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IAI Actuarial Core Principles · Business Economics · How competitive markets operate

A firm sells a product with price elasticity of demand of -0.6 at the current price. If the firm raises its price by 5%, what is the likely effect on the firm's total revenue, other things equal?

Revenue rises by about 2 per cent. With elasticity of 0.6, a 5 per cent price rise cuts quantity demanded by about 3 per cent. Because demand is inelastic, the price gain outweighs the quantity loss, giving a net revenue increase of roughly 2 per cent.

  1. ARevenue falls by about 3%
  2. BRevenue rises by about 2%Correct
  3. CRevenue rises by about 5%
  4. DRevenue is unchanged
  5. Revenue falls by about 5%

Explanation

Quantity falls by 0.6 x 5% = 3%. Revenue change is approximately +5% - 3% = +2%. Demand is inelastic, so a price rise increases revenue. Saying revenue falls by 3% confuses the quantity change with the revenue change.

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