Answers to Chapter 2 Exercises

Review and practice exercises

2.1. Village microbrew. Village microbrew raised its price from $10 to $12 a case
(wholesale). As a result, sales dropped from 10,500 to 8,100 (in units). Based on your
estimate of the demand elasticity, what percent change would you predict if price were cut
from $10 to $9? What demand level would this correspond to?
Answer: We can approximate it by the “change formula,”
✓ ◆✓ ◆
q p 10, 500 8, 100 12
✏⇡ = = 1.77
p q 10 12 8, 100
This is approximate, since we’re using discrete changes. If we assume that the elasticity of
demand is constant then we could get an exact solution by using the log formula:
log q log 10500 log 8100
✏= = = 1.42
log p log 10 log 12
Did revenue rise or fall? Since ✏ < 1, the increase in prices led to an overall fall in revenue.
(If you want to make sure, then calculate the revenues before and after the price change.)
If the elasticity is constant, what is the demand at $9? If the elasticity is constant then the
log formula calculates the elasticity exactly and in addition we know that:
log 10500 log q9
= 1.42
log 10 log 9
where q9 is the demand when the price is $9 per case, so (after a little bit of algebraic
manipulation) ✓ ◆
10
q9 = exp log 10500 + 1.42 log = 12195
9
With constant demand elasticity, the percent variation method only gives an approximation
of the value of demand elasticity. Moreover, estimating demand for a di↵erent price level
will give a di↵erent value than the log formula. Specifically, the demand estimate when
price is $9 is given by
⇣ ⌘
q9 = 10500 1 + ( 1.77) ⇥ ( 10%) = 12358
since the drop in price from 10 to 9 corresponds to a 10% variation

2.2. Demand elasticity. Based on the values in Table 2.1, provide an estimate of the
impact on sales revenues of a 10% increase in each product’s price.
Answer: Revenue is given by R = p ⇥ q. Di↵erentiating, we get

dR = dp q + p dq

Dividing by R,
dR q p
= dp + dq
R R R
Since R = p q and ✏ = dq /dp p/q, we have

dR q p
= dp + dq
R R R
q p
= dp + dq
pq pq
dp dp p dq
= +
p p q dp
dp dp
= + ✏
p p
dp
= 1+✏
p

Given that d p/p = 10%, we have

Product dR/R
Milk (1 0.5) ⇥ 10% = 5%
Cigarettes 5%
Beer 2%
Apples -3%
US luxury cars in US -9%
Foreign luxury cars in US -18%

2.3. Smartphones. The following pairs of price and quantity demanded for smartphones
have been observed: (100, 600); (105, 590); (110, 575); (115, 550); and (120, 510).
(a) Calculate the approximate elasticity of demand when price is $105.
Answer: Using the percent variation method, an increase in price to 110 leads to an esti-
mate of elasticity of (575 590)/(110 105)105/590 = .53. A decrease in price to 100
leads to an estimate of elasticity of (600 590)/(100 105)105/590 = .36. We conclude
that the value of the demand elasticity is somewhere between .36 and .53. Alterna-
tively, we can approach this problem by using logs. The elasticity estimates would then
be (log(575) log(590))/(log(110) log(105)) = .55 for a price increase and (log(600)

2
log(590))/(log(100) log(105)) = .34 for a price decrease. (Notice that, while the esti-
mates at each point are quite di↵erent, the resulting range is similar.)
(b) Is the demand elasticity constant at all prices?
Answer: Generally speaking, the value of demand elasticity does not need to be constant
at all price levels. In this particular case, it can be shown that it is not. In fact, if the
demand elasticity is constant, then the estimate obtained by using the log formula gives
the exact value of elasticity. As shown in part (a), the estimates obtained with the logs
formula applied to two di↵erent pairs of points are di↵erent. It follows that the value of ✏
varies for di↵erent price levels. This is consistent with the rather wide range of estimates
we obtained in the previous question.
(c) How does the value of demand elasticity vary as price increases?
Answer: Using logs and computing the elasticity at each point based on a $5 price increase,
we obtain the following estimates, starting at $100 : .35, .55, 1.00, 1.77. This pattern
is not infrequent: as we increase price, demand elasticity increases (in absolute value).
(d) If the monthly subscription fee for Internet access from a cell phone
falls from $10 to $2, what would you expect to happen to the quantity
of cell phones demanded at any given price? What e↵ect would this
Internet access price change have on the mobile phones’ elasticity of
demand?
Answer: We would expect the quantity of phones demanded to increase at all price levels
when the price of Internet access, a complementary product, decreases. However, it would
be difficult to determine what the change in demand elasticity would be at any given price
point.

2.4. Cars. Table 2.2 gives the “own” and cross-price elasticities for selected automobile
models.8 Specifically, each cell corresponds to the demand elasticity of the car model listed
in the row with respect to changes in the price of the car model listed in column.
(a) Why are the “own” elasticities so high?
Answer: These are models for which many substitute models are available. Thus, even if
the demand for cars is not very elastic, the demand for a particular model is.
(b) Are the Accord and Taurus complements or substitutes?
Answer: The cross-price elasticity of the Accord with respect to the price of the Taurus is
given by 0.1, a positive value. The two models are therefore substitutes. In fact, no two
models in this sample are complements.
(c) What are the Taurus’s closest competitors?
Answer: Looking at the Taurus row, we see that the cross-price elasticity is highest for
the Accord. In other words, a 1% change in the price of the Accord would have a greater
impact on the demand for the Taurus, than a 1% change in the price of any other model
(other than the Taurus).

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 (d) If GM lowers the price of its Chevy Cavalier, does it “cannibalize” its
Buick Century sales?
Answer: Yes. However, the cross price elasticity of the Century with respect to the price
of the Cavalier is fairly small. Therefore, a decrease in the price of the Cavalier will reduce
the demand for the Century by only a small amount.
(e) Why is the direct elasticity for the Mazda not lower than the elasticity
for more expensive models (as the rule of thumb would suggest)?
Answer: As suggested by the qualitative analysis of demand elasticity, luxuries tend to
have higher elasticity than non-luxuries. However, another rule of thumb to keep in mind is
that the elasticity for a particular product is always higher than the elasticity for the group
of products it belongs to. As it happens, there are many more compact car models than
there are luxury car models. Therefore, even though the elasticity for luxury cars is higher
than the elasticity for compact cars, the elasticity for a particular luxury model may not
be much greater than the elasticity for a particular compact car.
(f) Suppose Honda sold 300k Accords in 2001. In 2002, the price of the
Accord decreased by 2%, whereas the price of the Taurus decreased
by 3%. What is the likely change in Accord sales?
Answer: The percent change in demand is approximately given by ( 2%) ⇥ ( 4.8) +
( 3%) ⇥ (0.1) = 9.3%. We would expect an increase in Accord sales of approximately 9.3%,
or .093 ⇥ 300k = 27.9 k units.

2.5. Netflix and Blockbuster. Suppose the demand for Netflix is given by
qN = a b N pN + b B p B
where qN is the number of Netflix subscriptions, pN the price of a Netflix plan, and pB the
price of a Blockbuster plan.
(a) What is the price elasticity of Netflix subscriptions?
Answer: The price elasticity is
d qN p N pN
✏= = bN
d pN qN qN
Note the demand is elastic for high values of pN /qN and inelastic for low values of pN /qN .
(b) Suppose a = 500, bN = 10, bB = 5, and pB = pN = 50. What
are N ’s elasticity and cross-price elasticity? Are products N and B
substitutes or complements?
Answer: The cross-elasticity of Netflix with respect to Blockbuster’s price is given by
d qN p B pB
✏NB = = bB
d pB qN qN
Substituting the values in the above expressions, we get ✏ = 2, and ✏NB = 1. The positive
sign of the cross-elasticity means the products are substitutes. (You might have guessed it.)

4
 (c) How much do consumers get in surplus at these prices?
Answer: Consumer surplus is the area under the demand curve but above the price. First
we compute the choke price, that is the highest value of willingness to pay. Since

qN = a b N pN + b B p B

when a = 500, bN = 10, bB = 5, and pB = pN = 50 we get

qN = 500 10 pN + 5 ⇥ 50

If qN = 0, then pN = (500 + 250)/10 = 75. This means the choke price is given by 75.
Next we compute total output at the prevailing prices. This is given by

qN = 500 10 ⇥ 50 + 5 ⇥ 50 = 250

Since demand and cost are linear, consumer surplus is a triangle where the height is the
di↵erence between the demand choke price (75) and price (50), whereas the base is output
(250). This implies
1
CS = ⇥ 250 ⇥ (75 50) = 3125
2

2.6. Lamborghini. The current US demand for the Lamborghini Gallardo SE is elastic;
specifically, it is estimated that demand elasticity is given by ✏ = 3. The current price is
p = $120k. Annual sales at this price amount to q = 160 (number of cars).
(a) What do you estimate would be the impact of an increase in price to
$140k?
Answer: From the definition of elasticity, we have
q2 q1 p2 p1
⇡✏
q1 p1

An increase to 140k represents a 16.6% shift in price. We should thus expect a change in
sales of 3 ⇥ 16.6 = 50%. The new level of sales is therefore

q2 = 160 ⇥ (1 50%) = 80

If instead we us logs, then we solve the equation

log q1 log q2
✏=
log p1 log p2

which in this case becomes (price in thousands of dollars)

log 160 log q2

3=
log 120 log 140

log q2 = log 160 + 3 (log 120 log 140) = 4.613

5
Finally
q2 = exp(4.613) = 100.76
that is, between 100 and 101 cars.
Suppose the cross price elasticity of the demand for Lamborghinis with respect to the price
of the Maserati MC12 is ✏LM = .05; and with respect to the price of gasoline, ✏LG = .1.
(b) What are the definitions of a substitute and of a complement? Are
Maserati MC12 and gasoline substitutes or complements with respect
to Lamborghinis? Can you think of other substitutes and comple-
ments to the Lamborghini Gallardo SE?
Answer: Product A is a substitute with respect to B if the cross-price elasticity is pos-
itive; and a complement if the cross-price elasticity is negative. Given these definitions,
the Lamborghini and the Maserati are substitute products, whereas the Lamborghini and
gasoline are complements. Additional substitutes might include other luxury models, e.g.,
the Porsche Carrera. Additional complements might include Lamborghini merchandise; see
http://www.lamborghini.co.uk/merchandising/index.php (Question: could this conceivably
be a substitute instead of a complement?)
(c) Suppose that, in addition to the price increase considered in (a), there
is also an increase in the price of the Maserati MC12 (from $110k
to $115k); and an increase in the price of gasoline (from $2 to $2.8
per gallon). What do you estimate will be the new demand for the
Lamborghini Gallardo SE?
Answer: The price of the Maserati MC12 increases from $110k to $115k. That’s a 4.545%
increase in price. Since the cross-price elasticity is ✏LM = .05, we get a percent increase in
demand of (.05) ⇥ 4.545% = .227%. Finally, new demand is

q2 = 160 ⇥ (1 + .227%) = 160.3632

(We thus have a very small impact, at most one extra car sold.) As to the price of gasoline,
we would have ✓ ◆
2.8 2
q2 = 160 ⇥ 1 + ( .1) ⇥ = 153.6
2
If we want to consider the compound e↵ect of all three changes, then we add the three
e↵ects:
✓ ◆ ✓ ◆ ✓ ◆!
140 120 115 110 2.8 2
q2 = 160⇥ 1 + ( 3) ⇥ + (.05) ⇥ + ( .1) ⇥ = 73.96
120 110 2

Let us now consider the solution with logarithms. From the definition of elasticity, we have

log q2 log q1 = ✏ (log p2 log p1 )

This expression is valid both for a change in the own price (in which case ✏ is the own
elasticity) and for the change in the price of a di↵erent product (in which case ✏ is the

6
cross-price elasticity). And when there are several price changes, we simply add the various
elasticity-times-di↵erence-in-log-price terms. Specifically, in this case we have

log q2 log 160 = 3⇥(log 140 log 120)+(.05)⇥(log 115 log 110) (.1)⇥(log 2.8 log 2.0)

which implies
log q2 = 4.581
or simply
q2 = exp(4.581) = 97.612
that is, between 97 and 98 cars.

Challenging exercises

2.7. Constant elasticity demand. Linear demand curves have constant slope, that is,
constant derivative dq /dp. Consider now a demand curve with constant elasticity.
(a) Show that such demand curve has the form q = ↵ p
Answer: As shown in the text, demand elasticity may be written as
d log q
✏=
d log p
If the value of ✏ is independent of p and q, then it must be that log q is liner in log p, that
is,
log q = a + b log p
Applying the exponential function to both sides of the equation, we get

q = e a pb

which is the desired expression, where = b and ↵ = ea .

(b) Consider two points from the demand curve, (q1 , p1 ) and (q2 , p2 ).
Show that the expression log q/ log p gives the exact value of the
demand elasticity.
Answer: Since
log q = a + b log p
we have
log q1 = a + b log p1
log q2 = a + b log p2

Taking di↵erences, we get

log q1 log q2 log q
✏=b= =
log p1 log p2 log p

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 Applied exercises

2.8. Demand curve. Find data on prices and quantities, as well as variables that shift
the demand curve, from a particular market where you believe price is set exogenously.
Estimate the demand curve and the value of demand elasticity. Discuss the assumptions
you need to make in your estimation.
Answer: For an example, see the estimation of the demand for gasoline presented in the
main text.