Question

The price elasticity of demand for coffee in a local area has been found to be 1.5. Maddie a coffee seller is concerned about this since she would like to raise the price of each cup of coffee by 40%. If she currently sells 130 cups of coffee each day and she goes ahead to raise the price of coffee, how many cups would she be expected to sell each day? From what we have learned about elasticity, why exactly is Maddie concerned about raising her price? Explain both numerically and intuitively. (2 points)

5. Continuing with the preceding question, if Maddie, having taking ECON 2020 in college, knows that the reason for the reaction to a price increase is because she is one of many coffee sellers in the neighborhood and that other sellers are not particularly keen on raising their prices, so she embarks on an aggressive advertising campaign in which she brands her coffee as uniquely different from others. She consults an economist friend who estimates that her campaign will cause the price elasticity of demand for her brand of coffee to be 0.5. Explain both numerically and intuitively why she should now go ahead with the 40% increase in the price of her coffee (2 points)

Answer 1

Price elasticity of demand(e) = Percentage change in quantity demand/Percentage change in Price

e = 1.5

Currently, q = 130

From elasticity we have

1.5 = Percentage change in quantity demand/40%

Percentage change in quantity demand = 60%

Thus a 40% increase in price will result in 60% decline in quantity.

If the current quantity sold is 130, after the price change the quantity will be 52.

When e>1, a Percentage change in quantity demand > Percentage change in Price and the firm raises the price. Thus a 40% increase in price will result in 60% decline in quantity. This implies that the loss of revenue from reduced quantity is greater than the gain in revenue from the increase in price. Hence, the Total Revenue declines.

Thus raising price will cause a reduction in total revenue

Advertising campaign

Now e = 0.5

0.5 = Percentage change in quantity demand/40%

Percentage change in quantity demand = 20

Thus a 40% increase in price will result in 20% decline in quantity.

If the current quantity sold is 130, after the price change the quantity will be 104.

In this case, she will go ahead with the increase in price.

A 40% increase in price will result in 20% decline in quantity. This implies that the loss of revenue from reduced quantity is lesser than the gain in revenue from the increase in price. Hence, the Total Revenue increases.

Thus raising price will cause an increase in total revenue