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Sheet1 Page 1 BUSINESS 702 FIRST EXAM KEY SPRING 1998 MANAGERIAL ECONOMICS 1. A. What would an upward-sloping demand curve imply about the marginal utility derived from consumption? B. Why aren't upward sloping demand curves observed in the real world? 1. ANSWER A. The law of diminishing marginal utility states that the marginal utility derived will fall as the consumption of a given product increases during a given time interval. This gives rise to a downward sloping demand curve for all goods and services. For a given demand curve to be upward sloping, an increasing marginal utility of consumption would have to be operative. This is counter to human nature. Despite myths that sometimes arise concerning the pricing of some luxury goods, like perfume, there is no real-world evidence of upward sloping demand curves. B. In this regard, it is worth emphasizing the fact that an upward sloping demand curve implies that higher prices lead to an increase in quantity demanded. Under such a wonderful circumstance, firms would have an incentive to charge higher and higher prices ("to infinity and beyond!"). Nothing would limit the firms ability to gain revenues by raising prices. In the real world, higher prices eventually result in some buyers being priced out of the market and to an eventual downturn in revenues. 2. A. An estimated 80% increase in the retail price of cigarettes is necessary to cause a 30% drop in the number of cigarettes sold. Would such a price increase help or hurt tobacco industry profits? B. What would be the likely effect on industry profits if this price boost were the direct result of a $1.50 per pack increase in cigarette excise taxes? 2. ANSWER A. The price elasticity of demand for cigarettes is highly inelastic if an 80% increase in retail prices would cause only a 30% drop in the number of cigarettes sold. An arc price elasticity for cigarettes on the order of EP = -0.375 (= -30%/80%) implies that tobacco industry revenues would rise sharply following a big price increase. Since the variable costs of producing and selling cigarettes would fall with a 30% drop in the number of cigarettes sold, a significant industry-wide increase in cigarette prices could cause industry profits to explode on the upside. B. It is less certain what would happen to tobacco industry profits if the price increase described above were the simple result of an increase in excise taxes on each pack of cigarettes sold. For example, a new $1.50 tax on a pack of cigarettes would increase typical retail prices from $1.88 to $3.38 per pack, or by roughly 80%. If all new revenues went to the government in the form of taxes, then industry revenues and variable costs would both fall by 30% following a 30% drop in unit sales. Unless the tobacco industry cut fixed expenses, industry profits would fall in the long run. On the other hand, with such inelastic demand and government-sanctioned price increases, the tobacco industry might be expected to lobby hard for further profit-enhancing price increases in the post tax-increase era. Q2.10
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