To maximize revenue, Toyota should charge the price that makes de- 1 point mand unit elastic. Using the own price elasticity of demand formula, 1 point P EQ,P = 1.25 100,000 1.25P = 1. Solving this equation for P implies that the revenue maximizing price is P = \$40, 000. 1 point 16. As newly appointed Energy Czar, your goal is to reduce the total demand for residential heating fuel in your state. You must choose on e of three legislative proposals designed to accomplish this goal: (a) a tax that would eectively increase the price of residential heating fuel by \$2; (b) a subsidy that would eectively reduce the price of natural gas by \$1; or (c) a tax that would eectively increase the price of electricity (produced by hydroelectric facilities) by \$5. To assist you in your decision, an economist in your oce has estimated the demand for residential heating fuel using a linear demand specication. The regression results are presented in Table 3-1. Based on this information, which proposal would you favor? Explain.

7 points

SUMMARY OUTPUT Regression Statistics Multiple R 0.76 R-Square 0.57 Adjusted R0.49 Square Standard Error 47.13 Observations 25 Analysis of Variance Degrees Regression Residual Total

of Freedom 4 20 24

Sum of Squares 60936.56 44431.27 105367.84 Standard Error 43.46 29.09 9.17 8.35 0.35

## Mean Square 15234.14 2221.56

F 6.86

Signicance F 0.03

Intercept Price of Residential Heating Fuel Price of Natural Gas Price of Electricity Income

## Upper 95% 223.32 -33.89 62.1 4.67 0.65

Table 3-1 The estimated demand function for residential heating fuel is Qd RHF = 136.96 91.69PRHF + 43.88PN G 11.92PE 0.05M , where PRHF is the price of residential heating fuel, PN G is the price of natural gas, PE is the price of electricity, and M is income. However, notice that coecients of income and the price of electricity are not statistically dierent from zero. Among other things, this means that the proposal to increase the price of electricity by \$5 is unlikely to have a statistically signicant impact on the demand for residential heating fuel. Since the coecient of PRHF is -91.69, a \$2 increase in PRHF would lead to a 183.38 unit reduction in the consumption of residential heating fuel (since 91.69 2 = 183.38 units). Since the coecient of PN G is 43.88, a \$1 reduction in PN G would lead to a 43.88 unit reduction in the consumption of residential heating fuel (since 43.88 (1) = 43.88). Thus, the proposal to increase the price of residential heating fuel by \$2 would lead to the greatest expected reduction in the consumption of residential heating fuel.

best guess effect of each policy: 1 point each 4 statistical significance of each prediction: 1 point each decision for increasing the price of residential heating fuel: 1 point

10 points

20. According to CNN, two dairy farmers challenged the legality of the funding of the Got Milk?campaigns. They argued that the Got Milk? campaigns do little to support milk from cows that are not injected with hormones and other sustainable agriculture products, and therefore violate their (and other farmers) First Amendment rights. The 3rd U.S. Circuit Court of Appeals agreed and concluded that dairy farmers cannot be required to pay to fund the advertising campaigns. One of the obvious backlashes to the National Dairy Promotion and Research Board is reduced funding for advertising campaigns. To asses the likely impact on milk consumption, suppose that the National Dairy Promotion and Research Board collected data on the number of gallons of milk households consumed weekly (in millions), weekly price per gallon, and weekly expenditures on milk advertising (in hundreds of dollars). These data, in forms to estimate both a linear and a loglinear model, are available online at http: // www. cepe. ethz. ch/ education/ ManagerialEconomics in a le named hw3 q20.xls. Use these data to perform two regressions: a linear regression and a loglinear regression.1 Compare and contrast the regression output of the two models. Comment on which model does a better job tting the data. Suppose that the weekly price of milk is \$3.10 per gallon and the National Dairy Promotion and Research Boards weekly advertising expenditures falls 25 percent after the courts ruling to \$100 (in hundreds). Use the best-tting model to estimate the weekly quantity of milk consumed after the courts ruling. Table 3-11 contains the output from the linear regression model. That model indicates that R2 = .55, or that 55 percent of the variability in the quantity demanded is explained by price and advertising. In contrast, in Table 3-12 the R2 for the log-linear model is .40, indicating that only 40 percent of the variability in the natural log of quantity is explained by variation in the natural log of price and the natural log of advertising. Therefore, the linear regression model appears to do a better job explaining variation in the dependent variable. This conclusion is further supported by comparing the adjusted R2 s and the F -statistics in the two models. In the linear regression model the adjusted R2 is greater than in the log-linear model: .54 compared to .39, respectively. The F -statistic in the linear regression model is 58.61, which is larger than the F -statistic of 32.52 in the log-linear regression model. Taken together these three measures suggest that the linear regression model ts the data better than the log-linear model. Each of the three variables in the linear regression model is statistically signicant; in absolute value the t-statistics are greater than two. In contrast, only two of the three variables are statistically signicant
1

2 points for the right linear estimation, 2 points for the right log-linear estimation, 4 points for basing the decision on the F-stat, the t-stats and the R-square (3 points for two of the three, 2 points for only one argument).

## this should be 6.52 - 1.61*3.1+....

in the log-linear model; the intercept is not statistically signicant since the t-statistic is less than two in absolute value. At P = \$3.10 and A = \$100, milk consumption is 2.029 million gallons per week (Qd milk = 6.521.61 3.10 + .005 100 = 2.029).

2 points

3 points

## If this is only rounded to 0.0047, result is 1.985

23. The owner of a small chain of gasoline stations in a large Midwestern town read an article in a trade publication stating that the own-price elasticity of demand for gasoline in the United States is 0.2. Because of this highly inelastic demand in the United States, he is thinking about raising prices to increase revenues and prots. Do you recommend this strategy based on the information he has obtained? Explain. The owner is confusing the demand for gasoline for the entire U.S. with demand for the gasoline for individual gasoline stations. There are not a great number of substitutes for gasoline, but in large towns there are usually a very high number of substitutes for gasoline from an individual station. In order to make an informed decision, the owner needs to know the own price elasticity of demand for gasoline from his stations. Since gas prices are posted on big billboards, and gas stations in cities are generally close together, demand for gas from a small group of individual stations tends to be fairly elastic.

1 point

2 points

Excel output

SUMMARY OUTPUT Regression Statistics Multiple R 0.739723793 R Square 0.547191289 Adjusted R Square 0.537855027 Standard Error 1.063235986 Observations 100 ANOVA df Regression Residual Total 2 97 99 SS 132.5120801 109.6556639 242.167744 MS 66.25604004 1.130470762 F Significance F 58.60924693 2.05053E-17

Intercept P A

Coefficients Standard Error t Stat 6.519839045 0.823090822 7.921166011 -1.614382372 0.151475863 -10.65768723 0.004664382 0.001575003 2.961506969

## P-value 3.94495E-12 5.12726E-18 0.003849344

Lower 95% Upper 95% 4.886231606 8.153446484 -1.915020029 -1.313744714 0.001538437 0.007790326

SUMMARY OUTPUT Regression Statistics Multiple R 0.633559439 R Square 0.401397563 Adjusted R Square 0.389055245 Standard Error 0.586876073 Observations 100 ANOVA df Regression Residual Total 2 97 99 SS 22.40272212 33.40908188 55.811804 MS 11.20136106 0.344423524 F Significance F 32.52205574 1.55316E-11

## Intercept lnP lnA

Coefficients Standard Error t Stat -1.98867503 2.243299214 -0.886495666 -2.16951336 0.276091563 -7.857948763 0.910658367 0.370342406 2.458963249

## P-value 0.377543082 5.37032E-12 0.015705726

Lower 95% Upper 95% -6.441002994 2.463652934 -2.717478687 -1.621548032 0.175631206 1.645685527

## Possible MATLAB code for regression

In the following output, the left column is output from the linear model, and the right column is output for the loglinear model. [num,txt,raw] = xlsread(hw3_q20.xls); linear = num(:,1:3); loglinear = num(:,5:7); [n_row,n_columns] = size(linear); X_lin = linear(:,2:3); y_lin = linear(:,1); X_log = loglinear(:,2:3); y_log = loglinear(:,1); stats_lin = regstats(y_lin,X_lin,linear); stats_log= regstats(y_log,X_log,linear); betas = [stats_lin.beta,stats_log.beta] tstats = [stats_lin.tstat.t,stats_log.tstat.t] pvals= [stats_lin.tstat.pval,stats_log.tstat.pval] Rsquares = [stats_lin.rsquare,stats_log.rsquare] adjRsquares = [stats_lin.adjrsquare,stats_log.adjrsquare] Fstats = [stats_lin.fstat.f,stats_log.fstat.f] Fstat_ps = [stats_lin.fstat.pval,stats_log.fstat.pval] betas = 6.5198 -1.9887 -1.6144 -2.1695 0.0047 0.9107 tstats = 7.9212 -0.8865 -10.6577 -7.8579 2.9615 2.4590 pvals = 0.0000 0.3775 0.0000 0.0000 0.0038 0.0157 Rsquares = 0.5472 0.4014 adjRsquares = 0.5379 0.3891 Fstats = 58.6092 32.5221 Fstat_ps = 1.0e-10 * 0.0000 0.1553