P2.8 Not-for-Profit Analysis.

The Denver Athlete's Club (DAC) is a private, not-for-

profit athletic club located in Denver, Colorado. DAC currently has 3,500 members
but is planning on a membership drive to increase this number significantly.
An important issue facing Jessica Nicholson, DAC's administrative director, is the
determination of an appropriate membership level. In order to efficiently employ
scarce DAC resources, the board of directors has instructed Nicholson to
maximize DAC's operating surplus, defined as revenues minus operating costs.
They have also asked Nicholson to determine the effects of a proposed
agreement between DAC and
a neighboring club with outdoor recreation and swimming pool facilities. Plan A
involves paying the neighboring club $100 per DAC member. Plan B involves
payment of a fixed fee of $400,000 per year. Finally, the board has determined
that the membership fee for the coming year will remain constant at $2,500 per
member irrespective of the number of new members added and whether plan A
or plan B is
adopted.
In the calculations for determining an optimal membership level, Nicholson
regards price as fixed; therefore, P = MR = $2,500. Before considering the effects
of any agreement with the neighboring club, Nicholson projects total and
marginal cost relations during the coming year to be as follows:
TC = $3,500,000 + $500Q + $0.25Q2
MC = ΜTC/ΜQ = $500 + $0.5Q
where Q is the number of DAC members.
A. Before considering the effects of the proposed agreement with the neighboring
club, calculate DAC's optimal membership and operating surplus levels.
B. Calculate these levels under plan A.
C. Calculate these levels under plan B.
P2.8 SOLUTION
A. Set MR = MC and solve for Q to find the operating surplus (profit)-maximizing
activity level:
MR = MC
$2,500 = $500 + $0.5Q
0.5Q = 2,000
Q = 4,000
Surplus = P Η Q - TC
= $2,500(4,000) - $3,500,000 - $500(4,000) - $0.25(4,000^2)
= $500,000
(Note: Μ2π/ΜQ2 < 0, and this is a profit maximum because surplus is decreasing
for Q > 4,000.)
B. When operating costs increase by $100 per member, the marginal cost function
and optimal activity level are both affected. Under plan A we set MR = MC + $100,
and solve for Q to find the new operating surplus (profit)-maximizing activity
level.
MR = MC + $100
$2,500 = $500 + $0.5Q + $100
0.5Q = 1,900
Q = 3,800
Surplus = P Η Q - TC - Plan A cost
= $2,500(3,800) - $3,500,000 - $500(3,800)
- $0.25(3,800^2) - $100(3,800)
= $110,000
C. When operating costs increase by a flat $400,000 per year, the marginal cost
function and operating surplus (profit)-maximizing activity level are unaffected. As
in part A,
Q = 4,000.
The new operating surplus (profit) level is:
Surplus = PQ - TC - Plan B cost
= $500,000 - $400,000
= $100,000
Here, the DAC would be slightly better off under plan A. In general, a fixed-sum
increase in costs will decrease the operating surplus (profit) by a like amount, but
have no influence on price nor activity levels in the short-run. In the long run,
however, both price and activity levels will be affected if cost increases depress
the operating surplus (profit) below a normal (or required) rate of return.
P2.9 Revenue Maximization. Desktop Publishing Software, Inc., develops and
markets software packages for business computers. Although sales have grown
rapidly during recent years, the company's management fears that a recent
onslaught of new competitors may severely retard future growth opportunities.
Therefore, it believes that the time has come to "get big or get out."
The marketing and accounting departments have provided management with the
following monthly demand and cost information:
P = $1,000 - $1Q TC = $50,000 + $100Q
MR = ΜTR/ΜQ = $1,000 - $2Q MC = ΜTC/ΜQ = $100
A. Calculate monthly quantity, price, and profit at the short-run revenue
maximizing output level.
B. Calculate these same values for the short-run profit-maximizing level of output.
C. When would short-run revenue maximization lead to long-run profit
maximization?
P2.9 SOLUTION
A. To find the revenue-maximizing output level, set MR = 0 and solve for Q. Thus,
MR = 1,000 - 2Q = 0
2Q = 1,000
Q = 500
At Q = 500,
P = $1,000 - $1(500)
= $500
π = TR - TC
= ($1,000 - $1Q)Q - $50,000 - $100Q
= -$50,000 + $900Q - $1Q2
= -$50,000 + $900(500) - $1(5002)
= $150,000
(Note: Μ2TR/ΜQ2 < 0, and this is a revenue maximum since revenue is
decreasing
for Q > 500.)
B. To find the profit-maximizing output level set MR = MC, or Mπ = 0, and solve
for Q.
Since,
MR = MC
1,000 - 2Q = 100
2Q = 900
Q = 450
At Q = 450,
P = $1,000 - $1(450)
= $550
π = -$50,000 + $900(450) - $1(4502)
= $152,500
(Note: Μ2π/ΜQ2 < 0, and this is a profit maximum since profit is decreasing for Q
> 450.)
C. In pursuing a short-run revenue rather than a profit-maximizing strategy,
Desktop
Publishing can expect to gain a number of important advantages, including:
enhanced product awareness among consumers, increased customer loyalty,
potential economies of scale in marketing and promotion, and possible limitations
in competitor entry and growth. To be consistent with long-run profit
maximization,
these advantages of short-run revenue maximization must be at least worth the
sacrifice of $2,500 per outlet in monthly profits.
P2.10 Average Cost Minimization. Giant Screen TV, Inc., is a San Diego-based
importer and distributor of 60-inch screen, high-resolution televisions for
individual and commercial customers. Revenue and cost relations are as follows:
TR = $1,800Q - $0.006Q2
MR = ΜTR/ΜQ = $1,800 - $0.012Q
TC = $12,100,000 + $800Q + $0.004Q2
MC = ΜTC/ΜQ = $800 + $0.008Q
A. Calculate output, marginal cost, average cost, price, and profit at the average
cost-minimizing activity level.
B. Calculate these values at the profit-maximizing activity level.
C. Compare and discuss your answers to parts A and B.
P2.10 SOLUTION
A. To find the average cost-minimizing level of output, set MC = AC and solve for
Q.
Because,
AC = TC/Q
= ($12,100,000 + $800Q + $0.004Q2)/Q
= $12,100,000Q-1 + $800 + $0.004Q
Therefore,
MC = AC
$800 + $0.008Q = $12,100,000Q-1 + $800 + $0.004Q
0.004Q = 12,100,000/Q
Q2 = 12,100,000/0.004
Q =sqrt 12,100,000/0.004 = 55,000
And,
MC = $800 + $0.008(55,000)
= $1,240
AC = $12,100,000 + $800 + $0.004(55,000)
55,000
= $1,240
P = TR/Q
= ($1,800Q - $0.006Q2)/Q
= $1,800 - $0.006Q
= $1,800 - $0.006(55,000)
= $1,470
π = P Η Q - TC
= $1,470(55,000) - $12,100,000 - $800(55,000) - $0.004(55,0002)
= $12,650,000
(Note: Μ2AC/ΜQ2 > 0, and average cost is rising for Q > 55,000.)
B. To find the profit-maximizing level of output, set MR = MC and solve for Q (this
is
also where Mπ = 0):
MR = MC
$1,800 - $0.012Q = $800 + $0.008Q
0.02Q = 1,000
Q = 50,000
And
MC = $800 + $0.008(50,000)
= $1,200
AC = $12,100,000 + $800 + $0.004(50,000)
50,000
= $1,242
P = $1,800 - $0.006(50,000)
= $1,500
π = TR - TC
= $1,800Q - $0.006Q2 - $12,100,000 - $800Q - $0.004Q2
= -$0.01Q2 + $1,000Q - $12,100,000
= -$0.01(50,0002) + $1,000(50,000) - $12,100,000
= $12,900,000
(Note: Μ2π/ΜQ2 < 0, and profit is falling for Q > 50,000.)
C. Average cost is minimized when MC = AC = $1,240. Given P = $1,470, a $230
profit per unit of output is earned when Q = 55,000. Total profit π = $12.65
million.
Profit is maximized when Q = 50,000 since MR = MC = $1,200 at that activity level.
Since MC = $1,200 < AC = $1,242, average cost is falling. Given P = $1,500 and AC
= $1,242, a $258 profit per unit of output is earned when Q = 50,000. Total profit
π = $12.9 million.
Total profit is higher at the Q = 50,000 activity level because the modest $2 (=
$1,242 - $1,240) decline in average cost is more than offset by the $30 (= $1,500 -
$1,470) price cut necessary to expand sales from Q = 50,000 to Q = 55,000 units.

B.B. Lean is a catalog retailer of a wide variety of sporting goods and recreational
products. Although the market response to the company’s spring catalog was
generally good, sales of B.B Lean’s $140 deluxe garment bag declined from 10,00
to 4,800 units. During this period, a competitor offered a whopping $52 off their
regular $137 price on deluxe garment bags.
 
A.
Calculate the arc cross-price elasticity of demand for B. B. Lean's
deluxe garment bag.
B.
B. B. Lean's deluxe garment bag sales recovered from 4,800 units to 6,000
units following a price reduction to $130 per unit. Calculate B. B. Lean's arc
priceelasticity of demand for this product.
C.
Assuming the same arc price elasticity of demand calculated in Part B,determine the
further price reduction necessary for B. B. Lean to fully recover lost sales (i.e., regain a volume
of 10,000 units).

P5.9SOLUTION
A.
EPX= Q+QP+P P-PQ-Q
1Y2Y 1X2X 1X2X 1Y2Y
×
=
10,000+4,800$137+$85 $137-$8510,000-4,800
×
=1.5 (Substitutes)
B.
E
P
=
Q+QP+P P-PQ-Q
12121212
×
=
4,800+6,000$140+$130 $140-$1304,800-6,000
×
=-3 (Elastic)
C.
E
P
=
Q+QP+P P-PQ-Q
12121212
×
-3=
6,000+10,000$130+Px$130-P6,000-10,000
22
-3=
$130)-P4($130+P
22
-12P
2
+ $ 1 , 5 6 0 = P
2
+ $13013P
2
= $ 1 , 4 3 0

P
2
= $ 1 1 0 This implies a further price reduction of $20 because:Δ P = $ 1 3 0 -
$ 1 1 0 = $ 2 0

P5.7Cross-Price Elasticity
. The South Beach Cafe recently reduced appetizer prices from$12 to $10 for afternoon “early
bird” customers and enjoyed a resulting increase in sales from 90 to 150 orders per day.
Beverage sales also increased from 300 to 600units per day.
 A.
Calculate the arc price elasticity of demand for appetizers.
 B.
Calculate the arc cross-price elasticity of demand between beverage sales and appetizer
prices. A.Holding all else equal, would you expect an additional appetizer price
decreaseto $8 to cause both appetizer and beverage revenues to rise? Explain
 P5.7SOLUTION 
A.B.
B . Y e s , t h e | E
P
| = 2.75 > 1 calculated in part A implies an elastic demand for appetizersand that an additional
price reduction will increase appetizer revenues. E
PX
= -3.67 < 0indicates that beverages and appetizers are complements. Therefore, a further
decreasein appetizer prices will cause a continued growth in beverage unit sales and
revenues.Alternatively, If P = a + bQ, then $12 = a + b(90) and $10 = a + b(150). Solvingfor the
demand curve gives P = $15 - $0.033Q. At P = $12, total revenue is $1,080 (=$12 × 90). If P =
$10, total revenue is $1,500 (= $10 × 150). At P = $8, total revenue is$1,680 (= $8 × 210). In
any case, to determine the profit effects of appetizer pricechanges it is necessary to consider
revenue and cost implications of both appetizer and beverage sales.
 P5.8Income Elasticity
. Ironside Industries, Inc., is a leading manufacturer of tufted carpeting under the
Ironside brand. Demand for Ironside's products is closely tied tothe overall pace of building and
remodeling activity and, therefore, is highly sensitiveto changes in national income.
The carpet manufacturing industry is highlycompetitive, so Ironside's demand is
also very price-sensitive. During the past year, Ironside sold 30 million square yards
(units) of carpeting at an average wholesale price of $15.50 per unit. This year,
household income is
75.2-= 0)9+05(1 )2$1+10($  )2$1-10($ 0)9-50(1  =Q+QP+P PQ =E
1212P
××∆∆
67.3-= 0)30+600( )2$1+10($  )2$1-10($ 0)30-600(  =Q+QP+P PQ =E
121X2X XPX
××∆∆

 
expected to ssurge from $55,500 to $58,500 per year in a booming
economicrecovery.
 A.
Without any price change, Ironside's marketing director expects current-year  sales to soar to
50 million units because of rising income. Calculate theimplied income arc elasticity of
demand.
 B.
Given the projected rise in income, the marketing director believes that
avolume of 30 million units could be maintained despite an increase in price of $1 per unit. On
this basis, calculate the implied arc price elasticity of demand.
C.
 Holding all else equal, would a further increase in price result in higher or
lower total revenue?
 P5.8SOLUTION 
A.B.
Without a price increase, sales this year would total 50 million units. Therefore, it
isappropriate to estimate the arc price elasticity from a before-price-increase base
of 50million units:
C.
Lower. Since carpet demand is in the elastic range, E
P
= -8, an increase (decrease) in price will result in lower (higher) total revenues.
 P5.9Cross-Price Elasticity.
 B. B. Lean is a catalog retailer of a wide variety of sporting  goods and
recreational products. Although the market response to the company's spring
catalog was generally good, sales of B. B. Lean's $140 deluxe garment
bag declined from 10,000 to 4,800 units. During this period, a competitor offered
awhopping $52 off their regular $137 price on deluxe garment bags.
9.5=30+50$55,500+$58,500 $55,500-$58,50030-50 =Q+QI+I IQ =E
1212I
××∆∆
(Elastic)8-= 50+30$15.50+$16.50 $15.50-$16.5050-30 =Q1+Q2P1+P2 PQ =EP
××∆∆

 
 A.
Calculate the arc cross-price elasticity of demand for B. B. Lean's
deluxe garment bag.
 B.
 B. B. Lean's deluxe garment bag sales recovered from 4,800 units to 6,000
units following a price reduction to $130 per unit. Calculate B. B. Lean's arc
priceelasticity of demand for this product.
C.
 Assuming the same arc price elasticity of demand calculated in Part B,determine the
further price reduction necessary for B. B. Lean to fully recover lost sales (i.e., regain a volume
of 10,000 units).
 P5.9SOLUTION 
A.
E
PX
=
Q+QP+P P-PQ-Q
1Y2Y 1X2X 1X2X 1Y2Y
×
=
10,000+4,800$137+$85 $137-$8510,000-4,800
×
=1.5 (Substitutes)
B.
E
P
=
Q+QP+P P-PQ-Q
12121212
×
=
4,800+6,000$140+$130 $140-$1304,800-6,000
×
=-3 (Elastic)
C.
E
P
=
Q+QP+P P-PQ-Q
12121212
×
-3=
6,000+10,000$130+Px$130-P6,000-10,000
22
-3=
$130)-P4($130+P
22
-12P
2
+ $ 1 , 5 6 0 = P
2
+ $13013P
2
= $ 1 , 4 3 0

 
P
2
= $ 1 1 0 This implies a further price reduction of $20 because:Δ P = $ 1 3 0 -
$ 1 1 0 = $ 2 0
 P5.10Advertising Elasticity.
 Enchantment Cosmetics, Inc., offers a line of cosmetic and  perfume products
marketed through leading department stores. Product Manager  Erica Kane
recently raised the suggested retail price on a popular line of mascara products
from $9 to $12 following increases in the costs of labor and
materials.Unfortunately, sales dropped sharply from 16,200 to 9,000 units per
month. In aneffort to regain lost sales, Enchantment ran a coupon promotion featuring $5 off
thenew regular price. Coupon printing and distribution costs totaled $500 per monthand
represented a substantial increase over the typical advertising budget of $3,250 per month.
Despite these added costs, the promotion was judged to be a success, as it  proved
to be highly popular with consumers. In the period prior to expiration,coupons were
used on 40% of all purchases and monthly sales rose to 15,000 units.
 A.
Calculate the arc price elasticity implied by the initial response
t o t h e  Enchantment price increase.
 B.
Calculate the effective price reduction resulting from the coupon promotion.
C.
 In light of the price reduction associated with the coupon promotion and assuming
no change in the price elasticity of demand, calculate Enchantment'sarc advertising elasticity.
 D.
Why might the true arc advertising elasticity differ from that calculated in part C?
 P5.10SOLUTION 
A.
E
P
=
Q+QP+P PQ
1212
×∆∆
=
16,200+9,000$9+$12 $9-$1216,200-9,000
×
=-2
B.
The effective price reduction is $2 since 40% of sales are accompanied by a
coupon:Δ P = -
$ 5 ( 0 . 4 ) o r P
2
=$12 - $5(0.4)

 
= -
$ 2 = $
1 0 Δ P = $ 1 0 -
$ 1 2 = - $ 2
C.
To calculate the arc advertising elasticity, the effect of the $2 price cut implicit in
thecoupon promotion must first be reflected. With just a price cut, the quantity
demandedwould rise to 13,000, because:E
P
=
Q+Q*P+P P-PQ-Q*
112121
×
-2=
9,000+Q*$12+$10 $12-$109,000-Q*
×
-2=
9,000)+(Q*9,000)-11(Q*-
-2(Q* + 9,000)=-11(Q* - 9,000)-2Q* - 18,000=-
11Q* +
9 9 , 0 0 0  9 Q * = 1 1 7 , 0 0 0 Q * = 1 3 , 0 0 0
Then, the arc advertising elasticity can be calculated as:E
A
=
Q*+QA+A A-AQ*-Q
212122
×
=
13,000+15,000$3,250+$3,750 $3,250-$3,75013,000-15,000
×
=1
D.
It is important to recognize that a coupon promotion can involve more than just
theindependent effects of a price cut plus an increase in advertising as is implied in
PartC. Synergistic or interactive effects may increase advertising effectiveness
when the promotion is accompanied by a price cut. Similarly, price reductions can
have a muchlarger impact when advertised. In addition, a coupon is a price cut for
only the most

 
 price sensitive (coupon-using) customers, and may spur sales by much more than
adollar equivalent across-the-board price cut.Synergy between advertising and the
implicit price reduction that accompaniesa coupon promotion can cause the
estimate in Part C to overstate the true advertisingelasticity. Similarly, this
advertising elasticity will be overstated to the extent thattargeted price cuts have
a bigger influence on the quantity demanded than similar across-the-board
price reductions, as seems likely.