Relationship Between the Price Elasticity of Demand and Total Revenue

1709 words (7 pages) Business Assignment

16th Jun 2020 Business Assignment Reference this

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Introduction

The concept of price elasticity of demand has a significant role to play in economic theory and practice. It is a very important concept that measures the responsiveness of consumers to the quantity demanded or supplied of a good to a change in its price. It measures the degree to which demand is either price elastic or inelastic by computing it as the percentage change in quantity demanded or supplied divided by the percentage change in price. However, when computing the co-efficient of the price elasticity where the elasticity results in the same whether prices rise or fall; economists prefer to use the mid-point formula for calculating elasticity. This mid-point formula averages the two prices and the two quantities as the preference points for computing the percentages (McConnell, Brue & Flynn, 2018, pg. 123).

Relationship between the price elasticity of demand and total revenue

The relationship between price elasticity of demand and a firm’s total revenue is an important one since generating revenue is a necessary part of running a successful business. Total revenue is the total amount of money a company makes by selling goods and services. Price elasticity is the economic term which explains that if the price of a product goes up, consumers buy less of it. If the price goes down, consumers buy more. Understanding whether the price of a product is elastic or inelastic is essential for a company to develop an effective marketing campaign and survive in the marketplace. Price elasticity is a tool that marketers can use against their competitors to increase their share of a market (Woodruff, 2019).

Impacts of various forms of elasticities on Business decisions

Businesses must have knowledge about the elasticity of their products to set pricing strategies. If business managers/owners know that the demand for their products is inelastic, then they can raise prices without fear of losing sales. On the other hand, if demand for their products is highly elastic, then raising prices could be a detrimental to the company. There are basically three main types prices elasticity of demand: elastic demand, inelastic demand and unit elastic demand.

Elastic demand happens when there is a decrease in price that will increase total revenue. Even though in such a scenario it is assumed that a lesser price per unit will generate a loss, because of the law of demand enough additional units will be sold to make up for the decrease in price of the product. Additionally, when price a total revenue move in opposite directions and demand’s percentage change is greater than 1 demand is elastic (McConnel, Brue & Flynn, 2018, pg. 125). Elastic demand can be further categorized into perfectly elastic and relatively elastic. When a small change in price of a product causes a major change in its demand resulting in fall in demand to be zero, it is said to be perfectly elastic demand. Similarly, relatively elastic demand refers to the demand when the proportionate change produced in demand is greater than the proportionate change in price of a product (Méndez-Carbajo & Asarta, 2017).

Inelasticity of demand happens when there is a price decrease that reduces total revenue. In this case the increase in sales will not fully offset the decline in revenue per unit, hence total revenue will decline. Business will know when demand is inelastic since a price increase will increase total revenue and will move in the same direction and will be less than 1 (McConnel, Brue & Flynn, 2018, pg. 126). Like elastic demand, inelastic demand is also broken down into perfectly inelastic and relatively inelastic. A perfectly inelastic demand is one when there is no change produced in the demand of a product with change in its price. Similarly, relatively inelastic demand is one when the percentage change produced in demand is less than the percentage change in the price of a product (Méndez-Carbajo & Asarta, 2017).

In unit elasticity changes in price of a product or service do not affect total revenue. The loss in revenue from a lower unit price is exactly offset by the gain in revenue from the accompanying revenue in sales. Conversely, the gain in revenue from a higher unit price is exactly offset by the revenue loss associated with the accompanying decline in the amount demanded (McConnel, Brue & Flynn, 2018, pg. 126).

Figure 1

Figure 1 shows the demand curve for products when demand is elastic, inelastic and unit elastic.

To illustrate elasticity, let us look at an example that shows the demand for cooking/table salt. Table 1 shows the Demand schedule for table salt

Price $   Quantity (lbs.)
5 150
8 100

To compute the elasticity of demand for table salt it is recommended to use the midpoint formula. The formula is Ed  =

Change in quantity Sum of quantities  /2

÷

change in priceSum of prices  /2

Where p1= 5, P2= 8, Q1= 150, Q2= 100

Ed =

Q2-Q1Q1+Q2  /2

÷

P2-P1(P1+P2 )/2

Ed=

100-150100+150/2

  ÷

8-5(8+5)/2

=

-50125

÷

36.5

=

-0.40.462

= -0.866

The demand for table salt is inelastic since its elasticity is below 1.

Figure 2

Strategies to maximize profit

The goal of a company is to maximize profit, and maximizing profit is not usually the same thing as maximizing revenue. Therefore, while it may be appealing to think about the relationship between price and revenue, especially since the concept of elasticity makes it easy to do so, it is only a starting point for examining whether a price increase or decrease is a good idea (Beggs, 2019). Thus, business can use the total -revenue test or the midpoint equation to determine whether a product is elastic or inelastic. Once they have determined the elasticity of the product, they can then make pricing decisions. It would be most beneficial to the company to increase the prices of the inelastic products since regardless of the price consumers will still purchase the product. On the other hand, for elastic products business will have to look at factors such as its substitutes, if it is a luxury or necessity, the share of the consumers’ income, and the short-term versus long-term timing of the product. Once this is determined it would be wise to decrease the price per unit since this would cause total revenue to raise.

Elasticity of demand or supply in the short and long term

Normally, products are more inelastic in the short term since some products that are considered a necessity will still be purchased. However, depending on the customers’ income and the options available to them they will find other ways to put off or substitute the inelastic product if they cannot afford it any longer. Gasoline is an excellent example of a product whose prices is inelastic in the short term but elastic in the long term. When gas prices go up, the consumer still has to buy gas to get to work. However, if gas prices stay high for the long term, consumers make changes. They may buy more fuel-efficient cars, set up a carpool with other workers, or start taking a train or bus to work (Woodruff, 2019).

Impacts of government and market failures on the price elasticities of demand and supply

Government intervention to resolve market failures, and to manage the economy, can fail to achieve a socially efficient allocation of resources. They can also fix prices, such as minimum and maximum prices, but this can create distortions which can lead to shortages or surpluses resulting in disequilibrium. When they set price ceiling and floors, they eliminate the competition among sellers that can disrupt the demand and supply curves. Their imposition of taxes will also shift the demand and supply curve since sale taxes add to the price of a commodity. The government can also use elasticity when establishing taxes for inelastic products such as alcohol. The demand for these products is inelastic therefore the increase in taxes will generate significant increase in tax revenues.

Conclusion

The concept of elasticity of demand is of great importancefor determining prices of various factors of production. In other words, if the demand of a factor is inelastic, its price will be high and if it is elastic, its price will be low. It is related to total revenue which can benefit business once they have knowledge of it and can capitalize on how to treat their elastic and inelastic products in order to minimize their profits.

References

  • Beggs, J. (2019). Revenue and Price Elasticity of Demand. Retrieved from https://www.thoughtco.com/revenue-and-price-elasticity-of-demand-1147368
  • McConnel, C. R, Brue, S.L & Flynn, S.M. (2018). Economics Principles, Problems, and Policies: twenty-first Edition. McGraw -Hill Education. New York, NY.
  • Méndez-Carbajo, D., & Asarta, C. J. (2017). Using FRED data to teach price elasticity of demand. Journal of Economic Education, 48(3), 176–185. https://doi.org/10.1080/00220485.2017.1320607
  • Miller, T. (n.d). [file image]. Elasticity and revenue. Retrieved on October 1, 2019 from https://taramillermicroeconomics.wordpress.com/category/uncategorized/
  • Woodruff, J. (2019). The Relationship Between Price Elasticity & Total Revenue. Retrieved from https://smallbusiness.chron.com/relationship-between-price-elasticity-total-revenue-24544.html

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