CHAPTER 5: ELASTICITY (SEE QUIZ #3 AND EXCEL #2; recommended

problems and notes)

MULTIPLE CHOICE

1. Point elasticity measures elasticity:

a. over a given range of a function.
b. at a spot on a function.
c. over a given range along a function.
d. before non-price effects.
ANS: B

2. Arc elasticity is measured:

a. over a given range of a function.
b. at a spot on a function.
c. over a given range along a function.
d. before non-price effects.
ANS: C

3. With elastic demand, a price increase will:

a. decrease marginal revenue.
b. decrease total revenue.
c. increase total revenue.
d. decrease marginal revenue and total revenue.
ANS: B

4. With unitary elasticity of demand, a price increase will:

a. be associated with zero marginal revenue.
b. decrease total revenue.
c. increase total revenue.
d. decrease marginal and total revenue.
ANS: A

5. The demand for a product tends to be inelastic if:

a. it is expensive.
b. a small proportion of consumer's income is spent on the good.
c. consumers are quick to respond to price changes.
d. it has many substitutes.
ANS: B

6. Two products are complements if the:

a. cross-price elasticity of demand is less than zero.
b. cross-price elasticity of demand equals zero.
c. cross-price elasticity of demand is greater than zero.
d. price elasticity of demand for each good is greater than zero.
ANS: A
7. If the income elasticity of demand for a good is greater than one, the good
is:
a. a noncyclical normal good.
b. a cyclical normal good.
c. neither a normal nor an inferior good.
d. an inferior good.
ANS: B

8. When the product demand curve is Q = 140 - 10P, and price is decreased
from P1 = $10 to P2 = $9, the arc price elasticity of demand is:
a. -0.1
b. -3
c. -4
d. -10
ANS: B

9. If the point price elasticity of demand equals -2 and the marginal cost per
unit is $5, the optimal price is:
a. $5
b. $10
c. $2
d. impossible to determine without further information.
ANS: B

10. The concept of cross-price elasticity is used to examine the responsiveness

of demand:
a. to changes in income.
b. for one product to changes in the price of another.
c. to changes in "own" price.
d. to changes in income.
ANS: B

11. When the cross-price elasticity = 3:

a. demand rises by 3% with a 1% increase in the price of X.
b. the quantity demanded rises by 3% with a 1% increase in the
price of X.
c. the quantity demanded rises by 1% with a 3% increase in the
price of X.
d. demand rises by 1% with a 3% increase in the price of X.
ANS: A
PROBLEMS

12. Elasticity. The demand for mini cassette players can be characterized by
the following point elasticities: price elasticity = -2, cross-price elasticity with AA
Alkaline batteries = -1.5, and income elasticity = 3. Indicate whether each of the
following statements is true or false, and explain your answer.

A. A price increase for cassette players will decrease both the number
of units demanded and the total revenue of sellers.

B. The cross-price elasticity indicates that a 2% reduction in the price

of cassette players will cause a 3% increase in battery demand.

C. Demand for cassette players is price elastic and they are cyclical
normal goods.

D. Falling battery prices will definitely increase revenues received by

sellers of both cassette players and batteries.

E. A 3% price reduction in cassette players would be necessary to

overcome the effects of a 2% decline in income.

ANS:
A. True. A price increase will always decrease units sold, given a
downward sloping demand curve. The negative sign on the price
elasticity indicates that this is indeed the case here. The fact that
price elasticity equals -2 indicates that demand is elastic with
respect to price, and therefore that a price increase will also
decrease total revenues.

B. False. The cross-price elasticity indicates that a 2% decrease in the

price of batteries will have the effect of increasing cassette player
demand by 3%.

C. True. Demand is price elastic (see part a). Because the income
elasticity is positive, cassette players are a normal good. Moreover,
because the income elasticity is greater than one, cassette player
demand is also cyclical.

D. False. A negative cross-price elasticity indicates that cassette

players and batteries are compliments. Therefore, falling battery
prices will increase the demand for cassette players and resulting
revenues for sellers. However, we have no information concerning
the price elasticity of demand for batteries, and therefore do not
know the effect of falling battery prices on battery revenues.
E. True. A 3% reduction in price will cause a 6% increase in the
quantity of cassette players demanded. A 2% decline in income will
cause a 6% fall in demand. These changes will be mutually
offsetting.

13. Demand Analysis. The Crank Yankers DVD (season two) has been a hot
seller during recent weeks. An analysis of weekly demand shows:

Q = 3,000 - 90P

where Q is DVD sales and P is price.

A. How many DVDs could be sold at a $20 price?

B. Calculate the point price elasticity of demand at a price of $20.

ANS:

A. Q = 3,000 - 90P
= 3,000 - 90(20)
= 1,200

B. The point price elasticity of demand at a price of $20 is calculated

as follows:

= -90
= -1.5 (elastic)

14. Optimal Price. Last week, Discount Food Stores, Inc. reduced the average
price on the 22 ounce size of Dishwashing Liquid by 1%. In response, sales
jumped by 8%.
A. Calculate the point price elasticity of demand for Dishwashing
Liquid.

B. Calculate the optimal price for Dishwashing Liquid if marginal cost

is 70 per unit.

ANS:
A.

=
= -8 (elastic)
B. The optimal price is found setting MC = MR and solving for P where:
MC = MR = P

0.7 = P
0.7 = 0.875P
P = 0.8 or 80
15. Arc Price Elasticity. Assume that amazon.com dropped the price on a
men's Seiko watch (SGF719) from $120 to $60, and sales jumped from 50 to 100
units per day.

A. Calculate the implied arc price elasticity of demand.

B. Is a further price decrease warranted? Why or why not?

ANS:
A.

=
= -1

B. No further price decrease is warranted. At P = $60, the EP = -1. This

means that $60 is the revenue-maximizing price and any further
decrease in price would cause demand to fall into the inelastic
region of the demand curve. In the inelastic region of the demand
curve prices are too low because both revenues and profits would
rise with an increase in price.

16. Income Elasticity. Deluxe Carpeting, Inc., is a leading manufacturer of

stain-resistant carpeting. Demand for Deluxe products is tied to the overall pace
of building and remodeling activity and, therefore, is sensitive to changes in
national income. The carpet manufacturing industry is highly competitive, so
Deluxe's demand is also very price-sensitive.

During the past year, Deluxe sold 28 million square yards (units) of carpeting at
an average wholesale price of $16 per unit. This year, GNP per capita is expected
to fall from $19,000 to $17,000 as the nation enters a steep recession. Without
any price change, Deluxe expects current-year sales to fall to 20 million units.

A. Calculate the implied arc income elasticity of demand.

B. Given the projected fall in income, the sales manager believes that
current volume of 28 million units could only be maintained with a
price cut of $2 per unit. On this basis, calculate the implied arc
price elasticity of demand.
C. Holding all else equal, would a further increase in price result in
higher or lower total revenue?

ANS:

A.

=
=3

B. Without a price decrease, sales this year would total 20 million

units. Therefore, it is appropriate to estimate the arc price elasticity
from a (before-price-decrease) base of 20 million units:

=
= -2.5 (elastic)

C. Lower. Because carpet demand is in the elastic range, EP = -2.5, an

increase (decrease) in price will result in lower (higher) total
revenues.

CHAPTER 6: FORECASTING (SEE Ch.6 on line questions and Quiz #4 and

notes)

17. A forecast method based on the informed opinion of several individuals is

called:
a. personal insight.
b. panel consensus.
c. the Delphi method.
d. qualitative analysis.
ANS: B

18. A rhythmic annual pattern in sales or profits is called:

a. cyclical fluctuation.
b. secular trend.
c. trend analysis.
d. seasonal variation.
ANS: D

19. Growth trend analysis assumes:

a. constant unit change over time.
b. irregular percentage change over time.
c. sporadic unit change over time.
d. constant percentage change over time.
ANS: D
CHAPTER 7: PRODUCTION (See Quiz #4; recommended problems and
notes)

20. The law of diminishing returns:

a. deals specifically with the diminishing marginal product of fixed
input factors.
b. states that the marginal product of a variable factor must
eventually decline as increasingly more is employed.
c. can be derived deductively.
d. states that as the quantity of a variable input increases, with the
quantities of all other factors being held constant, the resulting
output must eventually diminish.
ANS: B

22. When PX = $60, MPX = 5 and MPY = 2, relative employment levels are
optimal provided:
a. PY = 16.7.
b. PY = $24.
c. PY = $60.
d. PY = $150.
ANS: B

23. When PX = $100, MPX = 10 and MRQ = $5, the marginal revenue product of
X equals:
a. $100.
b. $50.
c. $10.
d. $5.
ANS: B

24. Total output is maximized when:

a. average product equals zero.
b. marginal product is maximized.
c. average product is maximized.
d. marginal product equals zero.
ANS: D

25. A firm will maximize profits by employing the quantity of each input where
the marginal:
a. revenue product of each input equals its price.
b. revenue equals the price of each input.
c. product of each input is equal.
d. product of each input equals its price.
ANS: A
26. Optimal Input Mix. Hydraulics Ltd. has designed a pipeline that provides a
throughput of 70,000 gallons of water per 24-hour period. If the diameter of the
pipeline were increased by 1 inch, throughput would increase by 4,000 gallons
per day. Alternatively, throughput could be increased by 6,000 gallons per day
using the original pipe diameter with pumps that had 100 more horsepower.

B. Assuming the cost of additional pump size is $600 per horsepower

and the cost of larger diameter pipe is $200,000 per inch, does the
original design exhibit the property required for optimal input
combinations? If so, why? If not, why not?

ANS:
B. No. The rule for optimal input proportions is:
=

In this instance the question is:

0.02 0.10

Here the additional throughput provided by the last dollar spent on

more horsepower (0.10 gallons/day) is five times the gain in output
resulting from the last dollar spent to increase the pipe diameter
(0.02 gallons/day). Thus, horsepower and pipe diameter are not
being employed in optimal proportions in this situation.

27. Optimal Input Level. U-Do-It Furniture, Inc., sells hardwood chairs, in both kits
and fully assembled forms. Customers who assemble their own chairs benefit
from the lower kit price of $35 per chair. "Full-service" customers enjoy the luxury
of an assembled chair, but pay a higher price of $60 per chair. Both kit and fully
assembled chair prices are stable. The company has observed the following
relation between the number of assembly workers employed per day and
assembled chair output:

Number of
Workers Finished
per day Chairs
0 0
1 5
2 9
3 12
4 14
 5 15

A. Construct a table showing the net marginal revenue product

derived from assembly worker employment.

B. How many assemblers would U-Do-It Furniture employ at a daily

wage rate of $75?

C. What is the highest daily wage rate U-Do-It Furniture would pay to
hire four assemblers per day?

ANS:

A. Because the market for hardwood chairs is perfectly competitive,

the $25 price premium for fully assembled chairs versus kits is
stable. Thus, the net marginal revenue product of assembler labor
(sometimes referred to as the value of marginal product) is:

Net Marginal
Number of Fully Marginal Revenue
Assembler Assemble Product Product
s d of Labor of Labor
per Day Output (3) (4)=(3)$25
(1) (2)
0 0 -- --
1 5 5 $125
2 9 4 100
3 12 3 75
4 14 2 50
5 15 1 25

B. From the table above, we see that employment of three assemblers

could be justified at a daily wage of $75 because MRPA=3 = $75.
Employment of a fourth assembler could not be justified because
MRPA=4 = $50 < $75.

C. From the table above, the MRPA=4 = $50. Thus, a daily wage of $50
per assembler is the most U-Do-It Furniture would be willing to pay
to hire a staff of 4 assemblers.

CHAPTER 8: COST AND ESTIMATION (Use recommended problems and

notes)
 28. Breakeven. Three graduate business students are considering operating a tofu burger stand in the
Dalles, Oregon, windsurfing resort area during their summer break. This is an alternative to summer
employment with a local fruit cannery where they would earn $7,500 each over the three-month summer period.
A fully equipped facility can be leased at a cost of $8,000 for the summer. Additional projected costs are $2,000
for insurance, and 25 per unit for materials and supplies. Their tofu burgers would be priced at $1.50 per unit.

C. What is the economic breakeven number of units for this operation? (Assume a $1.50 price
and ignore interest costs associated with the timing of the lease payments.)

ANS The economic breakeven point is reached when:

C.
Q=

=
= 26,000 units

29. Profit Contribution Analysis. Ben Laden Rugs, Inc., sells hand-made cotton rugs to tourists at a price of $50.
Of this amount, $40 is profit contribution. Ben Laden is considering an attempt to differentiate his product from
several other competitors by using high quality natural herb dyes. Doing so would increase Ben Laden's unit
cost by $15 per rug. Current annual profits are $35,000 on 1,000 rug sales.

A. Assuming average variable costs are constant at all output levels, what is Ben Laden's total
cost function before the proposed change?

B. What will the total cost function be if high quality natural herb dyes are used?

C. Assume rug prices remain stable at $50. What percentage increase in sales would be
necessary to maintain current profit levels?

ANS:

A. From the definition of profit contribution we know that on a per unit basis:

Profit contribution = P - AVC

$40 = $50 - AVC
AVC = $10 per unit

Total fixed cost for Ben Laden can be calculated as follows:

= TR - TC
= TR - TVC - TFC
= (P Q) - (AVC Q) - TFC
$35,000 = $50(1,000) - $10(1,000) - TFC
$35,000 = $40,000 - TFC
TFC = $5,000

Therefore, the total cost function is:

TC = TFC + (AVC Q)
TC = $5,000 + $10Q
B. By using high quality natural herb dyes, Ben Laden's variable cost would increase by $15
while its fixed costs remain the same. Ben Laden's new total cost function would be:

TC = $5,000 + $10Q + $15Q

TC = $5,000 + $25Q

C. The new number of rug sales necessary to maintain current profit levels would be:

= (P Q) - (AVC Q) - TFC
$35,000 = $50Q - $25Q - $5,000
25Q = 40,000
Q = 1,600
Percentage increase in Q = = 0.6 or 60%.

Thus, a 60% increase in rug sales would be needed to maintain current profit levels.