Question

Royersford Knitting Mills, Ltd., sells a line of women's knit underwear. The firm now sells about 20,000 pairs a year at an average price of $10 each. Fixed costs amount to $60,000, and total variable costs equal $120,000. The production department has estimated that a 10 percent increase in output would not affect fixed costs but would reduce average variable cost by 40 cents. The marketing department advocates a price reduction of 5 percent to increase sales, total revenues, and profits. The arc elasticity of demand with respect to prices is estimated at -2 .

a. Evaluate the impact of the proposal to cut prices on
(i)total revenue,
(ii)total cost, and
(iii)total profits.

Answer 1

To evaluate the impact of the proposal to cut prices on total revenue, total cost, and total profits, we analyze the effects of the price reduction on the firm's variables. Total revenue may increase, decrease, or remain unchanged depending on the price elasticity of demand. Total costs would decrease due to the 10% increase in output, but the impact on total profits depends on the change in total revenue and total cost.

Step-by-step explanation:

To evaluate the impact of the proposal to cut prices on (i) total revenue, (ii) total cost, and (iii) total profits, we need to analyze the effects of the price reduction on the firm's variables.

(i) Total Revenue: The price reduction of 5% would result in a decrease in the average price per pair of knit underwear. Assuming the quantity sold increases as a result, the total revenue may increase, decrease, or remain unchanged depending on the price elasticity of demand.

(ii) Total Cost: Fixed costs do not change with the proposed price reduction. However, the variable cost per unit decreases by 40 cents due to the 10% increase in output. This would lead to a decrease in total variable costs.

(iii) Total Profits: To determine the impact on total profits, we need to compare the change in total revenue and total cost. If the increase in total revenue exceeds the decrease in total cost, total profits would increase. If the decrease in total revenue exceeds the decrease in total cost, total profits would decrease. If the change in total revenue and total cost is equal, total profits would remain unchanged.