BA533: Economics for Managers THE PENNSYLVANIA STATE UNIVERSITY

Fall 2017 Smeal College of Business

ANSWERS TO PRACTICE PROBLEMS:
Module 2

6. In this question, make sure you understand each of the following: 1) how to derive and analyze demand
curves; 2) how to graph non-linear pricing schemes; and 3) how to calculate consumer surplus.

a. We have two observations of price and quantity (P = .9, Q = 90) and (P = .8, Q = 100). Given two
points on a line we can find the slope of the demand curve (see the graph below):

DP/DQ = (0.9 - 0.8)/(90 - 100) = -0.01.

Using the slope and either of the two given points we can now find the vertical intercept, a:

P = a - 0.01Q => 0.9 = a - 0.01(90) => a = 1.8.

Thus the equation of the line (which is the equation of the inverse demand curve on the graph) is:

P = 1.8 - .01Q.

Graphically,

P
$1.8

$0.9
$0.8

90 100 180 Q

Now we can add AT&T’s new pricing scheme to the graph:

$1.8

$1.0
$0.8
$0.5

60 100 130 180 Q

Therefore, under AT&T's new pricing scheme, Woodbrook will place Q = 130 calls.

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BA533: Economics for Managers THE PENNSYLVANIA STATE UNIVERSITY
Fall 2017 Smeal College of Business
ANSWERS TO PRACTICE PROBLEMS:
Module 2
b. With its new pricing schedule, AT&T is charging the lower marginal price (for this customer) in the
relevant portion of Woodbrook's demand curve, .50 for AT&T, and .80 for MCI.

c. Average P for MCI = Total Expenditure/Q = [.80(100)/100] =.80

Average P for AT&T = [1(60) + .80(40) + .50(30)]/130 = 107/130 = .82

d. AT&T has a slightly higher average price for this consumer. MCI has reason to be upset with AT&T's
advertising, although it depends on whether AT&T is stating that its prices are lower for some
subscribers or all subscribers.

e. CS with MCI = .5(100)(1.8 - .80) = $50

CS with AT&T = [.5(100)(1.8-.8) - 60(.20)] + [.5(30)(.3)] = 38+4.5 = $42.50

=> don't switch back to AT&T: even though Q increases, consumer surplus decreases.

7.

a. Under plan (i), the price is $2 per minute. Solving for Q: 2 = 11 - .1Q => Q = 90 minutes. The annual
cost (or total expenditure) under this plan would be TE = 2(90) = $180. Under plan (ii), there is a $129
flat charge for unlimited calls. In this case, the per-unit price “P” is zero. Solving for Q: 0 = 11 - .1Q
=> Q = 110. The annual cost is $129.

P/min
($)

11

2
TE = $180

90 110 Q
(# of mins)

b. The customer chooses the plan that maximizes consumer surplus:

CS(i) = .5(90)(11-2) = $405

CS(ii) = .5(110)(11) – 129 = $476

Therefore, the customer should choose plan (ii).

8. The cross-price elasticity of demand for good Y with respect to the price of good X is:

eYX = %DQy/%DPx.

a. The cross-price elasticity between electricity and natural gas, commercial = 3.2 / 8 = 0.4; natural gas,
residential = 6.4 / 8 = 0.8; electric power tools = -1/8 = -0.125.

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BA533: Economics for Managers THE PENNSYLVANIA STATE UNIVERSITY
Fall 2017 Smeal College of Business
ANSWERS TO PRACTICE PROBLEMS:
Module 2
b. Electricity and natural gas are substitutes (positive cross-price elasticity), while electricity and electric
power tools are complements (negative cross-price elasticity).

9. This question highlights that we draw inverse demand curves in which Price is on the vertical axis, and
Quantity is on the horizontal axis. The demand curves in the problem are written in the form Q = a - bP.
The slope of this line is -b. The inverse demand curve would then be P = a/b - (1/b)Q, which has slope -
1/b. Either representation of the line is fine; you just have to be clear about which you are using and you
have to be consistent within a given problem.

a. The slopes of the demand curves written as Q = a - bP are -1.0, -0.5 and -0.5, respectively. The slopes
of the inverse demand curves are -1.0, -2.0, and -2.0, respectively.

b. The own-price elasticity is defined as (DQ/DP)(P/Q) = -b(P/Q) where b is the slope of the demand
curve (or 1/slope of the inverse demand curve). At P = 20, the elasticities are:

(1) -1.0 (20 / 180) = -0.11

(2) -0.5 (20 / 90) = -0.11

(3) -0.5 (20 / 190) = -0.053

c. No. The elasticity is defined in percentage terms, not in absolute terms. The elasticity is equal to the
slope, adjusted by the base price and quantity (and also, 1/slope of the inverse demand curve, adjusted
by the base price and quantity). You cannot directly infer the elasticity of demand from the slope of a
linear demand curve without knowing where you are on that demand curve. For example, demand
curves (1) and (2) have different slopes, but the same elasticity at P = $20, while demand curves (2)
and (3) have the same slope, but different elasticities at P = $20.

10. (a) Total revenue will rise if price is increased for inelastic demand. (The fact that TR is currently high
for a good may not be the best indicator of how revenue will respond to further price increases.)

11.

a. At P = $10, the quantity of tickets demanded is Q = 110 - 50 = 60, in thousands of seats. However,
since the stadium only holds 56,000 people, total revenues are TR = $560,000.

b. He has under-priced tickets. He could sell tickets at higher prices, as indicated by the fact that at the
current price of $10 he faces excess demand (60,000 - 56,000).

c. The revenue-maximizing price is the midpoint price (half the vertical intercept of the demand curve)
because we are assuming a linear demand curve. More generally, the revenue-maximizing price is the
price at which demand is unit elastic, which happens to be the midpoint for a linear demand curve.
Since the vertical intercept is 22, this means you should charge $11 per seat. At this price, you will
sell 55,000 seats, and generate total revenues of $605,000. If the owner keeps his promise, you should
make 10% of ($605,000 - $560,000) for each game, or $4500 per game this coming season.

d. The optimal number of empty seats = 56,000 - 55,000 = 1,000. If we allowed you to use more
sophisticated pricing schemes, say non-linear pricing, it might be that the optimal strategy would
involve filling the stadium (though not necessarily).

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BA533: Economics for Managers THE PENNSYLVANIA STATE UNIVERSITY
Fall 2017 Smeal College of Business
ANSWERS TO PRACTICE PROBLEMS:
Module 2

12.

a. First, find the current value of QHC, given the data in the problem: QHC = 26.01 + 2.45(24.50) +
1.82(21.95) - 3.6(24.95) = 36.16. (Note that your answers might be slightly different due to rounding.)
Therefore,

ΔQHC PCC 24.50

EHC,CC = • = 2.45• = 1.66
ΔPCC QHC 36.16

ΔQHC PHS 21.95

EHC,HS = • = 1.82 • = 1.10
ΔPHS QHC 36.16

The competitor’s compact cars are stronger substitutes for Hertz compact cars than are Hertz’s own
subcompacts.

b. Plug in current prices: QHC = 125.98 - 3.60PHC, or PHC = 34.99 - 0.278QHC. The slope of the inverse
demand curve (the one with P on the left-hand side) is –0.278, and the slope of the demand curve (the
one with Q on the left-hand side) is -3.60. The elasticity of demand at the current price is e = -
3.6(24.95/36.16) = -2.48. This indicates that the demand for Hertz compact cars is relatively elastic,
which we would expect. First, there are many other rental car companies that offer substitute compact
cars and second, there are other size cars that can be rented, even from Hertz.

c. With this kind of question, there is of course no one correct answer. Examples would include the price
of taxicab rides, the price of mid-sized rental cars, airfares, the day of the week, the time of year, the
price of gas, and so on. All of these variables (and more) might affect the demand for Hertz compact
car rentals per day.

d. You need to explain your reasoning in this answer. Taxicab rides, mid-sized rentals and air travel are
all substitutes for compact car rentals. We would expect their prices, when they go up, to have a
positive effect on the demand for Hertz’s compact car rentals. The day of the week and the time of
year effects would capture high demand during heavily traveled business days (Mondays and Fridays
maybe), and lower activity on weekends, for example. Similarly for seasons. Finally, gas is a
complement for car rentals, and so an increase in its price should reduce the demand for Hertz’s
compact cars.

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