Question

Anna owns the Sweet Alps Chocolate store. She charges $10 per pound for her hand made chocolate. You, the economist, have calculated the elasticity of demand for chocolate in her town to be 2.5. If she wants to increase her total revenue, what advice will you give her and why?  USE DIAGRAMS AND ECONOMIC TERMS TO ANSER YOUR QUESTION

Answer 1

The price elasticty is 2.5, which means the demand for hand made chocolate is elastic in nature. Based on the definition of price elasticity of demand, 1% increase in price leads to 2.5% reduction in demand and vice versa. Consider a case in the above diagram, where the initial price is p0 and initial quantity demanded is q0. Hence, total revenue can be measured by the area of the rectangle O p0 E0 q0, i.e., the price 0p0 multiplied by the quantity 0q0. If price is reduced by 1% (say, to p1), quantity increased by 2.5% (to q1). Hence, the revenue now would be represented by the area of the rectangle O p1 E1 q1). It can be observed that the area O p1 E1 q1 > area O p0 E0 q0. This is happening because the demand is elastic in nature, which results in a more than proportionate increase in quantity as compared to price. Hence, the reduction in revenue due to reduction is price is less that increase in revenue due to increase in quantity.

Also, it can be observed that the initial point on the demand curve E0 lies above the midpoint of the demand curve. In other words, for all the points above the midpoint of a linear demand curve, elasticity is greater than 1. As we observe, revenue can be increased by reducing the price, when demand is elastic in nature. On the other hand, revenue will be reduced if we want to increase in the price in case of an elastic demand. This can be verified from the same diagram. Consider now p1 as the initial price which is increased to p0. Hence, the initial quantity 1 will be reduced to q0. Hence, the overall revenue falls from area O p1 E1 q1 to area O p0 E0 q0.

Therefore, the recommendation for Anna to reduce the price from 10 to increase profit. Note that profit can be maximized wen elasticity equals 1. So, Anna may decrease the price so that it will lie on the mid-point of the demand curve. The resulting combination of the price and quantity will maximize the underlying revenue.