Question

You have determined that your firm’s own-price elasticity is -1.5 and that your firm’s cross-price elasticity with a competitor is 0.5. Last month your competitor increased prices by one percent. Today, in response, your manager has proposed also increasing prices by one percent. Your manager’s reasoning that by matching the competitor’s price increase, your firm will increase revenue. Would you support or refute your manager’s argument?

Answer 1

Given that the cross price elasticity of demand is 0.5, this means that the 1% increase in price by the competition would cause demand for the own good to rise by 0.5% as per the cross price elastcity of demand formula. So this benefits the own good. Now if the manger increases the price of the own good by 1% as well then this will lead to a loss of demand for the product as the demand for the other good will rise by 0.5% as the two goods are substitutes. A rise in the demand of one causes a fall in the demand of the other. Also the elasticity of demand for the product is 1.5 and hence it is price elastic. Given this an increase in the price of the own good will cause demand to fall and total revenue will fall due to price increase. Thus the managers argument is wrong. The price increase is not correct. As the goods are substitutes, the rise in the price of the own good will cause demand to fall and also as demand is price elastic , raising the price will cause total revenue to fall.