Question

The Lunchbox is one of many options for workers in Lanford, Illinois to get a quick and tasty meal at reasonable prices. The manager of the restaurant wanted to raise prices but did not know if the quantity demanded would fall off too much. He decided to raise prices and wait and see before making the increases permanent. In the first week after he raised prices on the menu an average of 10%, the restaurant served fewer lunches but revenue did not fall. Based on this, he decided to keep the new menu. Would you expect revenue to continue at this level?

Answer 1

Elasticity of demand (Ed) = % Change in quantity demanded / % Change in price

When a 10% increase in price leads to a decrease in quantity demanded (following law of demand) but revenue did not fall, it means two possibilities:

(1) Ed = 1, therefore % Change in price = % Change in quantity demanded.

In this case, demand is unit elastic, and an increase in price will not change revenue.

(2) Ed < 1, therefore % Change in price > % Change in quantity demanded.

In this case, demand is inelastic, and an increase in price will increase revenue.

In either of these cases, a price rise will lead to an increase in revenue in short run.

However, since buyers have many substitutes available, they will switch to the substitutes after few days of price rise, therefore Lunchbox will continue to lose sales. When demand will become elastic as more and more customers switch to substitutes, Lunchbox will start experiencing a decrease in revenue in medium to long run.