Question

A company has calculated their point price elasticity of demand to be -0.8 when they sell 6,000 units a month at a price of $120 per unit.

The production manager informs the CEO of the company they just discovered a new and cheaper way to produce the good they sell. His advice is to double production because the new procedure halves the cost per unit, so costs will remain unchanged. Should the recommendation be followed? Relate your answer to the concept of elasticity.

Answer 1

The elasticity is -0.8 which is negative but <1. This implies that the demand is inelastic. Hence the change in quantity demanded will be less than change in price.

The manager advices to increase the production according to new procedure. Moreover the procedure will cut the cost of production into half. As a result, if the company doubles production, cost of production will remain unchanged. Now due to increase in production, supply has increased. However as consumers are unaware of the fact thus demand is same. As a result of increase in supply, price has decreased and quantity demanded will increase. But following the elasticity we can say that the fall in price is greater than increase in quantity demanded. Thus if the company follows the advice, it will be left with excess supply because quantity demanded will not increase as much as the price drops due to increase in supply.