1. Royersford Knitting Mills, Ltd., sells a line of womens knit underwear. The firm now sells
about 20,000 pairs a year at an average price of $10 each. Fixed costs amount to $60,000, and
total variable costs equal $120,000. The production department has estimated that a 10 percent
increase in output would not affect fixed costs but would reduce average variable cost by 40
cents. The marketing department advocates a price reduction of 5 percent to increase sales
total revenues, and profits. The arc elasticity of demand with respect to prices is estimated at
a. Evaluate the impact of the proposal to cut prices on (i) total revenue, (ii) total cost, and (iii)
b. If average variable costs are assumed to remain constant over a 10 percent increase in
output, evaluate the effects of the proposed price cut on total profits.
2. The Poster Bed Company believes that its industry can best be classified as monopolistically
competitive. An analysis of the demand for its canopy bed has resulted in the following
estimated demand function for the bed
P = 1760 12Q
The cost analysis department has estimated the total cost function for the poster bed as
TC = 1 Q3 - 15Q2 + 5Q + 24,000
a. Calculate the level of output that should be produced to maximize short-run profits.
b. What price should be charged?
c. Compute total profits at this price-output level.
d. Compute the point price elasticity of demand at the profit-maximizing level of output.
e. What level of fixed costs is the firm experiencing on its bed production?
f. What is the impact of a $5,000 increase in the level of fixed costs on the price charged, output
produced, and profit generated?
3. Jordan Enterprises has estimated the contribution margin (P MC)/P for its Air Express
model of basketball shoes to be 40 percent. Based on market research and past experience
Jordan estimates the following relationship between the sales for Air Express and
a. What is the marginal revenue from an additional dollar spent on advertising if the firm is
currently spending $1,000,000 on advertising?
b. What level of advertising would you recommend to Jordans management?
4. If notorious firm behavior (i.e., defrauding a buyer of high-priced experience goods by
delivering low quality) becomes known throughout the marketplace only with a lag of three
periods, profits on high-quality transactions remain the same, and interest rates rise slightly, are
customers more likely or less likely to agree to pay high prices for an experience good? Explain.