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IAI Actuarial Core Principles · Business Economics · Consumer demand and behaviour

A tea company in Assam raises the price of its premium blend by 5% and finds that quantity demanded falls by 12%. Using the simple percentage-change method, which statement best describes demand for the blend and the effect on total revenue?

Demand is elastic with an elasticity of 2.4, found by dividing the 12% fall in quantity by the 5% rise in price. Because the quantity response is proportionately larger than the price change, total revenue falls after the price increase.

  1. ADemand is inelastic (elasticity 0.42) and total revenue rises
  2. BDemand is elastic (elasticity 2.4) and total revenue fallsCorrect
  3. CDemand is elastic (elasticity 2.4) and total revenue rises
  4. DDemand is unit elastic and total revenue is unchanged
  5. Demand is inelastic (elasticity 2.4) and total revenue falls

Explanation

Price elasticity = 12/5 = 2.4 in absolute terms, which is greater than 1, so demand is elastic. When demand is elastic, a price rise lowers total revenue because the percentage fall in quantity exceeds the percentage rise in price. Option 0 inverts the ratio (5/12 = 0.42).

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