Economics – Price elasticity, income elasticity and cross elasticity of demand | e-Consult
Price elasticity, income elasticity and cross elasticity of demand (1 questions)
A firm can use its understanding of PED to maximise total revenue by pricing the product where the Marginal Revenue (MR) equals the Price (P). The MR curve is derived from the demand curve.
Elastic Demand: A firm with a product facing elastic demand should lower its price to increase quantity demanded significantly. While the price per unit is lower, the substantial increase in quantity will more than compensate, leading to higher total revenue.
- Example: A clothing retailer selling fashion items. If the retailer increases prices, demand will drop sharply. Lowering prices will attract more customers and increase overall revenue.
Inelastic Demand: A firm with a product facing inelastic demand should increase its price. Even though the quantity demanded doesn't change much, the higher price per unit will result in increased total revenue.
- Example: A pharmaceutical company selling a life-saving drug. Patients need the drug regardless of price (inelastic demand). Increasing the price will generate significantly more revenue.
Unit Elastic Demand: A firm with a product facing unit elastic demand will maximise total revenue when the price is set at a level where the PED is equal to -1. Any change in price will result in an equal and opposite change in quantity demanded, leaving total revenue unchanged.
- Example: A competitive market for a standard product, where many firms offer similar goods. If one firm raises its price, consumers will switch to competitors, and if it lowers its price, it will attract more customers but at a lower profit margin.
Important Considerations:
- PED is not constant and can change over time due to factors like availability of substitutes, consumer income, and tastes.
- Other factors, such as production costs and competition, also influence pricing decisions.
- A firm must consider the long-term implications of its pricing strategy, including potential impacts on brand loyalty and market share.