Research Report: the Price Elasticity of Demand
Managerial Economics Research Report: The Price Elasticity of Demand The Price Elasticity of Demand: 1. Introduction: Price elasticity of demand is an economic measure that is used to measure the degree of responsiveness of the quantity demanded of a good to change in its price, when all other influences on buyers remain the same. Elasticity of demand helps the sales manager in fixing the price of his product, deciding the sales, pricing policies and optimal price for their products.
The evaluation of this measure is a useful tool for firms in making decisions about pricing and production which will determine the total revenues for the firms.
In our research, we will discuss about price elasticity of demand, we will explain how firms can use the price elasticity of demand for Goods and services to decide on sales, setting pricing policies and determining the optimal price to maximize revenues. 2. Analysis:
Before analyzing the effect of price elasticity of demand on change in a firm’s revenue, it is significant to analyze the price elasticity of demand itself. The price elasticity of demand reflects the relation between price and quantity. An elastic demand means that the quantity demanded is relatively responsive to changes in price i.
e. Elasticity ; 1. It is calculated as: Price Elasticity of Demand = % ? Quantity demanded % ? Price Sales:
After the analysis of price elasticity of demand we can identify the relationship between the prices and firm’s revenue. Given the price elasticity of demand facing the firm in the relevant range of production, how would a change in the price of the good affect a firm’s revenues? Remember, if a firm raises prices they reduce sales (for a typical downward sloping demand curve) and the firm increases sales when there is a reduction in prices. A firm’s revenues equals the total sales of a good sold times the price charged:
Total Revenue = Price x Quantity TR = P x Q The effect on total revenue is a factor of the three parts: 1.
Change in revenue as a result of change in price on the condition ceteris paribus. 2. Change in revenue as a result of change in volume of sale on the condition ceteris paribus. 3. Change in revenue as a result of both change in volume of sale and change in prices: The relationship between Price elasticity of demand and total revenue can be also be described as: 1.
When the price elasticity of demand for a good is perfectly inelastic (Ed = 0), changes in the price do not affect the quantity demanded for the good; raising prices will cause total revenue to I ncrease.
2. When the price elasticity of demand for a good is relatively inelastic (-1 < Ed < 0), the percentage change in quantity demanded is smaller than that in price. Hence, when the price is raised, the total revenue rises, and vice versa. 3.
When the price elasticity of demand for a good is unit (or unitary) elastic (Ed = -1), the percentage change in quantity is equal to that in price, so a change in price will not affect total revenue.
4. When the price elasticity of demand for a good is relatively elastic (-? < Ed < -1), the percentage change in quantity demanded is greater than that in price. Hence, when the price is raised, the total revenue falls, and vice versa. 5. When the price elasticity of demand for a good is perfectly elastic (Ed is ? ), any increase in the price, no matter how small, will cause demand for the good to drop to zero. Hence, when the price is raised, the total revenue falls to zero.
For better understanding let us illustrate the graph. A set of graphs shows the relationship between demand and total revenue (TR) for a linear demand curve. As price decreases in the elastic range, TR increases, but in the inelastic range, TR decreases. TR is maximized at the quantity where PED = 1.
Hence, as the accompanying diagram shows, total revenue is maximized at the combination of price and quantity demanded where the elasticity of demand is unitary. Since firms facing an elastic demand can increase total revenue when they cut prices, the opposite condition exists when they try to raise prices.
With many substitutes in consumption available, a price increase leads to a significant decline in consumption – the percentage change in quantity demanded exceeds the percentage change in price.
Producers that raise prices when facing an elastic demand will find that total revenues decrease as the gain from charging higher prices is more than offset by a desertion of consumers to cheaper substitutes, with sales and output falling. When price elasticity is inelastic, the percentage change in quantity demanded is less than the percentage change in price. As a result, the change in revenues due to the response in the quantity demanded is less than the change in revenues as a consequence of the price change.
We conclude that a firm pricing in the inelastic range of the demand curve will have a net increase in total revenues when they raise the price of the good they produce to the consumer.
For the most part, the consumer will have little opportunity to significantly reduce consumption and must pay the higher price and vice versa. Pricing Policy: Pricing strategies for products or services encompass three main ways to improve profits. These are that the business owner can cut costs or sell more, or find more profit with a better pricing strategy.
When costs are already at their lowest and sales are hard to find, adopting a better pricing strategy is a key option to stay viable. In pricing its products , supplier ought to know the price elasticity of demand for the products.
This is important because whether revenue can be increased or not depends on knowledge about how to apply the concept of price elasticity of demand in this regard. When the price of a product is increased or decreased, the revenue (total revenue) also changes except where the demand is unit elastic.
As to whether the revenue will increase or decrease when price is adjusted, depends on the price elasticity of demand for the product. When the price of a product is increased, the total revenue derived from the sale of the commodity, will increase, if the demand for that product is inelastic. This is because the increase in price of the product by the seller (for whatever reason) results in a less than 1 percent decrease in quantity demanded.
In other words, since the demand is inelastic, the decrease in the buyer’s quantity purchased as a result of increase in price, is not large enough, compared to the increase in the price.
For the fact that we multiply price by quantity to get revenue, it means, for inelastic demand, increase in price will lead to increase in revenue. For this reason, for a product that has inelastic demand, the firm, producer or supplier must increase price in order to increase revenue. Pricing Objectives: * Current profit maximization * Current revenue maximization Maximize long-term profits by increasing market share and lowering costs. * Maximize quantity * Maximize profit margin * Quality leadership An application of price elasticity of demand on producer pricing policy: Say product X is initially $100 and demand for A at that price is 21 units. Price of X increases to $150 and demand falls to 15 units. In this case the demand is inelastic (% change in quantity is less than % change in price).
Revenue at the initial price is $100 ? 21 = $2100. At the new price of $150, revenue = $150 ? 5 = $2250. Clearly, revenue increases when price of good X increases. Thus for a commodity with inelastic demand, we increase its price in order to increase total revenue and vice-versa for decrease in price. Say product X were to increase from $100 to $120 (20% change) and the related demand falls from 60 to 20 units (66.
67% change), indicating that demand is elastic for good X. Total revenue at price $100 is $100 ? 60 = $6000. However, when price of X increases to $120, revenue falls to $2400 ($120 x $20).
Since revenue before the increase in price is more than after the price increase, and knowing that the demand is elastic, it shows that for a product with elastic demand, seller will have to reduce the price to increase revenue. For unit elastic demand, a change in price of the product results in the same % change in quantity demanded.
Say a product falls from $51 to $50 (2% fall in price) and its quantity increases from 100 to 102 (10% rise in quantity demanded), then total revenue at $50 is $51 ? 100 = $5100. The revenue at price $50 is also $50 ? 02 = $5100. Total revenue at both the prices is the same i. e. $5100. For unitary elastic demand therefore, an adjustment in price as an attempt to increase revenue will not yield any results.
Optimal Pricing Policy: Optimal pricing policy is also known as perfect price discrimination, which means that a company segments the market into distinct customer groups and charges each group exactly what it is willing to pay. The optimal price and volume refer to the selling price and volume at which a company maximizes its profits.
It is impossible for a small-business owner to know exactly what consumers are willing to pay because he would have to poll them at regular intervals. Still, he can make reasonable assumptions based on historical sales patterns and set his product mix and pricing strategy accordingly. Optimal pricing is possible only when there is a difference in price elasticity for different consumer groups. The factors that affect price elasticity include the availability of substitute products and the proportion of disposable income required to buy certain product.
The price elasticity will be high if consumers can buy alternative products or if they have to pay too much of their income. 3. Conclusion: According to the information above we have concluded that the price elasticity of demand helps the management to decide on sales and pricing policies for products and services. Price elasticity indicates the sensitivity of customer’s decision to changes in pricing, which in turn affects sales, revenues and profits. An optimal pricing policy maximizes profits by fixing exactly what the market will bear.
Managers may adjust their pricing strategies depending on changes in the competitive environment and in customer’s demands.
4. References: 1. http://www. netmba. com/marketing/pricing/ 2.
http://www. netmba. com/econ/micro/demand/elasticity/price/ 3. http://www. enotes. com/business/q-and-a/discuss-importance-elasticity-demand-and-its-146187 4.
http://economics. about. com/cs/micfrohelp/a/priceelasticity. htm 5. http://www.
tutor2u. net/economics/revision-notes/as-markets-price-elasticity-of-demand. html