of University Illinois At Chicago Microeconomics for Business Decisions (ECON520) Quiz #2 (Fall 2010) Answer Key 1. (4 pts.) The cross-price elasticity of demand between two products that are complements will be: A. Positive
B. Negative
C. Zero D. Positive or negative, depending on the strength of the relationship. An elasticity measure captures the magnitude of a change in one of the demand factors with respect to its effect on demand, it doesnt change the expected relationship: a change in the price of a complementary product or service is inversely related to the change in demand for the other complementary good or service some consumers view the overall price as a combination of the complements, causing demand to fall when the price of a complement increases, and demand to increase as the price of a complement falls. 2. (4 pts.) For most consumer goods, price elasticity of demand is: A. Negative only when price decreases
B. Negative regardless of the direction of the price change
C. Positive only when price decreases D. Positive regardless of the direction of the price change Price and demand are inversely related. In the case of falling prices, some consumers of other similar products or services may substitute toward the new, lower priced alternative, while other consumers may now be able to afford it both behaviors increasing demand. In the case of rising prices, some consumers may substitute away from the new, higher priced product and toward the now, relatively lower priced alternative, while other consumers may now be unable able to afford it both behaviors decreasing demand.
ECON520 Quiz #2 Answer Key (Fall 2010) Page 2 3. (8 pts.) If managers of funeral homes discover that the price elasticity of demand for caskets (i.e. coffins) is - 0.55, to increase revenue the funeral homes should increase prices. Indicate whether you believe the statement is true or false, and then briefly explain your answer. 4pts. TRUE 4pts. A price elasticity value of -0.55 implies inelastic demand. If demand is inelastic, the % decrease in QD is less than the % increase in P: the revenue gained from a higher price is greater than the revenue lost from fewer casket (i.e. coffin) sales. As a result, revenue increases in response to the price increase. See the Arlington Stallions calculation exercise as a numerical example (e.g., in the inelastic price range of the demand schedule, say between $50 and $100 a ticket [EP = -0.43], an increase in ticket price from $50 to $100 increases revenue from tickets sales from $4,000,000 per game to $6,000,000 per game). 4. (8 pts.) Local cable companies recently increased the price of basic services. While prices have increased 10%, the cable company reports only an 8% increase in revenue. This remark suggests the demand for basic cable service is elastic. Indicate whether you believe the statement is true or false, and then briefly explain your answer. 4pts. FALSE 4pts. If demand is elastic, the % decrease in QD is greater than the % increase in P - revenue gained from a higher price is less than the revenue lost from fewer sales, therefore total revenue would decrease. Since total revenue increased in response to a higher price, demand for basic cable services must be inelastic (see answer to Question 3).
ECON520 Quiz #2 Answer Key (Fall 2010) Page 3
5. (28 pts. parts A and B) 5A (20 pts.) The focus of this question is part-time UIC graduate students that live in the Chicago metro. Which UIC part-time graduate student is more likely to have inelastic demand: a student just entering the program and taking their first course at UIC, or a student taking their final course at UIC? Defend your position by applying the four (4) criterions we used to assess price elasticity of demand. 4pts. A part-time graduate student at UIC student taking their final course is more likely to have inelastic demand than a student just entering the program, as they seem to better satisfy three of the four criterions for inelastic demand. Fewer substitutes: A student just entering the program likely has more options in terms of attending a different school than a student in their final course (e.g., the amount of transfer credits accepted is usually limited at most schools). Greater urgency: A student in their final course is one course away from degree completion and the benefits that go with having earned a graduate degree, whereas the student just beginning the program probably has a minimum of 12 months of course work remaining. The remaining education expense is a lesser percentage of the students spending budget: The tuition expense incurred to date for a student in their final course is a sunk cost (i.e. no longer relevant for forward-looking decisions a sunk cost has zero opportunity cost), whereas a student just entering the program has just started their cash outflow. Necessity: Any student committing to a graduate school program feels they need to earn the degree, whether for personal or professional reasons, or they would not have made the decision to do so; arguably applicable to both.
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5B. (8 pts.) Based on your answer to Part 5A, what type of tuition pricing strategy could UIC implement to increase revenue? Why would your recommendation increase tuition revenue?
4pts. If UIC wanted to take advantage of this elasticity difference, they could charge students closer to degree completion a higher tuition rate per credit hour than what they charge students just entering the program. Charging a higher tuition to students with inelastic demand would only cause a small number of graduate students, if any, to drop out of their program - the revenue gained from a higher price is greater than the revenue lost from fewer students taking a course. As a result, revenue increases in response to a tuition increase for this segment of the market (although probably not the best decision for public relations purposes, as well as for future enrollments, once a practice like this becomes known).
4pts.
ECON520 Quiz #2 Answer Key (Fall 2010) Page 4
6. (8 pts.) The current price changed by a local movie theater is $8 per adult ticket. At this price the theater typically sells 300 tickets per showing. If the theater raises its price to $10, they estimate they would sell 270 tickets per showing. Using the arc (averaging) elasticity formula, what is the theaters price elasticity of demand between ticket prices of $8 and $10? 4 pts. EP = (Q / Average Q) / (P / Average P) EP = (30 / 285) / (2 / 9) EP = 0.105263157 / 0.2222222 = - 0.47 7. (24 pts. parts A, B, and C) Assume you work for United Airlines and your primary accountability is revenue generation. Uniteds business class price elasticity of demand (EP) is to equal - 0.60, and Uniteds cross-price elasticity of demand with respect to any business class price changes undertaken by American Airlines (ECPUA,AA) is equal to 0.50. Use the simple (i.e. percentage change) elasticity formulas to answer this question. 7A. (8 pts.) You order a 5% increase in the price of Uniteds business class tickets. What should you expect in terms of the percentage change in the number of business class tickets purchased from United as a result of only Uniteds ticket price increase? Show/explain how you came up with your answer. 4pts. 4pts. Uniteds business class ticket sales should fall by 3%. A price elasticity measure of -0.60 implies that quantity demanded will change by 0.60% in response to a 1% change in price; and in the opposite direction (minus sign). Therefore, a 5% ticket price increase should reduce business class tickets sold by 3% (+5.0% x -0.60 = -3.0%).
7B. (8 pts.) On the day of Uniteds announced price increase, American Airlines announced an 8% decrease in the price of its business class tickets. What should you expect in terms of the percentage change in the overall number of business class tickets purchased from United as a result of only Americans ticket price decrease? Show/explain how you came up with your answer. 4pts. 4pts. Uniteds business class ticket sales should fall by 4.0%. A cross-price elasticity measure of 0.50 implies that quantity demanded will change by 0.50% in response to a 1% change in the price of the other good; and in the same direction ( i.e. the plus sign reflects a substitute). Therefore, an 8.0% ticket price decrease by American should reduce Uniteds business class trips ticket sold by 4% (-8.0% x 0.50 = -4.0%).
7C. (8 pts.) What would you expect to happen to Uniteds business class revenue after implementation of both Uniteds and Americans announced price changes? Would it increase, decrease, or remain unchanged? Support your answer. 4pts. 4pts. Uniteds business class revenue should decrease. The combined effect of the price changes can be expected to reduce the number of Uniteds business class tickets sold by 7.5%: 3.0% due to Uniteds price increase and 4.0% due to Americans price decrease. Since Uniteds ticket price increase (5%) is less than the reduction in business class tickets sold (7.5%), Uniteds business class revenue can be expected to decrease.
ECON520 Quiz #2 Answer Key (Fall 2010) Page 5
8. (16 pts.) The following regression outcome is based on median housing prices covering 506 communities in the Boston metro. P = 11.08 0.954Nox 0.134Dist + 0.255Rooms 0.052Sturatio Where: P= Nox = Dist = Rooms = Sturatio = median home price in dollars nitrous oxide in the air (in parts per million) a measure of air pollution distance in miles from the five largest employment centers average number of rooms in a home in a given community average student-to-teach ratio at elementary schools in a given community
IGNORING the value of the coefficients in front of each of the factors influencing the median home price, are the signs of each of the four factors what you would expect to see in terms of how a change in each factor would affect the median home price [i.e. would you expect that the factor should have a direct (+) or inverse (-) relationship]? Support your position with a BRIEF narrative statement as to why you think the regression outcomes (all four) either meet or dont meet your expectations. 4pts. Nox: Arguably a higher level of pollutants in the air should making living in such a community less attractive, thus lowering the median home price; and vice versa. This outcome (i.e. an inverse relationship) is as expected. Dist: The further residences are from places of employment, the greater the transportation expense to go to work (in terms of both time and money). As such, it seems to make sense that holding constant all other factors that influence median home prices, a premium would be paid for communities closer to the employment centers. This outcome (i.e. an inverse relationship) is also as expected the further away from employment centers (i.e. a greater distance) the lower the median price; and vice versa. Rooms: It seems to make sense that communities that feature homes with more rooms would likely have bigger houses, and therefore we could expect a higher median home price; and vice versa. This outcome (i.e. a direct relationship) is as expected. Sturatio: The quality of education in a community is often directly related to median home prices. Arguably an increase in the classroom size (i.e. a higher student/teacher ratio) signals a reduction in education quality, and therefore a likely decrease in the median home prices in these communities; and vice versa. This outcome too (i.e. an inverse relationship) is as expected. Note that in the case of using ratios as demand factor, how the ratio is defined affects the expected outcome (e.g., a teacher/student ratio would suggest a direct relationship fewer students per teacher would signal improved education quality, as well as increase the ratio).
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ECON520 Quiz #2 Answer Key (Fall 2010) Page 6 Extra Credit (8 points in total parts A and B) Assume the following demand model for AT&T cable television subscriptions: QD = 7,047 65*P + 250*D + 0.75*A 1.5*PC Where: QD = P= D= number of households that subscribe to AT&T cable television services monthly subscription price of AT&T cable television service (in dollars) number of homes and apartments in the targeted AT&T service area (in thousands) A = amount of advertising expenditures by AT&T (in thousands of dollars) PC = average retail price of 42-inch LCD and plasma televisions in the targeted AT&T service area (in dollars) * implies a multiplication sign A. (4 pts.) What would have a greater influence on QD? Circle ONE answer. A. The construction of a housing development that adds 1,000 apartments in the targeted AT&T service area (+1 x 250 = +250)
B. A $5 increase in the monthly subscription price (+5 x -65) = -325
C. A $100,000 reduction in advertising expenditures in the targeted AT&T service area (-100 x 0.75 = -75) D. A $100 reduction in the average retail price of 42-inch LCD and plasma televisions in the targeted AT&T service area ( -100 x -1.5 = +150) B. (4 pts.) What is the combined effect on QD of all the changes noted in part A?
No Change: [phone] + 150 = 0 Note: The focal point of this question is knowing the scale of the variables being measured. Absence of knowing whether a variable is measured in dollars or thousands of dollars, for example, can lead to incorrect outcomes as to its effect. Suggestion always make sure your analyst explain the scale of the variables used.