If a firm supplies separable markets with price elasticities h1 and h2, it should set prices P1 and P2 so that:
a.P1 /h1 = P2 /h2
b.P1/(1 - 1 /h1) = P2 / (1 - 1/h2)
c.P1(1 + 1/h1) = P2 (1 + 1/h2)
d.P1 = 1 - 1/h1 and P2 = 1 - 1/h2
e.P1h1 = P2h2
The correct answer is option e. P1h1 = P2h2.
To understand why, we need to know what price elasticity of demand is. Price elasticity of demand measures the responsiveness of the quantity demanded to changes in price. It is calculated as the percentage change in quantity demanded divided by the percentage change in price.
In this scenario, the firm is facing two separable markets, each with its own price elasticity of demand (h1 and h2). The firm wants to set the prices (P1 and P2) in such a way that it maximizes its total revenue.
To find the optimal prices, the firm should consider setting P1h1 equal to P2h2. This is because the product of the price and the elasticity of demand gives us the percentage change in revenue for the respective market.
If P1h1 is greater than P2h2, it means that increasing the price in market 1 will have a larger impact on revenue than increasing the price in market 2. In this case, the firm should consider setting a higher price in market 1. Conversely, if P1h1 is smaller than P2h2, the firm should set a higher price in market 2.
By setting P1h1 equal to P2h2, the firm ensures that the percentage changes in revenue resulting from price changes are equal in both markets. This helps achieve revenue maximization across the separable markets. Therefore, option e. P1h1 = P2h2 is the correct answer.