VOLUNTARY EXERCISES

Demand Theory

Example 1

After the “Milk Company” did some statistical analysis with their data, they found out that the
demand function for their product is the following:

Q = 1200 – 30P

a) Calculate the point elasticity at P = 15.

b) Calculate the arc elasticity at P = 15. (Use P = 16 as your second reference point.)
c) Why is there a difference between the two numbers?
d) Calculate the marginal revenue curve.

Example 2

Use the given demand function to compute the following numbers.

Qx = 100 – 8Px + 0.5Py + 2I

Qx … Quantity demanded of good x

Px … Price of good x
Py … Price of good y
I … Income

Px = 7, Py = 12, I = 4.5

a) Calculate the cross price elasticity for the given values.

b) Is good y a substitute or a complementary product?
c) Calculate the income elasticity.
d) Is good x a normal or an inferior good?

Estimating Demand Functions

Example 3

The “French Cheese Company” hired a consultant to estimate the demand function in the
cheese market. After the consultant did some research about the market during the last year,
he came up with the following equation:

log Q = 1200 – log 2.4P + log 0.8A – log 1.2PW

Q = Quantity demanded, P = Price of cheese, A = Advertisement; PW = Price of red wine

(complementary good)

a) What is the economic concept called that is described by the log-numbers?

 b) Is it true, that the quantity demanded would increase by 4.8 % if the price would be
reduced by 2 %?

In the last year the cheese market experienced rapid growth. Not only more and more
consumers enjoy cheese, but there are several new producers of diary products, which offer
cheese and other milk products.

c) What does that mean for our estimated demand function? Do you think it is a very
reliable guess?

Example 4

The marketing department did some analysis of the demand of a good and came to the
following result:

Demand function: Q = 50 – 0.78 P + 0.1 I + 0.25 A + 0.02 Px

T-values: (4.2) (2.7) (0.8) (2.1) (1.2)
R²: 0.85

Q = Quantity demanded, P = Price of the good, I = Income, A = Advertisement, PW = Price of

good x

a) What does the R² value state and is this a good value?

b) What des the t-values represent and what do the given values suggest?

Technological Change and Industrial Innovation

Example 5

A company produced 50,000 units in 2005 and 65,000 units in 2006. Given the data below,
calculate the change in total factor productivity?

Input Quantity 2005 Price 2005 Quantity 2006 Price 2006

Steel 1,000 tons 500,- 1,300 tons 650,-
Labor 40,000 hours 8,- 55,000 hours 9,-
Coal 1,200 tons 2,- 1,400 tons 3.5
SOLUTIONS

Example 1

dQ P
a) The formula to calculate the point elasticity is: *
dP Q
15
η = −30 * = −0.6
(1200 − 30 * 15)

The point elasticity at a price of 15 is -0.6

ΔQ ( P1 + P2 ) / 2
b) The formula to calculate the arc elasticity is: *
ΔP (Q1 + Q2 ) / 2

Quantity demanded at a price of 15 is: 1200 - 30*15 = 750

Quantity demanded at a price of 16 is: 1200 – 30*16 = 720

− 30 (15 + 16) / 2
η= * = −0.633
1 (750 + 720) / 2

The arc elasticity at a price of 15 (with a reference price of 16) is -0.633

c) The different values for η are a result of the fact that you actually measure the elasticity at
different positions of the demand curve. With the point elasticity you measure the
elasticity at the point P=15. With the arc elasticity you measure the elasticity between
P=15 and P=16.

d) Q = 1200 – 30P
P = (1200 – Q)/30
P = 40 – Q/30

TR = 40Q – Q2/30
dTR
MR = = 40 – Q/15
dQ

The marginal revenue curve is: MR = 40 – Q/15

Example 2

dQx Py
a) The formula for the cross price elasticity is: η x , y = *
dPy Qx

Qx for the given numbers is: Qx = 100 – 8*7 + 0.5*12+2*4.5 = 59

12
η x , y = 0.5 * = 0.102
59

The cross price elasticity is 0.102

b) Good y is a substitute product to good x. Since the quantity demanded of good x increases
as the price of good y increases (positive sign of the cross price elasticity), while quantity
demanded for good y decreases, we find an inverse relationship between the quantities
demanded of those two goods.

Example 3

a) The log-numbers represent the elasticities. P, A ,and PW represent the price elasticity,
the advertisement elasticity, and the cross price elasticity, respectively.

Example: Price elasticity

∂ log Q
ηP = = −2.4
∂ log P

b) Yes, that’s true.

Change in quantity demanded = price change * elasticity = -2% * -2.4 = 4.8 %

c) No. Since there were some changes during the time the consultant did his research and
collected the data, one should assume that both, demand and supply curve shifted.
Therefore one should not rely on that function.

Example 4

a) The R² value shows you the percentage of total variations in Q that can be explained
with these variables. 0.85 is a pretty good value and shows a strong relationship between
the variables and Q.

b) The t-value shows the probability if a variable is just random or really reliable. If the
value is higher than 2 or so, it is very likely that the relationship really exists and you
can work with that number. With the given t-values you should disregard the
relationship between Q and I and between Q and Px.

dQ x I
c) Formula for the income elasticity: hI = *
dI Qx
4.5
hI = 2 * = 0.153
59
The income elasticity of good x is 0.153

d) The positive sign of the income elasticity indicates that good x is a normal good, which
means that quantity demanded increases as income rises.
Example 5

To calculate total factor productivity, you need to compute the coefficient α for both
years.

Q2005
α 2005 =
I 1
2005
1
*p2005 + I 2005 * p 2 2005 + I 32005 * p 32005
2

50,000
α 2005 = = 0.060798
1,000 *500 + 40,000 *8 + 1,200 * 2
Q2006
α 2006 = 1
I 2006 * p 2005 + I 2006 * p 2 2005 + I 32006 * p 32005
1 2

65,000
α 2006 = = 0.05948
1,300 *500 + 55,000 *8 + 1,400 * 2

Now, divide the two coefficients to find the proportion of these productivities.

TFP = 0.9783

This means that total factor productivity was lower by 2.17 % in 2006 than in 2005.