CHAPTER 12
Demand and Revenue Management
CHAPTER SUMMARY AND TEACHING OBJECTIVES
This chapter is not much different from standard microeconomic text chapters on the consumer. The
emphasis is on the usefulness of concepts such as price elasticity to the manager.
1. Students must understand what knowing the customer means—that it requires knowledge of
IMPORTANT TERMS
price elasticity of demand percentage change in quantity demanded divided by percentage change in
price
elastic price elasticity is greater than one
inelastic price elasticity is less than one
unit-elastic price elasticity is one
income elasticity of demand percentage change in quantity demanded divided by percentage change
in income
TOPICS AND TEACHING SUGGESTIONS
1. Price, Sales and Consumer Choice
The basis of this section—in fact the entire chapter—is demand. The first section focuses on price
elasticity. The relationship of price elasticity and revenue is emphasized. Income and cross price
54 Chapter 12: Demand and Revenue Management
ANSWERS TO EXERCISES
1. For each of the following pairs of goods or services, identify the one for which the price
elasticity of demand is greater and explain why:
Coffee; Starbucks Coffee
The branded item has a greater price elasticity of demand because there are more substitutes.
2. Although water is essential to life no matter where one lives, the demand for water differs
across regions. In one study it was found that the price elasticity of demand for water in all
regions of the United States ranged from .39 to .69.
a. Why is the demand for water price inelastic?
There are few substitutes for water.
b. In those regions where outdoor use of water is a relatively large portion of total use, the price
elasticity is high. Why?
c. The demand for water in the summer months is greater than in the winter months. Explain why.
3. Many proponents of public transit argue that the service should be provided free to the public
in metropolitan areas in order to reduce pollution and traffic congestion. Estimates by
economists found the price elasticity of demand for public transit to be .17. The economists
also found the cross-price elasticity of demand with the automobile to be .10.
a. What will free public transport mean to the use of the public transportation service?
b. What will free public transport mean to the use of the automobile?
4. The income elasticity of demand for automobiles in the United States was estimated by a
government agency to be between 2.5 and 3.9.
a. What does this mean?
b. If incomes rise by 10 percent, what happens to the purchase of automobiles?
5. Explain why the demand curve is a horizontal line in the situation called perfect competition
In perfect competition a single firm cannot affect the market price. They are a price-taker. If they
6. Many retailers will use short-term price cuts to attract customers. These often include “loss–
leaders,” products sold at a loss for a short time. Why would a firm ever sell at a loss?
7. The demand curve slopes downward. Explain why it slopes down.
8. What would happen to the demand curve in each of the following cases:
a. income rises – the demand curve would shift to the right if the good was normal and shift to
the left if the good was inferior.
9. Economists have found that cigarette smoking declines about 4 percent for every 10 percent
increase in cigarette price. Several states have increased taxes by 100 percent on cigarettes to
pay for improvements in education. Does the policy make sense? Explain.
10. Using the following equation for the demand for a good or service, calculate the price
elasticity of demand, cross elasticity with good x, and income elasticity. Q = 8-2P+0.10I+Px
where Q is quantity demanded, P is the price of the product, I is income, and Px is the price of
a related good. Assume that P=$10, I=100, and Px=20.
56 Chapter 12: Demand and Revenue Management
11. A firm has estimated the following demand function for its product:
Q = 10-2P+.20I+2A where Q is quantity demanded per month in thousands, P is product price, I is
12. If a firm has two sets of customers, those who want the newest version of the product
immediately and those who are more patient, how should it price its product?
13. Under what condition would it make sense for a firm to offer quantity discounts?
14. The price elasticity of demand for Japanese autos is more elastic in the United States than it is
15. If the rice of a Big Mac is increased by $.50 and the price of a BMW convertible is increased
by $5,000, who will react more, the Big Mac customers or the BMW customers? Explain.
16. Why would movie theaters offer discounts to seniors?
17. Explain why the price elasticity of demand is negative. What would the price of demand be
for a “prestige good,” one for which quantity purchased increases a price increases? How do
you reconcile these two statements?
Price elasticity is negative because the law of demand describes the negative relationship between
18. Using elasticity, explain what “market power” means.