Question

Recently, Pacific Cellular ran a pricing trial in order to estimate the elasticity of demand for its services. The manager selected three states that were representative of its entire service area and increased prices by 5 percent to customers in those areas. Two weeks later, the number of customers enrolled in Pacific’s cellular plans declined 4 percent in those states, while enrollments in states where prices were not increased remained flat. The manager used this information to estimate the own price elasticity of demand and, based on her findings, immediately increased prices in all market areas by 5 percent in an attempt to boost the company’s 2012 annual revenues. One year later, the manager was perplexed because Pacific Cellular’s 2012 annual revenues were 10 percent lower than those in 2011--the price increase apparently led to a reduction in the company’s revenues.

a. What assumptions did the manager make in the analysis?

b. Was she in error?

c. How would you redesign the experiment in order to correct the mistake made by the manager?

Answer 1

(a) The manager assumed that all the areas have equally elastic demand, therefore a given increase in price will increase revenue in all the areas.

(b) She made an error, because the 5% increase in price resulted in lower total revenue, meaning that quantity demanded has definitely decreased in at least one area out of the three, which lead to overall decrease in total revenue.

(c) I would, in the first place, estimate the price elasticity of demand in all the three areas. Next, I would use price discrimination to maximize revenue and profits, by charging a lower price (i.e. decrease price) in the area where demand is elastic (absolute value of elasticity > 1, so % decrease in quantity demanded is higher than % increase in price, leading to a rise in revenue from a decrease in price), and charge a higher price (i.e. increase price) in the area where demand is inelastic (absolute value of elasticity < 1, so % decrease in quantity demanded is lower than % increase in price, leading to a rise in revenue from an increase in price).