Question

Three Guys Named Al, a moving company, is contemplating a price hike. Currently, they charge $\mathrm{\$}30$ per hour, but Al thinks they could get $\mathrm{\$}40.$ Al disagrees, saying it will hurt the business. Al, the brains of the outfit, has calculated the price elasticity of demand for their moving services in the range from $\mathrm{\$}30$ to $\mathrm{\$}40$ and found it to be 0.5 a. Should they do as Al suggests and raise the price? Why or why not? b. Currently, Three Guys is the only moving company in town. Al reads in the paper that several new movers are planning to set up shop there within the next year. Twelve months from now, is the demand for Three Guys' services likely to be more elastic, less elastic, or the same? Why?

Short answer

Yes, they should raise the price, as the price elasticity of demand shows inelastic demand and they will earn more revenue. When new competition enters, the demand for Three Guys Named Al's services will likely become more elastic as customers will have more choices.

Step-by-step solution

Understanding Price Elasticity of Demand

If the price elasticity of demand is less than 1, this means that the demand is inelastic, indicating that the quantity demanded does not respond strongly to changes in price. In other words, increases in price would lead to a less than proportionate drop in quantity demanded.

Decision to Raise Price based on Price Elasticity of Demand

Since Three Guys Named Al has an inelastic demand (0.5), raising the price would actually increase their total revenue. This is because the percentage change in quantity demanded is less than the percentage change in price. Therefore, they should raise the price as suggested.

Effect of Competition on Price Elasticity of Demand

The entry of new competitors generally increases the price elasticity of demand, as consumers have more alternatives, and thus demand is more sensitive to price changes. Therefore, it can be predicted that twelve months from now, the demand for Three Guys' services will be more elastic than it currently is.

Key concepts

Economic Decision Making

Making economic decisions involves assessing various factors that could influence the outcome of those decisions. For a business, decisions like setting the right price for a service or product are crucial. Understanding consumers' responsiveness to price changes, which is quantified by the price elasticity of demand, can guide such decisions.

Price elasticity measures how demand varies with a change in price. If demand changes significantly when the price changes, we say that the demand is elastic. Conversely, if demand hardly changes with a price increase or decrease, the demand is inelastic. In the case of 'Three Guys Named Al', their decision to raise the price from $30to$40 requires considering their service's price elasticity.

With the calculated price elasticity of demand at 0.5, a value less than 1, the demand is considered inelastic. This suggests that the quantity demanded for their services is relatively unresponsive to price changes. Therefore, a strategic increase in price could be beneficial if it does not substantially reduce the quantity demanded, potentially leading to increased total revenue for the company.

Inelastic and Elastic Demand

Demand elasticity is a spectrum, with 'inelastic' and 'elastic' demand at opposite ends. Elastic demand is sensitive to price changes: a small increase in price could lead to a significant drop in the quantity demanded. For instance, luxury items often have elastic demand because consumers can forgo these items or find substitutes when prices rise.

Conversely, inelastic demand occurs when a change in price does little to affect the quantity demanded. Necessities, for which there are few or no substitutes, typically have inelastic demand. This means that consumers will continue to purchase the item even at higher prices. Understanding this concept is vital for businesses when pricing their products or services. If a product has inelastic demand, like the moving services offered by 'Three Guys Named Al', a price increase can lead to an increase in total revenue since the decrease in quantity demanded will be proportionally smaller than the price hike.

Impact of Competition on Demand Elasticity

The presence or absence of competition in a market can significantly impact demand elasticity. In a monopoly, where there is no competition, demand for a product or service tends to be more inelastic because consumers lack alternatives. As a result, monopolistic businesses can often raise prices without substantially losing customers.

However, introducing new competitors into the market changes the dynamics. Customers now have choices and may switch to alternatives if they perceive better value. This scenario is what 'Three Guys Named Al' may face as they learn about new moving companies entering the market.

With the imminent arrival of these competitors, it is likely that the demand for 'Three Guys Named Al's' services will become more elastic. When more options are available, consumers become more price-sensitive, thus enhancing the demand elasticity. The company might need to reconsider their pricing strategy to retain customers, emphasizing customer service or unique value propositions to stand out from the competition.