Question

Jones is the manager of an upscale clothing store in a shopping mall that contains only two such stores. While these two competitors do not carry the same brands of clothes, they serve a similar clientele. Jones was recently notified that the mall is going to implement a 10 percent across-the-board increase in rents to all stores in the mall, effective next month. How should Jones change her prices in response to this 10 percent increase in monthly rent? She should raise her prices by 10 percent. She should raise her prices by more than 10 percent. She should raise her prices, but by less than 10 percent. She should not change her prices.

Answer 1

As the store's costs are going up, Jones will seek to raise revenues to offset the costs. A firm may raise revenues by selling more products at the current price, or by either lowering or raising price.

This question is asking if raising prices will raise revenue and offset the increase in monthly rent. Whether revenues will rise or fall from an increase in price will depend on the demand elasticity of the firm's products. If demand is price elastic, then a 10% increase in prices will lead to a more than 10% decline in products sold. This may actually reduce revenues and make the firm's profits decline even further. In such case, the firm may be better off actually lowering the price. If, on the other hand, demand is price inelastic, then a 10% increase in prices will lead to a less than 10% decline in products sold, which will raise revenues and could offset the increase in costs from the higher rent.

As we see, the firm's decision depends on the elasticity of its product's demand with regards to price. As the firm has only one competitor in the mall, the question becomes whether the firm's customers will remain loyal after a 10% price increase, or if they will switch to buying from the competitor. If the firm commands high customer loyalty (inelastic demand), then, indeed, raising the price is recommended to offset the rise in costs.