The Aadi price cut: revenue up, profit down
A knitwear shop in Tiruppur buys cotton kurtis at ₹600 each from a unit two streets away and sells them at ₹900, moving about 400 pieces in a normal month. Rent and staff salaries come to ₹40,000 a month and do not change with volume; the owner owns the premises but still counts the rent as a cost because he could let it out. For the Aadi season he cut the price to ₹750 and sold 520 pieces. A neighbouring shop kept its price unchanged and reports no fall in its own sales. In the same quarter the mill workers who make up much of his customer base received an 8 per cent wage revision. The accountant calls the season a success because 'revenue went up', and the owner is now planning a Deepavali cut to ₹600, expecting to sell about 600 pieces.
1. Using the percentage method, calculate the price elasticity of demand between ₹900 and ₹750. Then work out total revenue and total profit in both months. Was the price cut a success?
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Elasticity: %ΔQ = (520 − 400)/400 = +30%; %ΔP = (750 − 900)/900 = −16.67%. Ignoring sign, e = 30 ÷ 16.67 ≈ 1.8, i.e. demand is elastic over this range.
| At ₹900 | At ₹750 | |
|---|---|---|
| Units | 400 | 520 |
| Total revenue | ₹3,60,000 | ₹3,90,000 |
| Margin per unit | ₹300 | ₹150 |
| Total contribution | ₹1,20,000 | ₹78,000 |
| Less fixed cost | ₹40,000 | ₹40,000 |
| Profit | ₹80,000 | ₹38,000 |
Judgement: revenue rose 8.3% but profit fell by more than half. Elasticity predicts only the direction of revenue; profitability depends on the margin sacrificed on the existing units versus the margin earned on the extra ones. Here he gained 120 × ₹150 = ₹18,000 and lost 400 × ₹150 = ₹60,000. So the cut was good for turnover and customers, bad for the owner. Also note that the 8% wage rise means the ₹400-to-520 jump is not a clean ceteris paribus comparison, so 1.8 probably overstates the true price elasticity.
2. The wage revision raised customer incomes by 8 per cent, and the owner's earlier market survey suggested an income elasticity of demand of about 1.4. How much of the extra 120 pieces can reasonably be credited to the price cut, and what does that do to your elasticity estimate?
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Income effect: %ΔQ from income = 1.4 × 8% = 11.2%, which on a base of 400 pieces is about 45 pieces. So of the 120 extra pieces, roughly 45 may have come from higher incomes and only about 75 from the price cut.
Revised elasticity: %ΔQ (price only) = 75/400 = 18.75%; e = 18.75 ÷ 16.67 ≈ 1.1. Demand is still elastic, but barely, not comfortably.
Why this matters: the original calculation mixed two shifts - a movement along the demand curve (price change) with a shift of the curve (income change). Before cutting again, the owner needs cleaner evidence: test the new price on one product line only, compare with a shop whose customers are not mill workers, and separate the festival month from ordinary months. The neighbour's unchanged sales are weak evidence, because the two shops may serve different income groups. Judgement call: do not extrapolate an elasticity estimated from contaminated data into a further price cut.
3. Should the owner go ahead with the ₹600 Deepavali cut, expecting 600 pieces? Answer using contribution margin and the idea of diminishing marginal utility.
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Arithmetic: at ₹600 the selling price equals the buying price, so contribution per unit is zero. Even at 600 pieces, revenue of ₹3,60,000 equals the cost of goods; the ₹40,000 rent is then an outright loss. At the current ₹750 price he needs 40,000 ÷ 150 ≈ 267 pieces just to break even, so 520 pieces is comfortably profitable territory; at ₹600 no volume can break even.
Marginal utility reasoning: each successive price cut draws in buyers with lower willingness to pay. The buyers between the 520th and 600th piece value a kurti somewhere between ₹600 and ₹750; the shop cannot charge each buyer his own reservation price, so it must give up margin on all 520 earlier buyers to reach those 80 marginal ones. That is precisely why a cut below the profit-maximising price destroys profit even when quantity rises.
Better options: restore the margin by sourcing at ₹520 instead of ₹600, bundle a stole to raise perceived value without cutting the headline price, or run a members-only Deepavali offer that segments customers instead of discounting to everyone. Verdict: reject the ₹600 plan.