HOMEWORK 1 + SOLLUTION

Please solve the exercises below and answer all questions. Answer in full sentences in English
language and transmit your answers by e-mail (PDF, doc) to bernd.speta@gmx.at
Deadline for submission: Thursday 15th of April

1) ESTIMATING DEMAND FUNCTIONS:

Using data covering the period May 1988 through October 1990, a graduate student attempted
to estimate the demand for meals at a Mexican restaurant in Clemson, South Carolina. The
data included the average price per meal (p), the number of customers (q), and advertising
expenditures (a). She estimated the following model in level and logs:
q = 0 + 1 p + 2 a + 3 s + 4 trend +
The s variable measures seasonality and requires a little explanation. Clemenson is a small
town with big crowds during athletic events and few students in the summer. The graduate
student set the season variable equal to 1 during the regular school months and 0 in the
summer months and December, the times when there are few students in town. The trend
variable captures any time trend and takes the value 1 for the first month of the data, 2 for the
second, and so on. Table 1 reports estimates of the model first in levels and then in logs. The
table also reports the means of the variables.
Table 1 (levels)
Variable
Intercept
Price (p)
Advertising Expenses (a)
Season (s)
Trend (trend)

Table 2 (logs)
Variable
Intercept
Price (p)
Advertising Expenses (a)
Season (s)
Trend (trend)

Parameter estimate
8790.423
-505.929
0.824
966.142
25.866
F Ratio
Prob > F
R squared

Standard Error
1716.784
18.451
0.593
178.373
11.076
19.354
0.0001
0.7559

T Ratio
5.12
-3.003
1.39
5.416
2.335

Prob > /t/

0.0001
0.006
0.1767
0.0001
0.0279

Parameter estimate
10.018
-0.995
0.097
0.199
0.005
F Ratio
Prob > F

Standard Error
0.823
0.316
0.062
0.032
0.002
23.994
0.0001

T Ratio
12.177
-3.15
1.575
6.212
2.539

Prob > /t/

0.0001
0.0042
0.1277
0.0001
0.0177

R squared

0.7993

Means of Variables
Variable
Customers
Price
Ads

Number of
observations
30
30
30

Mean
5026.73
10.42
602.2

Standard
Deviation
726.011
0.577
148.227

Minimum
Value
3952
9.25
305

Maximum
Value
6610
11.42
970

a) What is the price elasticity of demand?

Price elasticity of demand equals -0.995 (from the logs table).
b) Is the restaurants advertising program effective?
We cannot say if the restaurant's advertising program has a significant effect on sales (t-ratio
is too low). Our parameter might be random, it is not a reliable information for decision
making.
c) If you were the manager of the restaurant, would you change the advertising budget?
T-ratio of advertising is below 2, so we cant say which effect it will have if we change the
advertising budget.
d) Is the business in the restaurant stable, getting better, or declining over time?
The trend variable has a positive sign, this indicates that business is getting better.
e) Is business slower during the months when students are gone from the area?
Business is better during student season.

2) MARK UP
Over the last decade, Apple Computer has seen its global share of the personal computer
market fall from above 10 percent to less than 5 percent. Despite a keenly loyal customer
base, Apple has found it more and more difficult to compete in a market dominated by the
majority standard: Microsofts Windows based operating system and Intels microchips.
Indeed, software developers put a lower priority on writing Mac applications than on
Windows applications.
a) In the 1980`s, Apple vigorously protected its proprietary hardware and software and
refused to license Mac clones. What effect did this decision have on long run demand?

The demand curve of Apple computers will shift to the left because of the price war in the PC
industry (a substitue to the Mac). It will also become flater because of the increased price
elasticity in the computer industry.
b) In the early 1990`s, Apple enjoyed high mark-ups on its units. In 1995 Apples chief,
John Scully, insisted on keeping Macs gross profit margin at 50 to 55 percent, even in
the face of falling demand. (Gross profit margin is measured as total revenue minus
total variable costs expressed as a percentage of total revenue.) At this time, the
business of selling PCs was becoming more and more commodity-like. Indeed, the
price elasticity facing a particular company was estimated in the neighbourhood of
p = -4 Using the mark-up rule ( P MC) / P = 1 / -p , carefully assess Scully`s
strategy.
P = MC/(1+1/p) =
MC/0,75 = MC*4/3
(4/3MC-MC)/(4/3MC)=(1/3)/(4/3) = 0,25 = 25%
Due to this result, John Scullys profit margin with 50-55% is too high. In case of Apple the
profit margin should be 25%. John Scully behaved like a monopolist with a unique product
and his strategy failed.

3) PRICE DISCRIMINATION:
A private-garage operator has identified two distinct market segments: short term parkers and
all-day parkers with respective demand curves of PS = 3 (QS / 200) and PC = 2 (QC / 200).
Here P is the average hourly rate and Q is the number of cars parked at this price. The garage
owner is considering charging different prices (on a per-hour basis) for short-term parking and
all-day parking. The capacity of the garage is 600 cars, and the cost associated with adding
extra cars in the garage (up to this limit) is negligible.
a) Given these facts, what is the owners appropriate objective? How can he ensure
that members of each market segment effectively pay a different hourly price?
The owner wants to maximize its profits, she tries to price discriminated between short term
and long term parkers. The common way to do this is handing out tickets to all customers.
b) What price should be charged for each type of parker? How many of each type of
car will use the garage at these prices? Will the garage be full?
= (3 QS /200*QS) + (2 QC /200)*QC

d/dQS=3 QS /100
d/dQC=2 QC/100
3 QS /100=0
QS=300
2 QC /100=0
QC=200
PS=1,5; PC=1
Just 500 spaces are occupied.
c) Answer the question in part b) assuming the garage capacity is 400 cars?
= (3 - QS /200)*QS + (2 (400 - QS)/200)*(400 - QS)
d/dQS = 3 - QS /100 - 2 - (QS - 400)/100 = 0
QS=250; QC=150
PS=1,75; PC=1,25

4) PRICE DISCRIMINATION
A bakery in the seaside resort town of Blackpool sells freshly baked bread to two categories
of customers: residents of town and tourists. The weekly demand for tourists is given by the
demand function:
XT = 120 ( 5 P )
For prices between 0 and 5 (There is no demand at prices above 5 ). The weekly demand
from locals is
XL = 180 ( 3 P )
For prices P between 0 and 3 (There is no demand at prices above 3 ) The bakery marginal
cost per loaf is a constant 1,20.
a) Suppose the baker could somehow set different prices for locals and for tourists.
What prices would it set for each group? What profit would it earn from the two
groups?
Xt = 120 (5 P)

Xl = 180 (3 P)
MC(t, l) = 1,20
P(t) = 5 (Xt / 120)
MR(t) = (5 * Xt (Xt 2/ 120) = 5 (Xt / 60)
Pl = 3 (Xl / 180)
MRl = (3 * Xl (Xl 2 / 180) = 3 (Xl / 90)
Profit Maximization: MC = MR
1,20 = 5 (Xt / 60)
Xt = 228
1,20 = 3 (Xl / 90)
Xl = 162
Pt = 5 (Xt / 120) = 5 (228 / 120) = 3,10
P(l) = 3 (Xl / 180) = 3 (162 / 180) = 2,10
The price for tourists is 3,10 per loaf and for locals 2,10 .
= Pt * Xt+ Pl * Xl MC *(Xt+ Xl)
= 3,10 * 228 + 2,10 * 162 1,20 * 390 = 579
The profit of the bakery is 579 .
b) If the bakery has to charge the same price to both locals and tourists, what price
would it set? What would be its profit?
Pt = Pl Xl = (3Xt / 2) 360
= Pt* Xt+ Pl * Xl MC *(Xt+ Xl )
= P * (Xl + Xt)- 1,2 * (X l + Xt )
= (5 (Xt / 120) * (3Xt /2) 360 + Xt 1,2 * ((3Xt) /2) 360 + Xt
d /dXt = - ((Xt 456) * (Xt 144) / 48) / 12,5 0,00417 Xt= 0
Xt = 300
X(l) = (3Xt/ 2) 360 = 450 360 = 90
P = 5 (Xt/ 120) = 3 (Xl / 180) = 2,50

The bakery charges 2,50 for both groups.

Profit = 2,5 * (300 + 90) 1,20 * (300 + 90) = 507
The bakery's profit is 507 .
c) The bakery has come to the Blackpool Town Council with a request for a zoning
permit that will permit it to sell bread inside the residential district of town. This will
permit it to sell bread at the optimal price for tourists at its store on Main Street and
sell bread at the optimal price for locals in this new outlet. The geography of the town
is such that no tourist could buy bread at the store intended for locals (they would be
unable to find it and, since the locals in Blackpool are very taciturn and suspicious of
strangers, no local will tell any tourist of its existence) and no local would buy from
the Main Street store unless the price on Main Street were lower than price in the
residential district. The bakerys argument in favour of this is that it would promote
the profits of local industry. As a member of Blackpool Town Council, you are
concerned about the profits of the bakery, it makes generous contributions to your reelection campaign, but you also need votes, and so you are very concerned with the
welfare of local consumers. Should you favour the zoning variance?
Price discrimination leads to increases in profits for the bakery and prices for locals are lower.
Just tourists have to pay more, because they have a higher willingness to pay.

5) LEARNING CURVE:
An entrepreneur plans to convert a building she owns into a video-game arcade. Her main
decision is how many games to purchase for the arcade. From survey information, she
projects total revenue per year as R = 10.000 Q 200 Q2, where Q is the number of games.
The cost for each game (leasing, electricity, maintenance, and so on) is 4.000 per year. The
entrepreneur will run the arcade, but instead of paying herself a salary, she will collect profits.
She has received offers of 100.000 to sell her building and a 20.000 offer to manage a
rivals arcade. She recognizes that a normal return on a risky investment such as an arcade is
20 percent.
a) As a profit maximizer, how many games should she order?
R = 10 000 Q - 200 Q2
MR = MC

10000 -400Q = 4000 => Q = 15

TR = 105 000
TC = 60 000
= 45 000
b) What is her economic profit?
The economic profit is the difference between the possible alternatives.
Economic profit = profit (salary + capital investment)
= 45000 (20000 + 0.2 100000) = 5000.
Her economic profit would be 5000 Euro

6) SHORT-RUN LONG-RUN EQUILIBRIUM

a) Suppose a firms short-run average-cost curve is U shaped. What does this imply about the
marginal return to the variable input?
Starting from high cost per item if only a few items are produced marginal return per input
increases until the quantity is reached where the U-shaped cost curve has its minimum (that's
the optimal quantity). If input is increased from this point, marginal return per input
decreases. Higher quantities than the optimal quantity cannot be produced efficiently.
b) Suppose a firms long-run average-cost curve is flat. What does this imply about returns to
scale in the firm? What does this mean for the firms long run marginal cost?
If the average-cost curve is flat returns to scale are constant. If you double the input the output
will also double. A flat long-run average-cost curve means constant returns to scale because
there are no diversifications in average-costs with, changes in firms size and production
capacity. The firms marginal cost are constant
c) Explain why increasing returns to scale imply declining log-run average cost?
Increasing returns to scale mean that you get more than one percent of output if you raise your
input by one percent. The production of an additional unit means a decrease in costs
decreasing marginal costs.

7) PRICE DISCRIMINATION

Show how managers use price discrimination for ticketing at professional sport events on the
basis of the homepages of the NEW YORK KNICKS
(http://www.nba.com/knicks/tickets/ticket_central.html) and ARSENAL FC
(http://www.arsenal.com/home).
Which kind of price discrimination does occur?
How many different membership-ticket combinations do exist?
You can find following kinds of price discrimination:
Peak Load pricing in peak season.
Bundling: great games with ordinary games
Third degree price discrimination through different fees for seat-zones, VIP and ordinary
tickets, vouchers, cheaper membership tickets.
Second degree price discrimination through season tickets and matchday tickets (larger
quantity is cheaper per game.