Question

Suppose a producer determines that above his current price of \(\$ 1.00 \mathrm{f}\) demand for his product is highly elastic, while below the \(\$ 1.00\) price, demand is highly inelastic. a) What might his demand curve look like? b) Why would you not expect this producer to alter his price, given only the information above?

Short answer

The demand curve for the producer's product might look like a kinked demand curve, with a relatively flat segment above the price of \(\$ 1.00\) (highly elastic demand) and a relatively steep segment below \(\$1.00\) (highly inelastic demand). The producer would not be expected to change the price because increasing the price above \(\$ 1.00\) would lead to a significant drop in quantity demanded and total revenue, whereas decreasing the price below \(\$ 1.00\) would not lead to a significant increase in quantity demanded or total revenue. Therefore, altering the price would not be beneficial to the producer based on the given information.

Step-by-step solution

Part a: Sketching the demand curve

The demand curve might look like a kinked demand curve. To illustrate this, let's consider two segments of the demand curve: 1. At prices above \( \$ 1.00\), demand is highly elastic. This means that small changes in prices will cause large changes in the quantity demanded. The demand curve in this price range will be relatively flat. 2. At prices below \( \$ 1.00\), demand is highly inelastic. This means that changes in prices will not have a significant impact on the quantity demanded. The demand curve in this price range will be relatively steep. The curve formed by combining these two segments will have a kink at the price of \( \$ 1.00\).

Part b: Explaining why the producer wouldn't alter his price

Given that the demand for the product is highly elastic above the price of \(\$ 1.00\) and highly inelastic below that price, we can examine the revenue effects of changing prices. 1. If the producer increases the price above \(\$ 1.00\), the quantity demanded will drop significantly due to high elasticity. This will decrease the total revenue since the higher price will not compensate for the substantially lower quantity demanded. 2. If the producer lowers the price below \(\$ 1.00\), the quantity demanded will not increase significantly due to high inelasticity. This will also decrease the total revenue since the lower price will not be compensated by a higher quantity demanded. As a result, the producer would not expect altering the price of \( \$ 1.00\) to increase revenue. Furthermore, the information provided in the question doesn't suggest that lowering or raising the price would benefit the producer in any other way (e.g., decrease/increase production costs). Therefore, we would not expect this producer to alter his price, given only the information provided above.

Key concepts

Price Elasticity of Demand

Understanding the price elasticity of demand is crucial when a business decides to adjust pricing for its products or services. It's a measure that indicates how much the quantity demanded of a good responds to a change in price. If a small price change causes a significant change in the quantity demanded, the demand is said to be elastic. Conversely, if quantity demanded is barely affected by price changes, we say the demand is inelastic.

The formula to calculate price elasticity of demand is:
\[ Elasticity = \frac{\text{% Change in Quantity Demanded}}{\text{% Change in Price}} \]
When the elasticity is greater than one, demand is labeled as elastic. If elasticity is less than one, it is inelastic, and if it equals one, demand is unit elastic. Elasticity helps businesses predict how changes in their pricing could affect their revenue and make informed decisions regarding their pricing strategies.

Kinked Demand Curve

The kinked demand curve model illustrates a market situation where a firm's demand curve has a distinct 'kink' at a certain price level. This kind of demand curve arises in oligopolistic markets where firms are price-setters rather than price-takers.

Above the kink, the demand curve is highly elastic indicating that consumers are sensitive to price increases and would significantly reduce their purchases or switch to competitors. Below the kink, the demand curve turns inelastic suggesting that consumers are less responsive to price decreases. A typical reason behind this shape is brand loyalty or perceived lack of close substitutes.

Businesses facing a kinked demand curve must be careful with pricing decisions, as it directs that slight price increases can lead to substantial revenue losses, while price decreases will not generate enough extra sales to cover the lost revenue from lower prices.

Revenue Effects of Price Changes

Changes in price can have a profound effect on a company's revenue, and this is directly tied to the concept of elasticity. The revenue effects of price changes depend on how consumers respond to those changes:

• If demand is elastic, a price increase will lead to a proportionately larger drop in quantity demanded, decreasing revenue.
• If demand is inelastic, a price increase results in a smaller decrease in quantity demanded, potentially increasing total revenue.
• Conversely, if demand is elastic, a price decrease may increase total revenue as more units are sold.
• If demand is inelastic, a price decrease will have a minimal effect on quantity demanded and can lower revenue.

It's essential for businesses to understand these dynamics when setting prices to avoid inadvertently shrinking their total revenue.

Elastic and Inelastic Demand

The two extremes of the elasticity spectrum are elastic and inelastic demand. With elastic demand, consumers are highly responsive to price changes. This happens usually with non-essential goods, where many substitutes are available, or the purchase can be delayed. Factors that contribute to elasticity include the availability of substitutes, the proportion of income spent on the good, and the time period considered.

Inelastic demand, on the other hand, characterizes situations where consumers are relatively unresponsive to price changes. This often occurs with necessities or products with fewer substitutes. Examples of goods with inelastic demand are medications, basic food items, and utilities. Inelastic demand is less affected by changes in price, but more influenced by changes in income and tastes.

Understanding whether a product has elastic or inelastic demand helps companies predict how changes in the market and their own pricing will affect sales volumes and revenue.