A knitting mill sells about 20,000 units of its product per 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 price elasticity of demand is estimated at -2.
a) Illustrate the initial equilibrium in a diagram. (Since the demand and cost equations are not available, a reasonable approximation of the curves is OK). Indicate the relevant magnitudes in the diagram.
b) Evaluate the impact of the proposal to cut prices on
Total revenue
Total cost
Total profit
c) Illustrate the resulting equilibrium in a diagram and indicate the relevant magnitudes. (Since the equations are not available, a reasonable approximation is OK).
d) What is the firm's actual markup after the 5% price cut? What is the optimal profit-maximizing markup suggested by economic theory?