Question

3. 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.

(c) What should be the price in order to sell 7,200 units?

(d) 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

(c)

% Increase in quantity = (7,200 / 6,000) / 6,000 = 1,200 / 6,000 = 0.2 = 20%

Elasticity = % Change in quantity / % Change in price

- 0.8 = 20% / % Change in price

% Change in price = 20% / (- 0.8) = - 25% (Decrease by 25%)

New price = $120 x (1 - 0.25) = $120 x 0.75 = $90

(d)

Doubling production will increase supply, which will decrease price. Since absolute value of elasticity is less than 1, demand is inelastic. With inelastic demand, a decrease in price will decrease total revenue. So the doubling of production is not recommended.