What is the effect on total revenue if demand is price elastic and price of the product falls?

Price inelasticity is very beneficial for businesses and is important in understanding how they should formulate their pricing strategy. Price inelasticity offers firms greater flexibility with prices as the change in demand remains essentially the same whether prices increase or decrease. If the price goes up or down, you can expect consumers’ buying habits to stay mostly unchanged.

For price inelastic goods or services, the change in the amount demanded is minimal with respect to the change in price.

This can affect demand and total revenue for a business in two ways.

If the price for an inelastic good is lowered, the demand for that good does not increase, resulting in less overall revenue due to the lower price and no change in demand. This would indicate that the firm should not reduce the price of its goods as there is no beneficial outcome in doing so.

On the other hand, if the price for an inelastic good is increased and the demand does not change, the total revenue increases due to the higher price and static quantity demanded. However, price increases typically do lead to a small decrease in quantity demanded.

This means that firms that deal in inelastic goods or services can increase prices, selling a little less but making higher revenues. Therefore, businesses that deal in goods that are price inelastic are better equipped for profit maximization and are better protected against economic downturns.

Price inelasticity shows that customers—and by extension, demand—are more tolerant to price changes. Therefore, firms that deal in inelastic goods or services can transfer the extra cost of production to their customers without adversely affecting the demand. As a result, price inelasticity offers better flexibility at setting up or establishing pricing strategies.

The main factors that determine demand are price, price of substitutes, income, taste, and expectations of future price changes. Other minor factors do come into play, such as brand loyalty.

Price inelasticity usually occurs with products that have fewer close substitutes, which means fewer options for customers. Such goods tend to be necessities that people can't do without and therefore their needs stay the same. Examples of inelastic goods include basic food, gasoline, important medicine, such as insulin, and habitual goods, such as tobacco products.

To enhance pricing flexibility and profit maximization, firms can strive to create or deal in more customized or distinctive goods or services where there are few close substitutes as sophisticated brands possess greater inelasticity. Though luxury items are typically price-elastic, many companies that sell distinct luxury goods that are unique might experience some inelasticity.

An example would be Apple's iPhone. Slight increases in the price would not adversely affect the demand for the phone. On the other hand, firms that deal in more ordinary products typically need to reduce prices and sell at competitive rates to gain an edge over competing brands.

Price elasticity of demand (PED) shows the relationship between price and quantity demanded and provides a precise calculation of the effect of a change in price on quantity demanded.

The following equation enables PED to be calculated.

% change in quantity demanded% change in price

We can use this equation to calculate the effect of price changes on quantity demanded, and on therevenue received by firms before and after any price change.

For example, if the price of a daily newspaper increases from £1.00 to £1.20p, and the daily sales falls from 500,000 to 250,000, the PED will be:

– 50+20=(-) 2.5

The negative sign indicates that P and Q are inversely related, which we would expect for most price/demand relationships. This is significant because the newspaper supplier can calculate or estimate how revenue will be affected by this change in price. In this case, revenue at £1.00 is £500,000 (£1 x 500,000) but falls to £300,000 after the price rise (£1.20 x 250,000).

The range of responses

The degree of response of quantity demanded to a change in price can vary considerably. The key benchmark for measuring elasticity is whether the co-efficient is greater or less than proportionate. If quantity demanded changes proportionately, then the value of PED is 1, which is called ‘unit elasticity’.

PED can also be:

• Less than one, which means PED is inelastic.
  

• Greater than one, which is elastic.

• Zero (0), which is perfectly inelastic.
  

• Infinite (∞), which is perfectly elastic.
  

PED along a linear demand curve

PED on a linear demand curve will fall continuously as the curve slopes downwards, moving from left to right. PED = 1 at the midpoint of a linear demand curve.

PED and revenue

There is a precise mathematical connection between PED and a firm’s revenue.

Revenue is measured in threee ways:

1. Total revenue (TR), which is found by multiplying price by quantity sold (P x Q).

2. Average revenue (AR), which is found by dividing total revenue by quantity sold (TR/Q). Average revenue is also the revenue per unit sold, which is also the price.

3. Marginal revenue (MR), which is defined as the revenue from selling one extra unit. This is calculated by finding the change in TR from selling one more unit.

   Consider these figures and calculate Total, Marginal and Average Revenue.

   PRICE (£)	Qd	TR	MR	AR
   10	1
   9	2
   8	3
   7	4
   6	5
   5	6
   4	7
   3	8
   2	9
   1	10

Answer

Study the patterns of numbers and see if you can analyse the relationships between the three measures of revenue – then answer the following:

1. How are price and average revenue connected?

2. What happens to total revenue as output increases?

3. What is the connection between total revenue and marginal revenue?

4. How are marginal revenue and average revenue connected?

Observations

When TR is at a maximum, MR = zero, and PED = 1.

1. Price and AR are identical, because AR = TR/Q, which is P x Q/Q, and cancel out the Qs to get P.
2. A curve plotting AR (=P) against Q is also a firm’s demand curve.
3. TR increases, reaches a peak and decreases.

Why does a firm want to know PED?

There are several reasons why firms gather information about the PED of its products. A firm will know much more about its internal operations and product costs than it will about its external environment. Therefore, gathering data on how consumers respond to changes in price can help reduce risk and uncertainly. More specifically, knowledge of PED can help the firm forecast its sales and set its price.

Sales forecasting

The firm can forecast the impact of a change in price on its sales volume, and sales revenue (total revenue, TR). For example, if PED for a product is (-) 2, a 10% reduction in price (say, from £10 to £9) will lead to a 20% increase in sales (say from 1000 to 1200). In this case, revenue will rise from £10,000 to £10,800.

Pricing policy

Knowing PED helps the firm decide whether to raise or lower price, or whether to price discriminate. Price discrimination is a policy of charging consumers different prices for the same product. If demand is elastic, revenue is gained by reducing price, but if demand is inelastic, revenue is gained by raising price.

PED = 1PED < 1PED > 1PricedecreasePriceincreaseElasticity and revenueRevenuefallsRevenuefallsRevenuerisesRevenuerisesRevenueconstantRevenueconstant

Non-pricing policy

When PED is highly elastic, the firm can use advertising and other promotional techniques to reduce elasticity.

Determinants of PED

There are several reasons why consumers may respond elastically or inelastically to a price change, including:

The number and ‘closeness’ of substitutes

A unique and desirable product is likely to exhibit an inelastic demand with respect to price.

The degree of necessity of the good

A necessity like bread will be demanded inelastically with respect to price.

Whether the good is habit forming

Consumers are also relatively insensitive to changes in the price of habitually demanded products.

The proportion of consumer income which is spent on the good

The PED for a daily newspaper is likely to be much lower than that for a new car!

Whether consumers are loyal to the brand

Brand loyalty reduces sensitivity to price changes and reduces PED.

Life cycle of product

PED will vary according to where the product is in its life cycle. When new products are launched, there are often very few competitors and PED is relatively inelastic. As other firms
launch similar products, the wider choice increases PED. Finally, as a product begins to decline in its lifecycle, consumers can become very responsive to price, hence discounting is extremely common.

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Firms may use persuasive advertising by to win new customers and retain the loyalty of existing ones.

Advertisers use a range of media, including television, press, and electronic media. Advertising will shift demand to the right, and make demand less elastic.

There are three extreme cases of PED. 

1. Perfectly elastic, where only one price can be charged.

2. Perfectly inelastic, where only one quantity will be purchased.

3. Unit elasticity, where all the possible price and quantity combinations are of the same value. The resultant curve is called a rectangular hyperbola.

   

   Go to: point elasticity of demand

   PED can also be illustrated through indifference curve analysis