Question

Exercise 10.7

Royersford Knitting Mills, Ltd., sells a line of women’s knit underwear. The firm now sells about 20,000 pairs a year at an average price of $40 each. Fixed costs amount to $240,000, and total variable costs equal $480,000. 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 arc elasticity of demand with respect to prices is estimated at −2.

The proposal to cut prices by 5 percent would   total revenues from $800,000 to

. Total costs would be

and total profits would be

.If average variable costs are assumed to remain constant over a 10 percent increase in output, total profits after a 5 percent price cut would be

.

Answer 1

Answer : The proposal to cut prices by 5 percent would total revenue from $8,00,000 to $8,36,000 i.e (22000*$38).It means that revenue has been increased from $36000. It shows that revenue has been increased.

Total cost included fixed as well as variable cost

Earlier :

Fixed cost = $2,40,000

Variable cost = $4,80,000

Total cost = $7,20,000

Now with the effect of price reduction and increase in output :

Fixed cost = $2,40,000

Variable cost = ?

Here , average variable cost reduction 40 cents

Now new average variable cost =$24-$9.6= $14.4

Variable cost =$14.4*22000= $3,16,800

Total cost = $5,56,800

Total profit has been increased as a result earlier profit is $80,000 but now the total profit has been increased as

Total profit= Total revenue - Total cost

$8,36,000- $5,56,800=$2,79,200

Answer : If average variable cost remains constant when there is 10% increase in the output and the 5% reduction in the price than the fixed cost is $2,40,000 and Variable cost is ($24*22000)$5,28,000

Total cost= FC+ VC= $2,40,000+$5,28,000= $7,68,000

Total revenue= $8,36,000

Total profit = Total revenue - Total cost

Total profit= $68000