Question

Managerial Economics Question.

(Please solve both A and B, and mention which one is A and B, thank you for working so much hard for me, I appreciate it.)

1. Royersford Kinitting Mills Ltd. sells a line of women's knit underwear. The firm now sells about 20,000 pairs a year at an average price of $10 each. Fixed costs amount to $60,000, and total variable costs equal $120,000. The production department has estimated that a 10 percent increase in output would not affect fixed costs but would reduce average variable cost by 40 cents.

The marketing department advocates a price reduction of 5 percent to increase sales, total revenues, and profits. The arc elasticity of demand with respect to prices is estimated at -2.

A) Evaluate the impact of the proposal to cut prices on (i) total revenue, (ii) total cost, and (iii) total profits.

B) If average variable costs are assumed to remain constant over a 10 percent increase in output, evaluate the effects of the proposed price cut on total profits.

Answer 1

a) Fixed cost = 60,000

Total variable cost of producing 20,000 pairs is $120,000 which is average variable cost of $6

Average price = $10

Total Revenue 10 * 20,000 = 200,000

Total cost = Fixed cost + Variable cost = 60,000 + 120,000 = 180,000

Profit = 200,000 - 180,000 = 20,000

Arc elasticity of demand of -2 says that when price reduce by 5%, quantity demanded rises by 10%.

If output rises by 10%, average variable cost is $5.6 which means total variable cost of 22,000 pairs is 22,000 * $5.6 = $123,200

Total cost of 22,000 pairs = 60,000 + 123,200 = 183,200

Total revenue from selling 22,000 at a price of $9.5 is 209,000

Profit = 209,900 - 183,200 = 25,800

Proposal to cut price by 5% will raise profit by 5,800 . Thus, it is a good option.

b) If average variable cost remain constant at $6. Total cost of 22,000 units is 60,000 + 22,000 * 6 = 192,000

Total revenue = 209,000

Profit = 209,000 - 192,000 = 17,000

Profit fall by 3,000 which is not a good policy to adopt.