You manage Mt. Claire Cafe which sells meals at a price of $8.50 each. The meals

Question

You manage Mt. Claire Cafe which sells meals at a price of $8.50 each. The meals includes a hot dish and a beverage of your choice. The average number of meals sold per month is 21,000. The owner of Mt. Claire Cafe would like to increase its sales and profits. They know that if price is lowered, they will sell more meals. So they run an experiment. Price is lowered to $7.50 per meal in March and the number of meals sold increases to 23,000. a. What is price elasticity of demand? b. is elasticity elastic, inelastic or neither? c. What does this mean and why does it matter? d. Will revenues increase or decrease as a result of the price cut? By how much? e. Beatrice has calulated the fixed costs for the Cafe are $18,000 per month and each meal costs $4.50. Will profits go up or down as a result of the price cut? By how much?

Explanation / Answer

Change in Price = Final Price - Initial Price => 7.50 - 8.50 = -1

Change in Quantity = Final Quantity - Initial Quantity => 23000 - 21000 = 2000

a) Elasticity = (Change in Q / Change In Price) / ( Initial Quantity / Initial Price )

= (2000 / -1) / (21000 / 8.50) => - 8.50

b) It is elastic as absolute elastcity (ignore negative sign) is more than 1

c) It means that if they reduce price by a very small amount , their sales will increase by a larger proportion. It matters because it tells about change in revenue whether it is profitable to decrease price or not.

d) Revenue = P x Q

Initial Revenue = 8.50 x 21000 = 178500

Final Revenue = 7.50 x 23000 = 172500

Revenue has decreased. by 6000 (172500 - 178500)

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