Price Elasticity of Demand and Its Impact on Business Profitability

The Price elasticity of demand measures the responsiveness of the quantity of goods sold to the changes in the product’s price. When the percentage change in the sales is more than the percentage change in the price of the product, the demand for the product is said to be Elastic. Such a product will exhibit a greater percentage increase in sales being followed by a smaller percentage decrease in price (Peterson & Lewis, 1999).

When demand is elastic (Ep > 1), price cuts are associated with increase in total quantity demanded and hence increase in revenue. However, for a linear demand function, beyond a certain range the decrease in price results in inelastic demand. So a business owner would want to own a firm that sells price elastic products when the prices are low or falling. If the price is lowered by one percent, the demand for the product rises by more than one percent benefiting the owner in the form of increased revenue.

The impact of price elasticity on demand is not a standalone factor and there are a range of other determinants that regulate the demand flow. The price elastic product is also affected by the market structure in which the firm operates. The Structure-Conduct-Performance (SCP) hypothesis states that the performance of a firm is determined by its conduct, which in turn is determined by structure of the market. For a firm dealing in price elastic goods, the type of market structure it operates in is a vital determinant of potential profits.

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A firm would like to own a business that sells price elastic products only when it has the power to control and manipulate the price of the product to gain benefits from the increased demand. In a perfect competition market structure, there are a large number of buyers and sellers competing with each other in the purchase and sale of goods and no single seller has any influence over the price. If the firm operating in this kind of a market structure lowers the price, the competitors will also do so and the firm will not be able to gain much from the reduced price, inspite of the price elastic product.

Since there is no influence of the any firm on the price, the demand curve is perfectly elastic shown by a horizontal demand curve. The firm can make some profits in the short run, but the firm will need to continue producing as long as the price is greater than the average variable cost as a profit maximizing strategy which is better than shutting down. There is no attraction for any firm to enter or operate since they can only earn minimal profit by setting price equal to the marginal cost.

The firm dealing in price elastic products might gain supernormal profits if it operates as a monopoly in the industry, where it is the price maker. If the firm is the only seller and there are no other close substitutes of the product available in the market, the firm has the power to control the price and the subsequent demand. According to McConnell, Brue and Campbell (2004), the firm might reduce the price in order to increase the sales to the desired level, hence earning increased revenue.

The price can be set much higher than the marginal cost, thus letting the firm earn supernormal profits even in the long run. Also, depending on the market size, the monopoly firm may exceed the optimum size to over-utilize its long run capacity (Dwivedi, 2008). Thus, I would like to own a firm that sells price elastic products if the firm has its monopoly in the industry and can afford to reduce the price of the product and yet earn supernormal profits by way of increased demand and the revenue.

In order to understand the impact of price elasticity on demand and revenue for a monopolist market structure, we use hypothetical data (Table 1) to plot the curve (cliffnotes, Profit maximization).

References

• Dwivedi, D. N. , (2008). Managerial Economics. Institute of Management Technology: Centre for Distance Learning, Ghaziabad. McConnell, C. R, Brue, S. L. , & Campbell, R. R. (2004). Microeconomics: Principles, Policies and Problems (16th ed). McGraw Hill Professional retrieved on March 16, 2009, from http://books. google. co. in/books?
• id=hObpeG6v1VsC&pg=PA201&lpg=PA201&dq=profit+maximization+demand+curve+for+monopoly&source=bl&ots=7E8Jy3v4qG&sig=ZMsaDU61mzFsR9tdG9mzziz9R_U&hl=en&ei=TYW-Sf6cHszzkAWdlqHlCw&sa=X&oi=book_result&resnum=6&ct=result#PPA197,M1 Peterson, H. C. , & Lewis, W. C. ,(1999). Managerial Economics (3rd ed. ). Prentice Hall of India. New Delhi. Profit Maximization, CliffNotes: Fastest Way to Learn Retrieved on March 17, 2009 from http://www. cliffsnotes. com/WileyCDA/CliffsReviewTopic/Profit-Maximization. topicArticleId-9789,articleId-9769. html

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