Question

Assume that a bus company increased costs and fears that it will make a loss. What should it do, if to rise the fares may be a wrong policy.
To help it decide what to do it commissions a survey to estimate passenger demand at three different fares: the current face of 10c per km, a higher fare of 12c per km, and a lower fare of 8c. The results of the survey are shown in the first two columns:

Fares	Estimated Demand		Total Revenue		Old total cost		New total cost
8	6		480000		360000		440000
10	4		400000		360000		440000
12	3		360000		360000		440000

Demand turns to be elastic. TR can be increased by reducing the price from current 10 to 8$.

What will happen to the company profits? Its profit is the difference between the total revenue from passengers and its total costs of operating the service. If buses are currently under-utilised , then is possible that the extra passengers can be carried without the need for extra buses with no extra cost..

At the fare of 10c , old profit was 40000. After the rase, a 10c now gives a loss of 40.000$. By raising the fare to 12c- loss increased to 80000$.

Questions:

1) Estimate the price elasticity of demand between 8c and 10c and between 10c and 12c. Show all detailed calculations.

2) 10c fare the best fare originally? Explain your answer detailed.

3) If the company considers lowering the fare to 6c and estimates the demand will be 8.5 million passenger km. What is your opinion, it is good idea? How should it decide?

Answer 1

1. Price Elasticity of Demand = ((Q₁ - Q₀) / (Q₁ + Q₀))/((P₁ - P₀)/(P₁ + P₀))

To find out price elasticity of demand between 8c & 10c

Q₁ = 6, Q₀ = 4, P₁ = 8, P₀ = 10

So Price elasticity of demand in this case will be equal to using the above formula = -1.8

To calculate price elasticity of demand between 10c and 12c

Q₁ = 3, Q₀ = 4, P₁ = 12, P₀ = 10

So Price elasticity of demand in this case will be equal to using the above formula = -1.57

2) No 10c may not be the best fare. Though a lower fare gives the same amount of profit, it will be a win-win situation for both company and its customers. With higher demand company can also win higher goodwill among customers. So the company should go with a lower fare.

3) At a fare of 6c, the price elasticity of demand will be 1.44. So for every 1% change in price there will be 1.44% increase in demand. This may not be profitable for the company as it may not end up generating enough revenue to meet the costs.