ECO CH 5

Describe some of the limitations of market experiments.

An alternative technique for obtaining useful information about a product’s demand function
involves market experiments. The firm locates one or more markets with specific
characteristics, and then varies prices, packaging, advertising, and other controllable variables
in the demand function, with the variations occurring either over time or between markets.
One market
experiment technique entails examining consumer behavior is actual markets. The firm may
also be able to sue census or survey data to determine how such demographic characteristics as
income, family size, educational level and ethnic background affect demand.

Market experimentation procedure utilizes a controlled laboratory experiment where in

consumers are given funds with which to shop in a simulated store. By varying prices, product
packaging, displays, and other factors, the experimenters can often learn a great deal
about consumer behavior. The laboratory experiment, while providing similar information as
field experiments has advantages/merits because of lower cost and greater control of
extraneous factors. Merits and limitations of market experiments can be shown as below:

Merits
1. Market experiments are based on actual consumer behavior and not on merely their
intentions to buy the commodity. 
2. They provide more accurate returns than those of consumer survey because consumers
are asked to make actual decisions regarding their purchase.
Limitations
1. Market experiments are costly and much time consuming. 
2. If the price rises, the consumers may switch over to the products of the rival firms. If the
price reduced to the original level, it may be difficult to regain the lost customers.
3. It is also difficult to select an area, which accurately represents the potential market.
4. Firm cannot control all the factors (i.e. bad weather, economic conditions, occupation
situations etc.) that influence demand for a product.
5. The changes in price or adverting to know consumer’s response may go unnoticed by
them in such a short period. 
6. The selected consumers may not respond accurately when they know they are a part of
an experiment being conducted and their behavior is being recorded.
Q: “When I go to the grocery store, I find centsoff coupons totally annoying. Why can’t they just cut the price and do away
with the clutter?” Discuss this statement and explain why coupon promotions are an effective means of promotion for
grocery retailers, and popular with many consumers

Q : Explain how shifting demand and supply curves makes market demand estimation difficult.

Q Demand Estimation Concepts. Identify each of the following statements as true

or false and explain why.
A. The effect of a $1 change in price is constant, but the elasticity of demand will vary along a
linear demand curve.
B. In practice, price and quantity tend to be individually rather than simultaneously determined.
C. A demand curve is revealed if prices fall while supply conditions are held constant.
D. The effect of a $1 change in price will vary, but the elasticity of demand is constant along a
log-linear demand curve.
E. Consumer interviews are a useful means for incorporating subjective information into
demand estimation
.

Q Regression Analysis.
Identify each of the following statements as true or false and
explain why:
A. A parameter is a population characteristic that is estimated by a coefficient derived from a
sample of data.
B. A one-tail t test is used to indicate whether the independent variables as a group explain a
significant share of demand variation.
C. Given values for independent variables, the estimated demand relation can be used to
derive a predicted value for demand.
D. A two-tail t test is an appropriate means for testing direction (positive or negative) of the
influences of independent variables.
E. The coefficient of determination shows the share of total variation in demand that cannot be
explained by the regression model.
Solution
 A. True. A parameter is a population characteristic that is estimated by a coefficient
derived from a sample of data.
B. False. An F test is used to indicate whether or not the independent variables as a
group explain a significant share of demand variation.
C. True.Given values for independent variables, the estimated demand relation can be
used to derive a predicted (or fitted) value for demand.
D. False. A one-tail t test is an appropriate means for tests of direction (positive or
negative) or comparative magnitude concerning the influences of the independent
variables on y.
E. False. The coefficient of determination (R2) shows the share of total variation in
demand that can be explained by the regression model. 

Q Revenue Versus Profit Maximization.

On weekends during summer months,
Eric Cartman rents jet skis at the beach on an hourly basis. Last week, Cartman rented jet skis
for20 hours per day at a rate of $50 per hour. This week, rentals fell to 15 hours per day when
Cartman raised the price to $55 per hour.
Using these two price–output combinations, the relevant linear demand and marginal revenue
curves can be estimated as P_$70_$1Q and MR _$70_$2Q
A. Calculate the revenue-maximizing price–output combination. How much are these
maximum revenues? If marginal cost is $30 per hour, calculate profits at this activity level,
assuming TC_MC_Q.

B. Calculate the profit-maximizing price–output combination along with revenues and profits
at this activity level.
solution
a If Cartman is maximizing his revenues he has to calculate the first-order
derivative of revenues (marginal revenues) and set these equal to zero. In our
case this will yield 
MR=70−2Q=0
Solving the latter for quantity yields the optimal (i.e., revenue-maximizing)
quantity
 Q=35
Each unit can be sold at market price 
P=70−35=35 usd
and since profits are revenues minus total costs, Cartman's total profits will be 
35×35−30×35=175
b. If Cartman is maximizing profits, instead, he will choose that quantity Q for
which marginal revenues will equal marginal costs or
 MR=70−2Q=30.
Solving for Q yields the optimal (i.e., profit-maximizing) quantity Q=20
. Each of these 20 units will sell for P=70−20=50 usd. His profits will increase
to 20×50−30×20=400

Xerox Corporation develops, manufactures,

and services document equipment and software solutions worldwide. Assume the company
offered $75 off the $1,475 regular price on the Phaser 6360, a durable high-speed color copier,
and
Internet sales jumped from 700 units to 800 units per week (see http://www.office.xerox.com).
A. Estimate the color copier demand curve, assuming that it is linear.
B. If marginal costs per unit are $650, calculate the profit-maximizing price–output
combination. [Remember: The marginal revenue curve has the same intercept as the
demand curve, but has twice its negative slope (falls twice as fast).]

SOLUTION
 A. When a linear demand curve is written as: P=a + bQ a is the intercept
and b is the slope coefficient. From the data given previously, two
points on this linear demand curve are identified. Given this
information, it is possible to exactly identify the linear demand curve
by solving the system of two equations with two unknowns,
a and b:
1,475=a + b(700) minus
1,400=a + b(800)
75=-100 b
b=-0. 75

By substitution,
if b = -0. 75, then:
1,475=a + b(700)
1,475=a – 0. 75(700)
1,475=a – 525
a=2,000
Therefore, the color copier demand curve can be written:
P=$2,000 – $0. 5Q
B To find the profit-maximizing output level, set
MR = $650 = MC,
and solve for Q.
Because TR=P ?
Q =($2,000 – $0. 75Q)
Q =$2,000Q – $0. 75Q2

MR= ?
TR=?
Q = MC MR=$2,000 – $1. 5Q = $650 1.
5Q=1,350
Q=900
At Q = 900,
the profit-maximizing price is
P=$2,000 – $0. 75(900) =$1,325
Q Multiple regreesion
Colorful Tile, Inc., is a rapidly growing chain of ceramic tile
outlets that caters to the do-it-yourself home remodeling market. In 2007, 33 stores were operated
in small to medium-size metropolitan markets. An in-house study of sales by these outlets revealed
the following (standard errors in parentheses):
Q_4_5P_2A_0.2I_0.25HF
(3) (1.8) (0.7) (0.1) (0.1)
R2_93%, Standard Error of the Estimate_6
Here, Q is tile sales (in thousands of cases), P is tile price (per case), A is advertising expenditures
(in thousands of dollars), I is disposable income per household (in thousands of dollars), and HF is
household formation (in hundreds).
A. Fully evaluate and interpret these empirical results on an overall basis using R2 ,
__
R2,F
statistic and SEE information.
B. Is quantity demanded sensitive to “own” price?
C. Austin, Texas, was a typical market covered by this analysis. During 2007 in the Austin
market, price was $5, advertising was $30,000, income was an average $55,000 per
household, and the number of household formations was 4,000. Calculate and interpret the
relevant advertising point elasticity.
D. Assume that the preceding model and data are relevant for the coming period. Estimate the
probability that the Austin store will make a profit during 2008 if total costs are projected to
be $300,000.
Solution
A. (i)Coefficient of determination
= R2 = 93%, implying that 93% of demand variation is explained by the regression
model.
(ii)Corrected coefficient of determination = pic = R2 – (k – 1/n – k)(1 – R2) = 0. 93
– (4/28)(1 – 0. 93) = 0. 2
, implying that 92% of demand variation is explained by the regression model
when both coefficient number, k, and sample size, n, are controlled for.
(iii)F statistic = (n – k/k – 1)(R2/1 – R2)
= (28/4)(0. 93/0. 07) = 93 > F*4, 28,
 ? = 0. 01 = 4. 07
implying one can reject the null hypothesis
H0: b1 = b2 = b3 = b4 = 0
and conclude with 99% confidence that the dependent variables as a group
explain a significant share of demand variation.
(iv)Standard error of the estimate = SEE = 6 implying that
Q= pic ± 2. 048 ?
6 with 95% confidence.
Q=pic ± 2. 763 ?
6 with 99% confidence.
B. To determine whether quantity demanded depends upon “own” price, the
question must be asked: is bP ? 0? If bP ? 0, then evidence exists that sales
do indeed depend upon price
.For testing purposes, the null hypothesis one seeks to reject is the converse of
the above question: H0: bP=0 (Two-tail test) where, |t|=pic Therefore, it is
possible to reject H0: bP = 0 with 99% confidence and conclude that demand is
sensitive to price.
C. Because pic=4 – 5P + 2A + 0. 2I + 0. 25HF =4 – 5(5) + 2(30) + 0. 2(55) + 0.
25(40) =60(000) The point advertising elasticity is calculated as: ?A=pic? Q/?
A ? A/Q =2 ? 30/60 =1 Because ? A = 1, a 1% increase in advertising will lead to
commensurate percentage increase in demand.
D. Pr = 0. 5 or 50%. To generate breakeven revenues of $300,000, Colorful Tile
would have to sell Q = TR/P = TC/P = $300,000/$5 = 60,000 cases. From part C,
pic = 60(000).Because there is a 50/50 chance that actual sales will be above or
below this level, there is a 50/50 chance that the Austin store will make a
profit when TC = $300,000.