Wednesday, July 18, 2012

Mojito.....10 Euros!!!

Good morning economists. After a day's well deserved rest I would like to discuss today the concept of pricing. I visited Protaras, a tourist resort in Cyprus, this past weekend and I was surprised at the extremely high prices that some restaurants and tourist shops were charging. I also noticed that a lot of people on the beach were bringing their own foods and drinks. This got me thinking about the price elasticity of demand, and most importantly its role in pricing products right.

There seems to be a confusion (at least in Cyprus) as to how to react when quantity demanded for a product is low. For example, hotel and restaurant managers have been complaining that the number of tourists has decreased over the last decade. So they figure (and I actually heard this as an explanation) that in order to keep constant revenues, they should increase the price in order to compensate for the loss of customers. The problem with this, however, is that such behavior totally ignores the concept of price elasticity of demand.
Hotel and restaurant managers believe that their services are represented with the red demand line. They are what we call "inelastic". As such when they increase the price, the total revenue (or income), represented with the rectangle with the dotted red lines, increases.

The problem is that the price elasticity of demand for their services is in reality elastic, represented with the blue demand line. As such when the price increases, their total revenue represented with the dotted blue lines, decreases.

Perhaps, it is not too late to reverse this type of thinking. Would you pay 10 Euros for a mojito?

Have a nice day!

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