The U.S. cigarette industry has negotiated with Congress and government agencies to settle liability claims against it. Under the proposed settlement, cigarette companies will make fixed annual payments to the government based on their historic market shares. Suppose a manufacturer estimates its marginal cost at $1.00 per pack, its own price elasticity at -2, and set is price at $2.00. The company's settlement obligations are expected to raise its average total cost per pack by about $.60. What effect will this have on its optimal price?
The key to deal with this question is that the demand elasticity of cigarette is -2. First we want to interpret this number.
When elasticity < -1, we say this good is elastic (this means that consumers are more responsive to price changes). An elasticity of -2 means that if we raise the price by $1, we will lose 2 quantities.
When price is elastic, firms cannot increase revenue by increasing sales price (because the amount of extra money ...