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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 $10 each. Fixed costs amount to $60,000, and total variable costs equal $120,000. 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.
a. Evaluate the impact of the proposal to cut prices on (i) total revenue, (ii) total cost, and (iii) total profits.
b. If average variable costs are assumed to remain constant over a 10 percent increase in output, evaluate the effects of the proposed price cut on total profits.
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