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Demand & Supply Problem

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Milo McClausland, Alexander Rhoads, William Kennedy, Kevin Bae, Bhavik Mistry

1. If the demand for sugar decreases when the price of tea increases, are tea and sugar

complements, substitutes or unrelated to each other? Explain.

Sugar and tea would be complements of each other. Because, when the price of tea

increases, the demand for tea decreases and from the given data the demand for sugar also

decreases. The scenario above gives us two goods for which an increase in the price of one

leads to a decrease in the quantity demanded of the other.

2. Researchers have just discovered that antibacterial agents in toothpaste are harmful

to human health. At the same time, the price of toothpaste-making equipment has

fallen. What definitely happens in the toothpaste market after these events occur (i.e.,

what are the new equilibrium price and quantity of toothpaste? Higher, lower, or the

same)? Show with graphs.

2 discovery regarding toothpaste will lead

to a sharp drop in demand for the product. Supply however will increase slightly because it

now costs less for firms to enter the industry due to equipment prices falling. So, new

equilibrium price and the quantity of toothpaste will be lower than before as shown in the

graph.

3. When you left your job at McDonalds, you expected that your days of dealing with

potatoes were over. Yet, given your extensive potato background, and armed with an

MBA from the prestigious McDonough School of Business at Georgetown, you are

hired as a market analyst in, of all things, the potato market. For the last several years,

production, demand and prices have been stable. Last year the quantity of potatoes

transacted in the United States was 450 million cwt (cwt is agriculture-speak for 100

pounds), and prices were $8MM per million cwt. Econometric estimates have

determined that, at this level, the own-price point elasticity of demand is 0.8.

a. Assume that demand is linear. Derive the slope and intercept of Q D(P), a linear

demand function.

We are given

P = $8MM per million cwt,

Q = 450 million cwt,

Own Price Point Elasticity of Demand = - 0.8 (minus sign because the demand curve is

downward sloping)

Therefore, in order to derive the slope we use the formula

= Slope x Price/Demand

- 0.8 = Slope x 8/450

Therefore, slope of QD(P) = - 45

We then need to plug the slope into the equation

b is the intercept of QD(P) and is a constant

P = Slope x QD(P) + b

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Milo McClausland, Alexander Rhoads, William Kennedy, Kevin Bae, Bhavik Mistry

P = - 45 QD(P) + b

8 = - 45 x 450 + b

b = 20,258

Therefore, P = -45 QD(P) + 20,258

So, our final linear demand equation is:

QD(P) = (20,258 P) / 45

b. Explain why this derivation is best interpreted as a linear approximation to the

true demand function. If only an approximation, why does the equation have

value?

This derivation is interpreted as a linear approximation since we are using a linear

equation to calculate price and quantity in simple terms. In reality, however, the true

demand function is curved in nature and therefore more difficult to quantify. Although the

linear equation is just an approximation, it still provides value in that it gives us an idea of

how to assess price and quantity given certain economic conditions related to demand.

c. A marketing campaign touting the health benefits of rice has produced a recent

forecast that the demand for potatoes will fall over the next year by 20 percent. If

this report is accurate, what would the new equilibrium price for potatoes be?

Assume that the supply curve is given by QS(P) = 56.25P.

Because the demand decreases by 20% we assume that:

QD(P)2 = (1 - 0.2) x QD(P)1

QD(P)2 = 0.8 x (20,258 P) / 45

QD(P)2 = 360.14 0.0178P

And QS(P) = 56.25P

Now, to find the equilibrium price,

QS(P) = QD(P)2

So,

56.25P = 360.14 0.0178P

56.2678P = 360.14

Therefore, P = 6.4

So, the new equilibrium price for potatoes is $6.4MM per million cwt

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Milo McClausland, Alexander Rhoads, William Kennedy, Kevin Bae, Bhavik Mistry

4. Now consider the market for branded designer dog tags. Economic consultants have

estimated a linear approximation to the market demand curve: Q D(P) = 120 30*P,

where the intercept and slope terms are in millions. The industry association, which

coordinates the marketing efforts of the firms in the market, is considering a 10%

increase in its marketing efforts from $40MM to $44MM. For the campaign to be

successful it must increase revenues by at least $8MM given the costs of production.

Assume that the current price of $1 per unit would be unlikely to change in reaction to

the marketing efforts.

a. To make the marketing campaign worthwhile, what is the smallest magnitude that

the advertising elasticity of demand could be?

QD(P) = 120 30*P

P = $ 1per unit

So, QD(P) = 120 30*1 = 90 million

Revenue must increase by at least $8MM due to the marketing efforts and price per unit

would be unlikely to change in reaction to the marketing efforts and hence would remain

the same i.e. $1 per unit.

So, QD(P) increases by 8 million

Advertising Elasticity

= Percentage change in QD(P) / Percentage change in Marketing Expenditure

= (8 / 90) x 100 / 10

= 0.8888

So, the smallest magnitude of the advertising elasticity of demand = 0.8888

b. How might one obtain information on what the advertising elasticity of demand

actually is?

A firm could obtain information about the actual elasticity of demand for their

products/services by:

Investigating historical cost patterns: A firm could look at the effect of increased

marketing expenditures and revenue outcomes when the firm's products entered new

markets, when the firm initiated advertising campaigns, and when new products were

introduced.

Consumer focus groups: A firm could pose questions to target consumers about the

product to gauge the effectiveness of potential advertising spending on brand

awareness and sales.

Look at outcomes of similar product introductions into new markets by competitors.

Delta Airlines looks to become the global leader in market share and service quality by

providing more flights hub to hub than any airline in the industry. Through increased flight

capacity and frequency of flights, profits will exceed $4 billion by 2015.

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