The producer of X is contemplating a price change and has asked for your advice. After some empirical investigation, you conclude that the price elasticity of demand for X is 1.25. As an economist, what would you advise the producer to do in order to raise total revenue? Would you advise him to raise prices or lower prices of good x? Why? Explain.
To advise the producer on whether to raise or lower the price of good X in order to raise total revenue, we would need to consider the price elasticity of demand. Price elasticity of demand measures the responsiveness of the quantity demanded of a good to a change in its price.
In this case, since the price elasticity of demand for good X is 1.25, it means that a 1% increase in price will result in a 1.25% decrease in quantity demanded, and vice versa. Now let's analyze the options:
1. Raise prices: If the producer raises the price of good X, the quantity demanded will decrease. However, the decrease in quantity demanded will not be proportionate to the increase in price due to the price elasticity being 1.25. This implies that the increase in revenue from the higher price per unit could potentially offset the decrease in quantity demanded. Therefore, if the producer wants to raise total revenue, it may be advisable to raise prices.
2. Lower prices: If the producer lowers the price of good X, the quantity demanded will increase. Again, due to the price elasticity of 1.25, the increase in quantity demanded will not be proportional to the decrease in price. Consequently, while the producer may experience an increase in sales volume, the decrease in price per unit may offset the revenue gain. Therefore, lowering prices may not be the most effective strategy to raise total revenue.
In summary, considering the price elasticity of demand is 1.25, it would be advisable for the producer to raise the price of good X in order to potentially raise total revenue. However, it is important for the producer to conduct further market research and analyses to gauge consumer behavior, competitor pricing, and affordability before implementing any significant price changes.