When to Vary Prices to Maximize Profits? Price Elasticity Answers the Question!

Suppose you are asked to decide whether to increase or decrease the price of a product to maximize profits for your company, your career and reputation go at stake. Your right decision can open more windows of opportunity, and a wrong decision can cost you even your job.

In such a situation the concepts of price elasticity of demand and supply help you to make the most economical decision. Increase in price to maximize profits is very attractive and it should bring more benefits to your company. However, in case of elastic products the increase can decrease the profits in most of the situations. In public policy formulation, a price tag with specific acts or commodities can help you to make your policies better for the general public. It also helps to control market failure in case of adverse externalities. Besides, the public managers can also analyze the incidence of direct or indirect taxes and measure wealth distribution in different income groups of the society.

The basic question would be:

“What will be the impact of increase/decrease in price on total revenue of your product?” 

In case of elastic products, the total revenue decreases with increase in price. However, in case of inelastic products, the increase in price increases total income. But how much would be the impact of such increase or decrease?

Price elasticity answers this question.

Applications of Price Elasticity

In all public or private situations of price variation, the concept of price elasticity becomes very important. There are some serious situations to help you to expand the applications in your own decision-making situation.

What should be Price of Your Product?

It is the most basic application of price variation. Whenever you are required to decide price variation for maximization of profits, you can use the concept and calculations of price elasticity of demand as well as supply. When the demand for the product is elastic to change of price, the increase in price may cause a decrease in profits. An increase in the price of inelastic products may cause a corresponding increase in the profits.

Suppose you are selling school books for which demand is inelastic. You increase 10% price on this book and you shall generate 10% more revenue. However, if you are selling general books for which demand is elastic, you decide to increase the price on these products by 10% there may be a decrease in revenue or very slight increase in comparison to the rise on school books.

What Should be Price of Joint Products?

There are several products which are produced jointly. For example, wheat and chaff are jointly produced in agriculture. Similarly, wool and meat are produced jointly in sheep farming. Sugar and wine can be produced jointly in the sugar industry. There are a lot of such things which are produced jointly for one reason or the other.

In such all situations, the cost of joint products is shared by each other, so it is not easy to find out exact cost to produce one item which creates difficulties in fixing prices individually. In such a situation, the price elasticity of demand helps us to determine the price of the jointly produced products to maximize profits. If the price elasticity of demand for the product is inelastic, you can put a high price tag confidently that it shall be sold well. However, you will have to fix a lesser price for the product which has elastic demand.

What should be Price for Factors of Production?

Almost all production managers have to deal with the cost of factors of production including labor, capital, and raw material. Most probably, you are not going to fix the price of these factors, but you have to pay it for production of your own products. Suppose you are producing mobile phones, you will have to pay for labor, steel, plastic, technical developments, etc. What will you pay to make the price of the end product acceptable to the sellers as well as consumers?

Suppose you have set up a mobile phone producing company in New York, the demand for labor would be inelastic. You can’t afford to pay less otherwise other producers shall hire the same workers at an increased wage. On the other hand, if you have established your factory in Pakistan you may not face such problems regarding availability of labor. You can hire better and better people at lower wages and still there would be a lot of pressure for more jobs. In the latter situation, you can maximize your profits even by placing a lesser tag of price than your competitors.

Importance of Supply & Demand

Origin of Supply and Demand Model

Supply and Demand Lesson

Elasticity Definition

Price Elasticity of Demand

Measurement of Demand Elasticity

Point Elasticity of Demand

Income Elasticity of Demand

Applications of Income Elasticity of Demand

Supply Curve and Elasticities

Perfect Price Elasticity of Supply

Relative Elasticities and Inelasticity of Supply

Exceptions to Demand and Supply