Kigoma Bakers: Elasticity, Cost Inflation and the Pricing Decision
Kigoma Bakers sells a 500g loaf at KSh 60 and currently sells 40,000 loaves a month. Unit variable cost is KSh 32 and monthly fixed costs are KSh 600,000. Following a 12% rise in the price of flour, unit variable cost has risen to KSh 35.84 and the increase is expected to be permanent. Market research on a comparable price change suggests a price elasticity of demand of −1.6. Management is considering three responses: (i) hold the price at KSh 60; (ii) raise the price by 10% to KSh 66; (iii) keep the price at KSh 60 but reduce the loaf to 450g, which cuts unit variable cost by a further 10%. The marketing manager warns that any price rise will 'destroy revenue' and should be avoided.
1. Using the elasticity estimate, compute the volume and total revenue under option (ii). Explain why revenue behaves as it does, and comment on the marketing manager's warning.
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Volume effect: a 10% price rise with elasticity −1.6 gives a volume change of −1.6 × 10% = −16%.
New volume = 40,000 × 0.84 = 33,600 loaves.
| Current | After 10% rise | |
|---|---|---|
| Price (KSh) | 60 | 66 |
| Volume | 40,000 | 33,600 |
| Revenue (KSh) | 2,400,000 | 2,217,600 |
Revenue falls by KSh 182,400 because demand is elastic (|−1.6| > 1): the percentage fall in quantity exceeds the percentage rise in price. The marketing manager is right that revenue falls - but revenue is the wrong objective. What matters is the margin retained per loaf, which rose from KSh 28 to KSh 30.16.
2. Compute monthly profit under each of the three options and recommend one, with reasons.
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| (i) Hold at 60 | (ii) Raise to 66 | (iii) Shrink to 450g at 60 | |
|---|---|---|---|
| Price | 60.00 | 66.00 | 60.00 |
| Unit variable cost | 35.84 | 35.84 | 35.84 × 0.90 = 32.256 |
| Unit contribution | 24.16 | 30.16 | 27.744 |
| Volume | 40,000 | 33,600 | 40,000 |
| Total contribution | 966,400 | 1,013,376 | 1,109,760 |
| Fixed costs | (600,000) | (600,000) | (600,000) |
| Profit | 366,400 | 413,376 | 509,760 |
All three beat the pre-inflation profit of KSh 520,000 only in the case of (iii); (i) and (ii) both fall short. Option (iii) is the strongest on numbers because it protects volume and cuts cost per loaf.
Recommendation: adopt (iii) only if the weight reduction is legally and commercially acceptable - it must be labelled accurately, customers may notice, and competitors may undercut. If a visible weight cut is judged too risky, choose (ii), which still adds KSh 46,976 of profit over doing nothing; option (i) should be rejected.
3. The finance officer proposes a 15% price increase instead. Test it using the same elasticity, and state two limitations of relying on a single elasticity estimate.
Read the worked answer
Test of a 15% rise: volume change = −1.6 × 15% = −24%, so volume = 40,000 × 0.76 = 30,400 loaves. Price = KSh 69. Unit contribution = 69 − 35.84 = KSh 33.16.
Profit = (33.16 × 30,400) − 600,000 = 1,008,064 − 600,000 = KSh 408,064, which is slightly worse than the 10% rise (KSh 413,376). The gain from the higher margin no longer offsets the lost volume, so 15% is not an improvement.
Limitations:
- The estimate is a single point elasticity taken from a 'comparable' market and applied as if it were constant over a wide price range; the true demand curve may be less elastic at low prices and far more elastic once the loaf exceeds competitors' prices.
- It ignores competitor reaction, the effect on the 450g versus 500g comparison, income effects and any change in the firm's own other products; a rival holding its price would make the actual loss of volume much larger than 16%.