The local bus company can use the elasticity of demand to determine the best fare option to maximize their profits. The elasticity of demand measures the responsiveness of the quantity demanded to a change in price. The company surveyed passengers at three different fares to estimate demand and calculate the total cost and total revenue.
Calculating Total Revenue
The total revenue per year can be calculated by multiplying the estimated demand (in millions) by the fare ($/km). For the fare of $0.40/km, the total revenue would be 6 million passengers x $0.40/km = $2.4 million per year. For the fare of $0.50/km, the total revenue would be 4 million passengers x $0.50/km = $2 million per year. For the fare of $0.60/km, the total revenue would be 3 million passengers x $0.60/km = $1.8 million per year.
Calculating the Firm’s Profit
The firm’s profit can be calculated by subtracting the total cost from the total revenue. The total cost for each fare is the same at $1.8 million per year. At the current fare of $0.50/km, the total revenue is $2 million per year, so the firm’s profit would be $2 million – $1.8 million = $0.2 million per year.
Was the $0.50/km Fare the Best Fare Originally?
No, the $0.50/km fare was not the best fare originally. The total revenue is higher for the $0.40/km fare at $2.4 million per year and for the $0.60/km fare at $1.8 million per year. The $0.50/km fare produces the lowest total revenue at $2 million per year. Therefore, the $0.50/km fare is not the best fare option for the local bus company.
- What is elasticity of demand?
- What is the difference between total cost and total revenue?
- What factors should a business consider when setting prices?
- How do firms use surveys to make pricing decisions?
- What is a profit-maximizing price?
- What is the revenue maximizing price?
- What is a price elastic demand?
- What is a price inelastic demand?
- What is an optimal price?
- What is the demand curve?