How do you decide when to increase the price to generate a positive impact on the income of your firm?
Does increase in price always maximize profits?
No, it is not like that
According to the simple law of demand, a decrease in price increases demand of the quantity in open competition. However, in case of inelastic products, an increase in price shall add up to your revenue.
In general, the demand elasticity is denoted with Ed. Its value may be one, more than one or less than one. We can interpret these values as under:
Ed<1: Inelastic demand
Ed>1: Elastic demand
Ed=1: Unitary elastic demand
There are some methods to measure price elasticity of demand. However, in general, they are clubbed into three significant ways:
1- Percentage Method
2- Total Expenditure Method
3- Graphic Method
Please keep in mind that price and demand have an inverse relation (an increase of one thing results in the decrease of other and vice versa). The resultant values of measurement of price elasticity of demand shall be invariably negative. We ignore the negativity of the resulting figure to interpret for business needs.
Furthermore, the calculations are made by manipulating values of currency (price) and other measures like weights or numbers (quantity) of the products. What should be the measuring value of the resulting figure?
The resulting figures are not measured in any measurement. They are valueless for their interpretations.
It is probably the most popular method to measure price elasticity of demand. We divide the percentage of change in demanded quantity with the percentage of change in price to find out a level of demand elasticity (degree of sensitivity of a product to the price variation). The formula for price elasticity of demand is:
Ed = %∆Q/ %∆P
Ed= Elasticity of demand
Q= Original Quantity
P= Original Price
∆= Change.
Suppose you are selling 50 candles for 50 dollars. You find that decrease of 10 dollars increases the demand for 60. What would be price elasticity of demand?
Ed= ((60-50)/50) / ((40-50)/50)
Ed= 0.2/-0.2= -1
Ed= 1
You may find following trends at different prices.
Price ($) |
Quantity (Candles) |
50 |
50 |
40 |
60 |
30 |
70 |
20 |
80 |
10 |
90 |
It is a simple method. However, instead of measuring demand elasticity in percentage change, we measure with the help of total expenditures or total revenue on price variation.
Another name for the method is ‘total outlay method.’ In case of total expenditures or total outlay, we can measure demand elasticity as under:
Ed= TE2-TE1
Where:
TE1= Total expenditures before change
TE2= Total Expenditures after change
Understandably, expenditures of consumers on certain products are equal to total revenue of the firm selling that product. So, we can find out demand elasticity with the help of the change in total revenue on price variation.
Ed= TR2-TR1
Where:
TR1= Total revenue before change
TR2= Total revenue after change
We can calculate total revenue by multiplying the price by the quantity.
When total expenditure/revenue decreases, the price elasticity of demand is considered lower than one. When it increases, it is more than one. Where there is no change in revenue with a change in price, we take the demand elasticity equal to one.
When Ed=1, the demand is unit elastic. In other words, the total expenditure or revenue of a firm is not disturbed by a change in price. The increase in price results in lesser demand and decrease results in more demand. However, in both situations, the revenue remains the same.
When Ed>1, the demand and the total expenditure (outlay) move in opposite directions. In other words, a decrease in price increases the cost and an increase in price results in the decrease in the expenditure. The demand is more than unit elastic.
When Ed<1, the demand and total expenditure move in the same direction. In other words, the outlay falls with a decrease in price and increases with increase in price. The demand is less than unitary elasticity.
There are two steps to determine the elasticity of demand in this method. First, we prepare a table of total expenditures or total revenue at different stages. Then we investigate changes in total expenditures or revenue with the change of price.
The private managers use it to know when a decrease in price increases their revenues. However, the public managers can use this method to maximize the availability of essential services at acceptable prices.