Question

Suppose you are the manager of a restaurant that serves an average of 400 meals per day at an average price per meal of $20. On the basis of a survey, you have determined that reducing the price of an average meal to $18 would increase the quantity demanded to 450 per day.(a) Compute the price elasticity of demand between these two points.(b) Would you expect total revenues to rise or fall? Explain.

Answer 1

Answer:

(a) 1.25 , (b) total revenues shall rise

Explanation:

Price elasticity of demand is a measure of degree of responsiveness of change in quantity demanded to change in price.

Price elasticity of demand is expressed as: $\frac{change\ in\ quantity}{change\ in\ price}$× $\frac{P}{Q}$

wherein, P= original price

              Q= Original quantity demanded

In the given case, it can be calculated as $\frac{450\ -\ 400}{18\ -\ 20} *\ \frac{20}{400}$

here we ignore the negative sign.

Price elasticity of demand = 25/20 = 1.25

This conveys relatively elastic demand i.e greater than 1. This means a little change in price would lead to a greater change in the quantity demanded.

Total revenue refers to revenue earned at a given level of output. Here,

Total revenue before =  400 units × $20 = $8000

Total revenue at new price level = 450 units × $18 = $8100

Total revenue has increased. This is because, the elasticity of demand is relatively elastic, so that a decrease in price is exceeded by more than proportionate increase in quantity demanded.