Case Study 1: Joint Products without Excess Byproduct

Source: Fundamentals of Managerial Economics. Mark Hirschey, James L. Pappas.

The Vancouver Paper Company, located in Vancouver, B.C., produces newsprint and
packaging materials in a fixed 1:1 ratio, or one ton of packaging materials per one
ton of newsprint. These two products, A (newsprint) and B (packaging materials), are
produced in equal quantities because newsprint production leaves scrap byproduct
that is useful only in the production of lower-grade packaging materials. The total and
marginal cost functions for Vancouver can be written:
TC = $2,000,000 + $50Q + $0.01Q2,
MC = $50 + $0.02Q,
Where Q is a composite package or bundle of output consisting of one ton of Product
A (newsprint) and one ton of Product B (packaging materials). Given current market
conditions, demand and marginal revenue curves for each product are as follows:
Newsprint Packaging Materials
PA = $400 - $0.01QA PB = $350 - $0.015QB
MRA = $400 - $0.02QA MRB = $350 - $0.03QB
For each unit of Q produced, the firm obtains one unit of product A and one unit of
Product B for sale to customers. The revenue derived from the production and sale of
one unit of Q is composed of revenues from the sales of one unit of Product A plus one
unit of Product B. Therefore, the total revenue function is merely a sum of the revenue
functions for Products A and B:
TR = TRA + TRB
= PAQA + PBQB
Substituting for PA and PB results in the total revenue function:
TR = ($400 – $0.01QA)QA + ($350 – $0.015QB)QB
= $400QA – $0.01QA2 + $350QB – $0.015QB2
Because one unit of Product A and one unit of Product B are contained in each unit of
Q, QA = QB = Q. This allows substitution of Q for QA and QB to develop a total revenue
function in terms of Q, the unit of production:
TR = $400Q - $0.01Q2 + $350Q - $0.015Q2
= $750Q - $0.025Q2
This total revenue function assumes that all quantities of Product A and B produced
are also sold. It assumes no dumping or withholding from the market for either
product. It is the appropriate total revenue function if, the marginal revenues of both
products are positive at the profit-maximization output level. When this occurs,
revenues from each product contribute toward covering marginal costs.
The profit-maximizing output level is found by setting MR = MC and solving for Q:
MR = MC
$750 - $0.05Q = $50 + $0.02Q
0.07Q = 700
Q = 10,000 units
At the activity level Q = 10,000 units, marginal revenues for each product are
positive:
MRA = $400 – $0.02QA MRB = $350 – $0.03QB
= $400 – $0.02 (10,000) = $350 – $0.03 (10,000)
= $200 (at 10,000 units) = $50 (at 10,000 units)
Each product makes a positive contribution toward covering the marginal cost of
production, where
MC = $50 + $0.02Q
= $50 + $0.02 (10,000) = $250
There is no reason to expand or reduce production because MR = MR A + MRB = MC =
$250, and each product generates positive marginal revenues.

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Prices for each product and total profits for Vancouver can be calculated from the
demand and total profit functions:
PA = $400 - $0.01QA PB = $350 - $0.015QB
= $400 - $0.01 (10,000) = $350 - $0.015 (10,000)
= $300 = $200
and
= PAQA + PBQB – TC
= $300 (10,000) + $200(10,000) – $2,000,000 – $50(10,000) – $0.01(10,0002)
= $1,500,000
Vancouver should produce 10,000 units of output and sell the resulting 10,000 units
of Product A (newsprint) at a price of $300 per ton and 10,000 units of Product B
(packaging materials) at a price of $200 per ton. An optimum total profit of $1.5
million is earned at this activity level.

Case Study 2: Joint Production with Excess Byproduct (Dumping)

Suppose that an economic recession causes the demand for Product B (packaging
materials) to fall dramatically, while the demand for Product A (newsprint) and
marginal cost conditions hold steady. Assume new demand and marginal revenue
relations for Product B of:
PB = $290 – $0.02QB,
MRB = $290 – $0.04QB
A dramatically lower price of $90 per ton [= $290 – $0.02(10,000)] is now required to
sell 10,000 units of Product B. However, this price and activity level are sub-optimal.
To see why, the profit-maximizing activity level must again be calculated, assuming
that all output is sold. The new marginal revenue curve for Q is:
MR = MRA + MRB
= $400 – $0.02QA + $290 - $0.04QB
= $690 - $0.06Q
If all production is sold, the profit-maximizing level for output is found by setting MR
= MC and solving for Q:
MR = MC
$690 – $0.06Q = $50 + $0.02Q
0.08Q = 640
Q = 8,000
At Q = 8,000, the sum of marginal revenues derived from both byproducts and the
marginal cost of producing the combined output package each equals $210, since:
MR = $690 – $0.06Q MC = $50 + $0.02Q
= $690 – $0.06 (8,000) = $50 + $0.02 (8,000)
= $210 = $210
However, the marginal revenue of Product B is no longer positive:
MRA = $400 – $0.02QA MRB = $290 – $0.04QB
= $400 – $0.02 (8,000) = $290 – $0.04 (8,000)
= $240 = - $30
Even though MR = MC = $210, the marginal revenue of Product B is negative at the
Q = 8,000 activity level. This means that the price reduction necessary to sell the last
unit of Product B caused Vancouver's total revenue to decline by $30. Rather than
sell Product B at such unfavorable terms, Vancouver would prefer to withhold some
from the marketplace. In contrast, Vancouver would like to produce and sell more
than 8,000 units of Product A since MR A > MC at the 8,000 unit activity level. It would
be profitable for the company to expand production of Q just to increase sales of
Product A, even if it had to destroy or otherwise withhold from the market the
unavoidable added production of Product B.
Under these circumstances, set the marginal revenue of Product A, the only product
sold at the margin, equal to the marginal cost of production to find the profit-

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maximizing activity level:
MRA = MC
$400 – $0.02Q = $50 + $0.02Q
$0.04Q = $350
Q = 8,750 units.
Under these circumstances, Vancouver should produce 8,750 units of Q = Q A = QB.
Since this activity level is based on the assumption that only Product A is sold at the
margin and that the marginal revenue of Product A covers all marginal production
costs, the effective marginal cost of Product B is zero. As long as production is
sufficient to provide 8,750 units of Product A, 8,750 units of Product B are also
produced without any additional cost.
With an effective marginal cost of zero for Product B, its contribution to firm's profits
is maximized by setting the marginal revenue of Product B equal to zero (its effective
marginal cost):
MRB' = MCB OR MRB' = 0
$290 - $0.04QB = $0
$0.04QB = $290
QB = 7,250
Whereas a total of 8,750 units of Q should be produced, only 7,250 units of Product B
will be sold. The remaining 1,500 units of Q B must be destroyed or otherwise withheld
from the market.
Optimal prices and the maximum total profit for Vancouver are as follows:
PA = $400 – $0.01QA PB' = $290 – $0.02QB
= $400 – $0.01 (8,750) = $290 – $0.02 (7,250)
= $312.50 = $145
 = PAQA + PB'QB – TC
= $312.50 (8,750) + $145 (7,250) – $2,000,000 – $50 (8,750) – $0.01
(8,7502)
= $582,500
No other price/output combination has the potential to generate as large a profit for
Vancouver.

Case Study 3: Price Discrimination vs Uniform Price

Source: Hirschey, M, & Pappas, J.L. (1992). Fundamentals of Managerial Economics (pp. 509-
512). The Dryden Press.
Price discrimination is profitable because it allows the firm to enhance revenues
without increasing costs. It is an effective means for increasing profits because it
allows the firm to more closely match marginal revenues and marginal costs. A firm
that can segment its market maximizes profits by operating at the point where
marginal revenue equals marginal cost in each market segment. A detailed example
is a helpful means for illustrating the process of price/output determination under
price discrimination.
Suppose that Midwest State University (MSU) wants to reduce the athletic
department’s operating deficit and increase student attendance at home football
games. To achieve these objectives, a new two-tier pricing structure for season
football tickets is being considered.
A market survey conducted by the school suggests the following market demand and
marginal revenue relations:
Public Demand Student Demand
PP = $225 - $0.005QP PS = $125 - $0.00125QS
MRP = $225 - $0.01QP MRS = $125 - $0.0025QS
From these market demand curves it is obvious that the general public is willing to
pay higher prices that are students. The general public is willing to purchase tickets

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up to a market price of $225, above which point market demand equals zero.
Students are willing to enter the market only at ticket prices below $125.
During recent years, the football program has run on an operating budget of $1.5
million per year. This budget covers fixed salary, recruiting, insurance, and facility-
maintenance expenses. In addition to these fixed expenses, the university incurs
variable ticket-handling, facility-cleaning, insurance, and security costs of $25 per
season-ticket holder. The resulting total cost and marginal cost functions are:
TC = $1500000 + $25Q,
MC = $25
What are the optimal football ticket prices and quantities for each market, assuming
that MSU adopts a new season ticket pricing policy featuring student discounts? To
answer this question, one must realize that since MC = $25, the athletic department’s
operating deficit is minimized setting MR = MC = $25 in each market segment and
solving for Q. This is also profit-maximizing strategy for the football program.
Therefore:
Public Demand
MRP = MC
$225 - $0.01QP = $25
$0.01QP = $200
QP = 20000
and
PP = $225 - $0.005 (20000)
= $125
Student Demand
MRS = MC
$125 - $0.0025QS = $25
$0.0025QS = $100
QS = 40000
and PS = $125 - $0.00125 (40000)
= $75
The football program’s resulting total operating surplus (profit) is:

Operating Surplus (Profit) = TRP + TRS – TC

= $125(20000) + $75(40000)
-$1500000 - $25(60000)
= $2.5 million
To summarize, the optimal price/output combination with price discrimination is
20000 in unit sales to the general public at a price of $125 and 40000 in unit sales to
students at a price of $25. This two-tier pricing practice results in an optimal
operating surplus (profit) of $2.5 million.
To gauge the implications of this new two-tier ticket pricing practice, it is interesting
to contrast the resulting price/output and surplus levels with those that would result if
MSU maintained its current one-price ticket policy.
If tickets are offered to students and the general public at the same price, the total
amount of ticket demand equals the sum of student plus general-public demand. The
student and general-public market demand curves are:
QP = 45000 – 200PP and QS = 100000 – 800PS
Under the assumption that PP = PS, total demand (QT) equals:
Q T = Q P + QS
= 145000 – 1000P,
and P = $145 - $0.001Q,
which implies MR = $145 - $0.002Q
These aggregate student plus general-public demand and marginal revenue curves

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only hold for prices below $125, a level at which both the general public and students
purchase. Tickets for prices above $125, only nonstudent purchasers buy tickets, and
the public demand curve PP = $225 - $0.005QP represents total market demand as
well. This causes the actual total demand curve to be kinked at a price of $125.
The uniform season ticket price that maximizes operating surplus (or profits) is found
by setting MR = MC for the total market and solving for Q:
MR = MC
$145 - $0.002Q = $25
$0.002Q = $120
Q = 60000
P = $145 - $0.001(60000)
= $85
and QP = 45000 – 200($85)
= 28000
QS = 10000 – 800($85)
= 32000
Operating surplus (profit) = TR – TC
= $85(60000) - $1500000 - $25(60000)
= $2.1 million
Observe that the total number of tickets sold equals 60000 under both the two-tier
and single-price policies. This results the marginal cost of a ticket is the same under
each scenario. Ticket-pricing policies featuring student discounts increase student
attendance from 32000 to 40000 and maximize the football program’s operating
surplus at $2.5 million (rather than $2.1 million). It is the preferred pricing policy
when viewed from MSU’s perspective. However, such price discrimination creates
both ‘winners’ and ‘losers’. Winners following adoption of student discounts include
students and MSU. Losers include members of the general public, who wind up paying
higher football ticket prices or find themselves priced out of the market.

Case Study 4:

Suppose that the Tasty Company markets coffee brand X and estimated the
following regression of the demand for its brand of coffee:
QX = 1.5 - 3.0PX + 0.8I + 2.0PY - 0.6PS + 1.2A
Where,
QX = Sales of coffee brand X in the United States, in millions of pounds
per year
PX = Price of coffee brand X, in dollars per pound
I = Personal disposable income, in trillions of dollars per year
PY = Price of the competitive brand of coffee, in dollars per pound
PS = Price of sugar, in dollars per pound
A = Advertising expenditures for coffee brand X, in hundreds of
thousands of dollars per year
Suppose also that this year, P X = $2, I = $2.5, PY = $1.80, PS = $0.50, and A =
$1. Substituting these values into Equation, we obtain
QX = 1.5 - 3(2) + 0.8(2.5) + 2(1.80) - 0.6(0.50) + 1.2(1) = 2
Thus, this year the firm would sell 2 million pounds of coffee brand X.
The firm can use the above information to find the elasticity of the demand
for coffee brand X with respect to its price, income, the price of competitive
coffee brand Y, the price of sugar, and advertising. Thus,
EP = –3 = –3 EI = 0.8
EXY = 2= 1.8 EXS = –0.6 = –0.15

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 EA = 1.2= 0.6
The firm can then use these elasticities to forecast the demand for its brand
of coffee next year. For example, suppose that next year the firm intends to
increase the price of its brand of coffee by 5 percent and its advertising
expenditures by 12 percent. Suppose also that the firm expects personal
disposable income to rise by 4 percent, P Y to rise by 7 percent, and P S to fall
by 8 percent. Using the level of sales (Q X) of 2 million pounds this year, the
elasticities calculated above, the firm's intended policies for next year, and
the firm's expectations about the change in other variables given above, the
firm can determine its sales next year (QX') as follows:
QX' = QX + QXEP + QXEI + QXEXY + QXEXS + QXEA
= 2 + 2(5%) (-3) + 2(4%) (1) + 2(7%) (1.8) + 2(- 8%) (-0.15) + 2(12%) (0.6)
= 2 + 2(0.05) (-3) + 2(0.04) (1) + 2(0.07) (1.8) + 2(- 0.08) (- 0.15) + 2(0.12)
(0.6)
= 2(1 - 0.15 + 0.04 + 0.126 + 0.012 + 0.072)
= 2(1.1)
= 2.2, or 2,200,000 pounds
Source: Managerial Economics in Global Economy. Dominick Salvatore

Case Study 5:
The demand and supply functions of rice are depicted by the following
equations:
Qd = 3000 – 50P and Qs = - 1500 + 50P
The government announces a program to support a price increase of Rs 45
per kg of this grain, which imposes a price floor of Rs 50.
a. What are the equilibrium price and quantity of before price floor policy?
b. What quantity of grain is purchased by the consumers, supplied by the
producers and purchased by the government at the floor price?
c. What is the change in consumer surplus, producer surplus and total
surplus? What is the cost of government to implement this price support
policy?
d. As per the suggestion of economic advisors, the government changes the
price support policy and provides subsidy of Rs 6 per kg sold. What is the
price paid by buyers, price received by sellers, change in consumer
surplus, change in producer surplus and government cost?
e. Interpret the results obtained from both policies.
Solution
a. At equilibrium, Qd = Qs
3000 – 50P = - 1500 + 50P
or - 100 P = - 4500
 P = 45
Qd = 3000 – 50 (45) = 750 units
Qs = - 1500 + 50 (45) = 750 units
b. When government follows price floor policy and fixes price Rs 50.
Quantity of rice purchased by consumers (Qd) = 3000 – 50 (50) = 500
units

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 Quantity of rice supplied by producers (Qs) = - 1500 + 50 (50) = 1000
units
Quantity of rice purchased by government = Qs – Qd = 1000 – 500 = 500
units
c. Willingness to pay of the consumer at Q = 0
0 = 3000 – 50P
 P = 60
Willingness to sell of the producer (or minimum supply price) at Q = 0.
0 = - 1500 + 50 P
Y
 P = 30
At price Rs 45 60 A

Price
Qs
50
C.S. = ½ × 750 × (60 – 45) = 5625 E
45
C
P.S. = ½ × 750 × (45 – 30) = 5625
Total surplus = CS + PS = 5625 + 5625 = 1125030 B
Qd
At price Rs 50 X
O 500 750 100
C.S. = ½ × 500 × (60 – 50) = 2500 0 Quantity
P.S. = ½ × 1000 × (50 – 30) = 10000
Change in C.S. = 2500 – 5625 = - 3125
Change in P.S. = 10000 – 5625 = 3375
New Total surplus = CS + PS = 2500 + 10000 = 12500
Change in total surplus = New total surplus – Initial total surplus
= 12500 – 11250 = 1250
Cost of government on price support policy = 500 × 50 = Rs 25000
Note: Calculation of consumer's surplus and producer's
surplus
In Figure, AEC is C.S.
Area of AEC is calculated as
AEC = ½ × base × height = ½ × 750 × (60 –
45) = 5625
In Figure, BEC is P.S.
Area of BEC is calculated as
BEC = ½ × base × height = ½ × 750 × (45 –
30) = 5625
d. When government follows price subsidy of Rs 6 on sales
New supply function (Q's) = 1500 + 50 (P + 6)
= - 1500 + 50P + 300
Q's = - 1200 + 50P
At new equilibrium, Qd = Q's Y
3000 – 50P = – 12000 + 50P
60
Price

Qs
or – 100P = – 4200 Q's
E1
 P = Rs 42 45
E2
Qd = 3000 – 50 × 42 = 900 units (eqm. quantity)
30
Here, 24 Qd
X
Price paid by consumers = Rs 42 O 750 900
Quantity
Price received by producers = Rs 48 (= 42 + 6)
CS = ½ × 900 × (60 – 42) = 8100

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 PS = ½ × 900 × (48 – 24) = 10800
New total surplus after subsidy = CS + PS = 8100 + 10800 = 18900
Change in CS = 8100 – 5625 = 2475
Change in PS = 10800 – 5625 = 5175
Change in total surplus = CS + PS = 2475 + 5175 = 7650
New Government cost = 900 × 6 = 5400
Change in government cost (= Surplus on government cost) = 25000 –
5400 = 19600
e. Under price support policy, government spent Rs 25000 whereas it spent
only Rs 5400 under the policy of subsidy. Hence, government saves Rs
19600.
Due to price floor policy, total surplus i.e. welfare of both consumers and
producers increases by 1250. But, total surplus, i.e. welfare of both
consumers and producers increases by 7650 under the policy of price
subsidy.
It proves that policy of price subsidy on sales to the producers is more
effective than price floor policy to achieve economic efficiency.

MOVING-AVERAGE METHOD
Moving-average method is simple device of reducing fluctuations and obtaining trend
values with a fair degree of accuracy.
Under this method, the forecasted value of a time series in a period (month, quarter,
year, etc.) is equal to the average value of the time series in a number of previous
periods. The forecasted value of the time series for the next period is given by the
average value of the time series in the previous three periods, under three period
moving average. The greater the number of periods used in the moving average, the
greater is the smoothing effect because each new observation receives less weight.

Numerical Illustration
Consider the following data for sales of product 'X' for period of May 2014 to April
2017 (given as quarter 12)
Quarter 1 2 3 4 5 6 7 8 9 10 11 12
Sales ('000 20 22 23 24 18 23 19 17 22 23 18 23
units)
Analyze the three quarterly and five quarterly moving average and forecast for the
13th quarter and very that which forecast is more consistent (or better).
Solution
Three quarter and five-quarter moving average forecasts and comparison.
Quarter Firm's 3-quar. A-F (A-F)2 5-quar. A - F' (A- F')2
actual MA forecast
market forecast (F')
share (A) (F)
1 20 – – – – – –
2 22 – – – – – –
3 23 – – – – – –
4 24 21.67 2.33 5.4289 – – –
5 18 23.00 –5.00 25.0000 – – –
6 23 21.67 1.33 1.7689 21.4 1.6 2.56
7 19 21.67 –2.67 7.1289 22.0 –3.0 9.00

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 8 17 20.00 –3.00 9.0000 21.4 –4.4 19.36
9 22 19.67 2.33 5.4289 20.2 1.8 3.24
10 23 19.33 3.67 13.4689 19.8 3.2 10.24
11 18 20.67 –2.67 7.1289 20.8 –2.8 7.84
12 23 21.00 2.00 4.0000 19.8 3.2 10.24
13 21.33 n=9 (A-F)2 = 20.8 n=7 (A - F')2
78.3534
= 62.48
Here, based on 3-quarterly MA, estimated demand for 13th quarter = 21.33 units
5-quarterly MA, estimated demand for 13th quarter = 20.8 units
In order to decide which of these moving average forecasts is more consistent, root-
mean-square error (RMSE) should calculated to each forecasts and utilized the
moving average that results in the smallest RMSE. The formula for the RMSE is
RMSE =
RMSE for 3-quarterly MA = = 2.95
RMSE for 5-quarterly MA = = 2.99
Here, 2.95 < 2.99. It implies that 3-quarterly moving average forecast is a little more
confident in the forecast of 21.33 units than 20.6 units for the 13th quarter.

Source: Managerial Economics in Global Economy. Dominick Salvatore