Question

Suppose the coronavirus pandemic escalates to the point that towns like Nacogdoches become completely cut off from other cities – no travel in or out is allowed and no shipments or deliveries. Fredonia Brewery is the only brewer of beer in town, and immediately becomes a monopoly producer. Suppose also that they hired you to estimate the demand elasticity for their product, and it turns out to be −0.5. Explain why this means that Fredonia Brewery cannot be maximizing profits.

Answer 1

For a Monopoly the demand function is downward sloping. This implies that the elasticity varies along the demand function and for a Monopoly to maximize profit, prices should be continued to increase till the entire inelastic portion of the demand is exhausted. This is because when demand is inelastic increase in the price will increase revenue and profit. This implies that profit-maximizing level of output occurs only in the elastic section of the demand. in this case the elasticity value is less than 1 in absolute terms which means the demand is inelastic. Therefore at the current level of output profits are not maximized. The firm should decrease output and increase price and should continue to do this unless the entire inelastic portion is exhausted.