Imagine that you work for the maker of a leading brand of low-calorie, frozen mi
ID: 1201039 • Letter: I
Question
Imagine that you work for the maker of a leading brand of low-calorie, frozen microwavable food that estimates the following demand equation for its product using data from 26 supermarkets around the country for the month of April. Note: The following is a regression equation. Standard errors are in parentheses. QD = -3,750 - 100P + 25A + 50PX + 8Y (5,234) (2.29) (525) (1.75) (1.5) R2 = 0.90 n = 26 F = 35.25 Your supervisor has asked you to compute the elasticities for each independent variable. Assume the following values for the independent variables: QD = Quantity demanded of a unit (dependent variable) P (in cents) = 300 cents per unit (price per unit) PX (in cents) = 200 cents per unit (price of leading competitor’s product) Y (in dollars) = $10,000 (per capita income in the Standard Metropolitan Statistical Area (SMSA) where the 26 supermarkets are located) A (in dollars) = $750 (monthly advertising expenditures) Write a four to six (4-6) page paper in which you: 1.Compute the elasticities for each independent variable. Note: Write down all of your calculations. 2.Determine the implications for each of the computed elasticities for the business in terms of short-term and long-term pricing strategies. Provide a rationale in which you cite your results. 3.Recommend whether you believe that this firm should or should not cut its price to increase its market share. Provide support for your recommendation. 4.Assume that all the factors affecting demand in this model remain the same, but that the price has changed. Further assume that the prices are 100, 200, 300, 400, 500, 600, 700, and 800 cents. •Plot the demand curve for the firm. •Plot the corresponding supply curve on the same graph using the following supply function (with the same prices 100, 200, 300, 400, 500, 600, 700, and 800 cents): QS = -7909.89 + 79.0989P •Determine the equilibrium price and quantity. (Show this graphically and/or calculate using algebra.) 1.What short-term and long-term changes in market conditions could shift the demand and supply curves for this product?
Explanation / Answer
Price elasticity of demand is the measure of responsiveness of change in the quantity of a product demanded as its price changes. It is the ratio of percentage change in the quantity demanded to the percentage change in its price.
Note that for a linear demand curve, elasticity is a the product of slope and the values of P/Q
For the demand function, Substitute the values in the demand function and see:
QD = -3,750 – 100(100) + 25(750) + 50(200) + 8(10000)
= 95000
1) a) When P = 300, QD = 95000. From the demand equation, the slope for P is -100.
Elasticity = -100*300/95000 = -0.31
b) When PX = 200, QD = 95000. From the demand equation, the slope for PX is 50.
Elasticity = 50*200/95000 = 0.10
c) When Y = 10000, QD = 95000. From the demand equation, the slope for Y is 8.
Elasticity = 8*10000/95000 = 0.84
d) When A = 750, QD = 95000. From the demand equation, the slope for A is 25.
Elasticity = 25*750/95000 = 0.19
2)
The demand is very less inelastic against the income, almost equal to one. This implies the good has large implication in consumer budget.
The demand is inelastic against the price of its substitute, almost close to zero. This implies substitute provides no competition at all.
The demand is inelastic against the own price, almost equal to zero. This implies revenues can be raised by raising prices.
3)
This firm should not cut the price since it faces no threat from competitor and the elasticity is low so revenue can be raised by raising prices.
4) The equilibrium price and quantity is determined where
Qd = Qs
105000 – 100P =
112910 = 179.098P
P = 630, Q = 41956 units
Hence, at the equilibrium, price is 630 cents and quantity is 41,956 units