Two Price Changes at Kaveri Dairy: Elasticity, Revenue and Contribution
Kaveri Dairy sells two products weekly in a district town: curd and paneer. In week 1 curd was priced at Rs 40 per kg and sold 5,000 kg; paneer was priced at Rs 400 per kg and sold 1,000 kg. In week 2 the dairy raised the curd price to Rs 44 and cut the paneer price to Rs 360. Curd sales fell to 4,600 kg and paneer sales rose to 1,150 kg. Variable cost is Rs 31 per kg of curd and Rs 330 per kg of paneer; allocated fixed costs are Rs 25,000 a week for the curd line and Rs 40,000 a week for the paneer line. At the review meeting the sales manager points out that revenue rose on both products and argues that both price decisions were therefore correct. The accountant is less cheerful. The dairy buys milk daily on contract, cannot store paneer for more than four days, and two rival dairies have outlets in the same town. This is the first price change the dairy has made in two years.
1. Calculate the price elasticity of demand for each product using the percentage method on the given price change, and interpret both values.
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Curd
- Percentage change in quantity = (4,600 − 5,000) ÷ 5,000 = −8 per cent
- Percentage change in price = (44 − 40) ÷ 40 = +10 per cent
- Elasticity = −8 ÷ 10 = 0.8 (ignoring sign, less than 1)
Curd demand is inelastic over this range: buyers did not cut back much when the price rose. Curd is a routine daily item with few close substitutes in the local market, which fits a low elasticity.
Paneer
- Percentage change in quantity = (1,150 − 1,000) ÷ 1,000 = +15 per cent
- Percentage change in price = (360 − 400) ÷ 400 = −10 per cent
- Elasticity = 15 ÷ 10 = 1.5 (greater than 1)
Paneer demand is elastic: a modest price cut drew a proportionately larger volume response. Paneer is a higher-value item with rivals nearby, so buyers switch.
Interpretation caution: these are arc estimates from a single price change, valid only over that price range. They say nothing about how buyers would respond to a 20 per cent change, and they are contaminated by anything else that moved in week 2 - festival demand, a rival's promotion, a supply shortage.
2. Evaluate the sales manager's claim that both decisions were correct because revenue rose on both products. Support your answer with total revenue and contribution figures.
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The claim is half right, and the half it gets wrong is the expensive half.
| Curd week 1 | Curd week 2 | Paneer week 1 | Paneer week 2 | |
|---|---|---|---|---|
| Price (Rs) | 40 | 44 | 400 | 360 |
| Quantity (kg) | 5,000 | 4,600 | 1,000 | 1,150 |
| Total revenue (Rs) | 2,00,000 | 2,02,400 | 4,00,000 | 4,14,000 |
| Contribution per kg (Rs) | 9 | 13 | 70 | 30 |
| Total contribution (Rs) | 45,000 | 59,800 | 70,000 | 34,500 |
Revenue does rise on both, by Rs 2,400 and Rs 14,000. But revenue is not the objective; contribution is. The curd decision is clearly good - margin per kg rose from Rs 9 to Rs 13 and contribution rose by Rs 14,800, so the inelastic demand was exploited correctly.
The paneer decision destroyed Rs 35,500 of contribution. Cutting price from Rs 400 to Rs 360 removed Rs 40 of margin while adding only Rs 0.30 of margin for each extra kilogram... put plainly, 150 extra kg at Rs 30 each added Rs 4,500, while 1,000 kg lost Rs 40 each, a fall of Rs 40,000. Revenue grew because volume grew; profit fell because each unit sold earns less than half its old margin.
Combined profit: week 1 = 45,000 + 70,000 − 65,000 fixed = Rs 50,000. Week 2 = 59,800 + 34,500 − 65,000 = Rs 29,300. The dairy is Rs 20,700 worse off while its revenue is higher. The lesson is the standard one: with elastic demand a price cut raises revenue but may reduce profit, because revenue ignores cost.
3. The manager now proposes a further 10 per cent cut in the paneer price, arguing that 'paneer is elastic, so revenue and profit will both grow'. Evaluate this reasoning and state what the dairy should check before acting.
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The revenue part is plausible; the profit part does not follow. With elasticity 1.5, a 10 per cent cut would raise quantity by roughly 15 per cent, so revenue would rise again. But margin per kg would fall from Rs 30 to Rs 24 (360 → 324 against a variable cost of Rs 330 would actually be negative; even at a 5 per cent cut the margin collapses). At Rs 324 the dairy would be selling below variable cost, so every extra kilogram would add to the loss. To restore the week-1 contribution of Rs 70,000 at a margin of Rs 30, sales would need to reach about 2,333 kg - more than double the current 1,150 kg, which the plant and the four-day shelf life will not permit.
What must be checked before any further move:
- Where the 150 kg came from. If it came from the two rival dairies, they will respond; an elasticity measured during a one-off price advantage is not sustainable.
- Cost side. The Rs 330 variable cost depends on the daily milk contract; a procurement price rise would make the discount ruinous.
- Capacity and perishability. Paneer cannot be stored beyond four days, so volume gains must be matched by daily sales, not produced into stock.
- Reliability of the estimate. One observation in two years is a weak base for extrapolating a further cut; a small controlled trial in two or three outlets over two weeks would be better evidence.
- Cannibalisation. A cheaper paneer may pull buyers away from curd, where the margin is now attractive - check curd volumes in the same outlets.
A defensible recommendation: hold or restore the paneer price, protect the Rs 70 margin, and compete on freshness and availability rather than price.