BUSINESS

ECONOMICS
Mid term Exam

WAN MUHAMMAD DANIAL

Assoc. Prof. Dr Gazi Md Nurul Islam

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Question 1
The following table lists the cross-price elasticities of demand for several goods, where
the percent quantity change is measured for the first good of the pair, and the
percentage change in price is measured for the second good. (20 marks)

Goods Cross Price elasticity of Demand

Air-conditioning units and kilowatts of electricity -0.34
Coke and Pepsi + 0.63
High-fuel-consuming sport-utility vehicles (SUVs) - 0.28
and gasoline
McDonald’s burgers and Burger King burgers +0.82
Butter and margarine +1.54

a. Explain the sign of each of the cross-price elasticities. What does it imply about the
relationship between the two goods in question?

Answer:

When two items are consumed together, for example, a negative sign appears in front of
the cross price elasticity, indicating that the two goods are complementary. A good's price
increase reduces the demand for another good.

When cross price elasticity is positive, it means that the two items in question are
competitors or alternatives for one another. When one's price rises, so does the other's
demand.

b. Compare the absolute values of the cross-price elasticities and explain their magnitudes.
For example, why is the cross-price elasticity of McDonald’s burgers and Burger King
burgers less than the cross-price elasticity of butter and margarine?

Answer:

The extent of the elasticities demonstrates how interdependent the items are. When two
products have a higher absolute worth, they are more connected.

Burger King and McDonald's have lower cross-price elasticity than butter and margarine
because of their closer relationship. Butter and margarine are seen by consumers as better
alternatives than Burger King and McDonald's.

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c. Use the information in the table to calculate how a 5% increase in the price of Pepsi
affects the quantity of Coke demanded.

Answer:
Cross price elasticity of coke and pepsi = (% Change in quantity of
coke)/(% Change in price of Pepsi)

0.63 = % Change in quantity of coke / 5

% Change in quantity of Coke = 0.63 x 5 = 3.15

There will be a 3.15 % rise in quantity of coke demanded when price of

Pepsi rises by 5%

d. Use the information in the table to calculate how a 10% decrease in the price of
gasoline affects the quantity of SUVs demanded.

Answer:
Cross price elasticity of SUV and gasoline = (% Change in quantity of
SUV)/(% Change in price of gasoline)

-0.28 = % change in quantity of SUV / (-10)

% Change in quantity of SUVs = -0.28 (-10) = 2.8

There will be 2.8% rise in SUVs demanded when price of gasoline falls by

10%There is an inverse relation since they are complements

Question 2:
In Malaysia, medical costs have increased more rapidly than other prices over the
past decade. In order to illustrate how rising medical costs have affected consumer
alternatives, let X represent the quantity of medical services, and let Y represent the
quantity of other goods. Furthermore, let income (M) be measured in thousand
ringgits, the price of medical services and other goods in terms of ringgit per minute,
with income is equal to RM200, Price of X = 4, and Price of Y = 5.
(20 marks)
a. Draw the budget line and determine the market rate of substitution. Show the
budget set.
Answer:
Earnings: $2,000

X's cost, or the medical service, is $4 per minute.

Maximum number of minutes that can be purchased for medical care is 200000 / 4 =
50000 minutes.

The cost of Y, or other items, is five per minute.

The maximum number of minutes that can be spent on other items is 200000 / 5 =
40000 minutes.

Budget line is as follows:

Market rate of
substitution =Minutes of
medical care / Minutes
of other goods

Market rate of
substitution =50000 /
40000

Market rate of substitution =

1.25

This indicates that 1.25 minutes

of medical care must be given
up for every minute of other
good.

The entire area of the triangle

'abo' represents the budget set,
whereas the line 'ab' represents
the budget line.
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 b. Explain with diagram what happens to the budget constraint if Px increases from
RM 4 to RM10. Illustrate the slope of the two budget constraints?

Answer:

The new cost for X, or the medical treatment, is $10 per minute.

The maximum number of minutes that can be purchased for medical care is 20000
minutes (200000 / 10).

As we can see, the budget line has rotated to the left and only a maximum of 20,000 minutes
can now be purchased due to the increase in medical care costs.

Old budget line slope is Px / Py = 4/5 = 0.80. The new budget line's slope is Px / Py, or 10/5,
or 2.0.

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 Question 3:
A monopolist always produces a quantity at which the demand curve is elastic.
Explain with a diagram and show the average and marginal cost for the monopolist.
(20
marks)

Answer:

PNRM=Supernatural Profit

MC
AC
P N

M R

D=R

0 Q MR Quantity

The part of the demand curve (AR) where the MR is positive is always made by a monopolist.
The point where MC = MR and P > MC of production is where a monopolist can make the most
money. Since MC is positive, MR must also be positive when everything is equal. Demand that
is elastic is at the top of the curve, demand that is inelastic is at the bottom, and demand that
is unitary elastic is in the middle.

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 Question 4:
Read the case study provided in the Appendix A entitled ‘The role of advertising’ and
answer the following FOUR (4) questions: (20
marks)

Case Study: The role of advertising

Firms often spend thousands to millions of dollars per year on advertising and other
forms of marketing. In terms of demand analysis the aim is twofold. Advertising is
designed to inform the consumer of the product and influence their tastes and
preferences. A successful advertising campaign should result in an increase in the
demand for the product at each given price level, thereby shifting the demand curve
to the right.

Advertising is also designed to increase brand loyalty. Successful advertising and

marketing will enable consumers to associate a certain lifestyle or image with the
product. If firms are able to successfully create a sense of brand loyalty, then this
makes their competitors’ products less viable as alternatives. Therefore, a
successful advertising campaign can decrease the Price Elasticity of Demand (PED)
for their product.

A lower PED for a product may allow the company to charge higher prices and gain an increase in
revenue. This may help to explain why some designer or luxury brands are able to charge far more
than what it costs to produce their product.

Questions
a. Outline two reasons why businesses spend millions of dollars on advertising.
b. Explain what is meant by brand loyalty and outline how advertising can generate
brand loyalty.
c. Discuss the possible relationship between an increase in advertising expenditure,
brand loyalty and the PED.
d. Explain why it is considered to be profit maximizing behaviour if a business raises
the price on those products with a low PED.

Answer :

a. Businesses spend millions of dollars on advertising for two major reasons:

i. To educate customers about the merchandise

ii. To sway their inclinations and tastes.

Advertising increases brand loyalty among consumers by influencing demand.

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b. Brand loyalty prevents customers from buying goods from competing brands. They will
identify with the brand and believe that it serves no purpose for them to use any other brand.

Consumers form associations in their minds as a result of advertising. Customer loyalty rises
as a result of their beginning to believe the advertisement's message.

c. Brand loyalty will increase and the PED will decrease as a result of higher advertising
expenditures.

Brands gain consumer appeal as companies increase their advertising expenditures. People
start to relate to the brand. Their price elasticity of demand decreases as a result. They won't
compromise and are willing to spend more for the same product from a particular brand.

d. Where MR = MC is the profit-maximizing position.

A company should try to sell more if it notices an increase in marginal revenue. The company
should calculate the utmost amount that customers are willing to pay at this point. This will
optimize revenue.

In order to recover costs, the company should charge the maximum price for a given quantity
if PED is low.

Price increases for goods with low PEDs can be made without significantly impacting demand.

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Question 5 (20 Marks)

The University Book Store is the only store (hence, it is a monopoly) that sells the
Krugman’s book (Microeconomics) for the Economics class. The staff of bookstore
can only identify customers as morning class or afternoon class, but other than that
they all look the same.

This monopolist faces demand from two groups of consumers, and they charge
relatively higher prices to the afternoon class customers. This problem assumes that
the bookstore is able to price discriminate between the two markets.
is able to price discriminate between the two markets.

a. Draw a diagram of monopolist’s price discrimination.(5 marks)

Price

eD<1
eD>1

P0

P1
MR D(AR)
MR D
0
Q0 Q Q1

Figure 1 Figure 2

Figure 1: Shows a set of clients (afternoon class) that have a high degree of demand

elasticity for the kit book and can afford to pay comparatively higher rates.

Figure 2: Shows a group of consumers (morning class) whose demand elasticity is lower

and so they are charged less than the afternoon class.

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b. Which group of customers has the more elastic demand curve?(5 marks)

• Figure 2 illustrates that the demand curve for the morning class client group is
more elastic.

c. Which class pays the higher price?(5 marks)

• Compared to the evening class customer group, the afternoon class customer
group pays a higher price since their demand elasticity is lower.

d. Which class gives the monopolist the greater revenue?(5 marks)

• Customers in the afternoon session bring in more money for the monopolist.

TR equals P times Q, hence if P is larger, revenue is likewise higher. However,

quantity also affects revenue. Therefore, it can only be concluded that the

nighttime class of customers will provide the monopolist with larger revenue if

quantity is assumed to be constant and the same for both of these groups.