Answer to Question #76618 in Macroeconomics for David

Question

1.A bus company operates two routes. On route 1, research suggests tht the price elasticity is -0.5 and on the other route -2.5. The company has decided to revise fares upwards on both routes by 1% this year. Comment on the decision.


2.The owners of an oil filling station read an article in a trade publication stating that the own-price elasticity of demand for diesel is -0.3. because of this highly inelastic demand, they are thinking about raising prices at their stations to increase revenue and profits. Do you recommend this strategy based on the information they have obtained. Explain.

Answer 1

1. As per general theory on elasticity of demand, when price elasticity of demand is lower than 1, the demand is inelastic. Hence, here when the price is raised, the total revenue increases, and vice versa. An increase in fares will lead to an increase in overall revenue to the bus company on both routes. Hence, on route 1 fare revision will increase revenue. Hence increasing fare will earn profit and the revision decision is good.
However on route, price elasticity is -2.5, which shows that it is relatively elastic. Hence, when the price is raised, the revenue will fall. So on route 2 , fare revision decision will cause revenue loss and hence is a bad decision.

2. The own-price elasticity of demand for diesel given is -0.3. Demand is in-elastic with respect to price, when percentage change in the quantity demanded is less than corresponding percentage change in the price. Hence the decision about raising prices at their stations to increase revenue and profits, is good, as revenue increases since demand for diesel is inelastic with respect to price.