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    Using price elasticity of demand to evaluate a price cut

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    Royersford Knitting 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 estimates 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.

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

    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.

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    Solution Preview

    See the attached file. The price elasticity of demand is -2, so a price reduction of 5% will result in 10% increase in demand. This means that Royersford will sell all of its increased ...

    Solution Summary

    This solution shows how to calculate the effects of a price cut when a firm's price elasticity of demand is known. Illustrated with a spreadsheet file that shows all the calculations.