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Elasticity and changes in prices

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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?

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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 ...

Similar Posting

Flower shops and price elasticity

You just opened a flower shop and are trying to understand pricing issues. You were told that elasticities are very important in determining prices and what products to supply, so you decide to investigate this concept.

You call your friend, an economics professor, and ask, "What is the price elasticity of demand? What determines it? What is elastic and inelastic demand?"

To really understand it, compute the following price elasticities of demand:

a) The price of a laptop increases by 20% and there is a 40% drop in the quantity demanded.
b) The price of a pack of cigarettes increases by 10% and there is a 5% drop in the quantity demanded.
c) The price of water increases by 15% but there is no drop in the quantity demanded.
d) Of the above examples, which is more elastic, and which is the least elastic? Why? Answer the following questions:
- Why is elasticity an important concept for a business? What if national income went up? How would that
affect elasticity?
- What is the price elasticity of supply? What determines it?
- Compute the following price elasticities of supply:
- The price of a hotel room increases by 20%, and the quantity supplied increases by 10%.
- The price of health care goes up by 50% , and the quantity supplied increases by an equal amount.
- The price of a book increases by 10%, and the quantity supplied increases 20%.
- In the above examples, which is more elastic and which is the least elastic? Why?
- What kind of supply and demand elasticities would the following goods have, and why?
- Bridge tolls
- Beachfront properties
- Gourmet coffee
- Luxury automobiles
- Gasoline
- Cell phones
- Computers
- College tuition

Now that you are an expert on elasticities, what do you think would be the best time of year to raise prices, and why? What do you think the elasticities are in the flower business? Use graphs and hypothetical tables to support your answer.

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