Setting a Price where Demand is Inelastic

[Kate]

Why wouldn't a producer want to set a price where demand is inelastic? Varian explains the concept on page 285 of the textbook (under the example "Setting A Price"), but it doesn't make much sense to me.

[Lindsay Appell]

Hi Kate!

Great question! The first thing you'll need to know is that elasticity of demand always measures the percentage response of quantity demanded to a 1% increase in price. So, for example, if elasticity of demand = - 0.5 (this would be inelastic demand because the absolute value is less than 1) this means that if price increases by 1%, the quantity demanded would fall by 0.5%. Thus, if a producer did choose to raise the price by 1%, the increase in revenue from the price increase would outweigh the decrease in revenue from the quantity decrease (because the percent increase in price is greater than the percent decrease in quantity). Therefore, a producer would not choose to settle on a price where demand is inelastic because they could increase their revenue by raising the price.

One last note: Notice that elasticity of -0.5 --> 0.5% decrease in demand. Although we are used to moving the decimal place over two places when we change from decimal to percent form, elasticity is already written in percent form so we don't need to do that. All we have to do is just take our answer for elasticity and tack a percent sign on it.

Let me know if that makes sense!

-Lindsay

[Kate]

Yes, it makes perfect sense. Thank you Lindsay!