Total revenue and price elasticity of demand. This article will explain what determines the price elasticity of demand. Furthermore, the article will explain how firms should change the price of their good in order to increase total revenue. Total revenue and price elasticity of demand.
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DETERMINANTS OF PRICE ELASTICITY OF DEMAND
The following factors determine what the value of the price elasticity of demand is for a good:
- The amount of income spent on the good – If a large proportion of income is spent on the good, the demand is usually price elastic. For example, consumers spend a high amount of their percentage on a car and therefore cars have price elastic demand. However, for a less income consuming good, demand will tend to be price inelastic like bread or milk for example.
- Addictive substances – Addictive substances like alcohol or cigarettes have demand which is price inelastic as consumers are willing to pay whatever it takes for the substance.
- Scope of substitutes – The more substitutes a good has the more price elastic its demand is. For example, a cornetto, which is a type of ice cream, has many substitutes like a choc-ice. However, a less narrowly defined good like ice-cream has fewer substitutes and therefore demand is price inelastic.
- Brand image – Goods with a strong brand image such as Nike or Adidas, will have inelastic demand because consumers are willing to pay extra for them.
TOTAL REVENUE AND PRICE ELASTICITY OF DEMAND
Total revenue is the total income that a company receives from selling goods. It can be calculated by multiplying the price per unit of a good by the quantity sold:
TOTAL REVENUE = PRICE PER UNIT OF GOOD × QUANTITY OF GOOD SOLD
There are many ways a firm can increase its total revenue. For example, adjusting the price of the good according to the price elasticity of demand for the good can lead to an increase in total revenue.
As shown by the diagram above, in order to gain maximum total revenue, a firm must try to get to the unit elasticity point.
If a firm has a good with price inelastic demand, then in order to increase total revenue they must increase the price of the good. This is because the extra revenue they would gain by raising the price would outweigh the loss in revenue due to a loss in demand as shown below:
If a firm increases the price of their good such that demand contracts from point A to B:
The area Pe P1 C B is the gain in revenue but the area A C Qe Q1 is the loss in revenue. It can be seen that on a price inelastic demand curve, the area of gain is higher than the area of loss when price increased. This explains why a firm should increase the price of a price inelastic good.
If a firm has a good with price elastic demand, then in order to increase total revenue they must decrease the price of the good. This is because the extra revenue they would gain by an increase in demand for the good would outweigh the loss in revenue due to a decrease in price per unit as shown below:
If a firm increases the price of their good such that demand extends from point A to B:
The area Q1 Qe B C is the gain in revenue, but the area P1 Pe C A is the loss in revenue. It can be seen that on a price elastic demand curve, the area of gain is higher than the area of loss when the price is lowered. This explains why a firm should decrease the price of a price inelastic good.
In conclusion, if the demand of a good is price inelastic, the price should be increased to increase total revenue. However, if the demand of a good is price elastic then price should be decreased to increase total revenue.
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