The local community bus service, which is a monopoly, charges $2.00 for a one-way fare. The city council is thinking of raising the fare to $2.50 and expects it to generate 25% more revenue. The council has asked for your advice as a student of economics.

The council predicts that raising the price by 25% will raise revenues by 25%. Which of the following is true?

B. The council has taken into account the price effect but not the output effect.

Explanation:

The answer choices are:

Choose one:

A. The council hasn't taken into account either the output effect or the price effect. B. The council has taken into account the price effect but not the output effect. C. The council has taken into account both the price effect and the output effect. D. The council has taken into account the output effect but not the price effect.

Solution

As a student of economics, you know very well the laws of supply and demand.

The law of supply states that the higher the prices the higher the supply and the lower the prices the lower the supply.

The law of demand states that the higher the prices the lower the demand and the lower the prices the higher the demand.

Based on the law of demand, the city council should be aware that, by raising the fare from $2.00 to $2.50, the demand would decrease.

That means that, the revenue from increasing the fare will not be proportional, but lower than proportional.

Thus, by predicting that raising the price by 25% will raise revenue by 25% means that the city council is just looking at the price effect (as if the revenue would be the product of the same demand by a 25% higher price), but the reallity is that they must predict a decrease on the demand (output), which will cause the revenue to increase less than 25%.

In conclusion, the correct choice is:

B. The council has taken into account the price effect but not the output effect.