Question

A firm started advertising its product and this changed the product’s elasticity from -2 to -1.5. The firm should

		raise price from $10 to $15
		reduce price from $15 to $10
		raise price from $7.5 to $10
		reduce price from $10 to $7.5.

Answer 1

Advertising changed the price elasticity of demand from -2 to -1.5, i.e., the demand is still elastic in nature or the price and quantity are in the elastic region of the demand curve. If price is increased by 1%, quantity will be reduced by 1.5% based on the current price elasticity of demand. This will result in a reduction in revenue [since R = pq => %change in revenue = %change in price + % change in quantity = 1% + (-1.5%) = -0.5% ]. Hence, the firm should never increase the price.

On the other hand, if price is decreased by 1%, quantity increases by 1.5% and hence revenue increases by (-1+1.5)%=0.5%. So, the firm should decrease the price. Now the question is whether it should decrease the price from $15 to $10 or $10 to $7.5. This really depends upon the current position. If the current price is $15, then it may reduce the price to $10. This is definitely the correct answer. The other condition of reducing price from $10 to $7.5, however, may or may not be the correct option. If both the price levels $10 and $7.5 lie above the mid-point of the demand curve, then the firm may reduce the price from $10 to $7.5. However, if $10 lies above and $7.5 lies below the midpoint of the demand curve, then it might not be advisable to change, because it will be in the inelastic range.

So, reducing price from $15 to $10 is the cirrect answer. Please check if there is any other information to identify the mid-point of the demand curve. Based on the above discussion, this could also be a valid option.