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Examine Microeconomic Tools

Examine Microeconomic Tools

Examine microeconomic tools for purposes of problem solving, analysis, and decision-making.

GB540M2

Michelle Freeman

October 5, 2020

· Explain the relationship between the price elasticity of demand and total revenue. What are the impacts of various forms of elasticities (elastic, inelastic, unit elastic, etc.) on business decisions and strategies to maximize profit? Explain your responses using empirical examples, formulas, and graphs.

Price elasticity of demand is the measure of change in the quantity of a product in demand to its price change (Price Elasticity of Demand, n.d.). Price elasticity is used to understand how supply or demand change is affected by the changes in price. The law of supply and demands states that when price increases, demand decreases. If the quantity of goods increases the market price increases this is known as the law of supply. However, this is a general rule that does not explain all factors that impact the supply and demand model. One of the quantitative measurements like elasticity was introduced to provide more details about market behavior.

Price elasticity is used to understand how supply or demand creates change in price. Some goods such as necessities are very inelastic for example housing and electricity. Meaning that their prices do not change due to changes in supply and demand. Price elasticity of demand is the concept of collecting the most revenue and the total revenue is the price multiplied by the quantity sold. The market is always fluctuating and when the price of a product changes the elasticity reveals if firms can pass higher cost to consumers.

Price elasticity and total revenue is important because elasticity management determines the necessary changes with regards to pricing policy and services. For a company’s revenue, one of the key factors is establishing the right price. This allows the price elasticity analysis to predict what their marginal revenue should be. This kind of economic analysis uses a specific calculation shown as Price Elasticity of Demand is equal to change in percent in Quantity Demanded divided by the Percentage of Change in price (Kenton, 2020), this is the ideal relationship between elasticity and marginal revenue. Companies can use the price elasticity of demand when setting pricing policies.

By using an optimal pricing policy firms can maximize the profit and have prices that closely match the market. To achieve this, managers should examine all factors that influence elasticity such as type of goods, price, income, and substitute availability.

The three types of goods include necessity, comfort, and luxury goods. As stated earlier, necessities are inelastic therefore the demand does not change since people need to use them. Comfort and luxury items are more elastic because economic changes could cause less consumer demand. Variables can include consumer’s taste and point of view.

Next is the price factor. This can affect demand elasticity because a change in the price level can cause a change in quantity of demand. For example, a luxury product might reduce their prices due to a surplus in inventory to increase demand. If prices are reduced low enough the product might be affordable to consumers who could not afford the luxury item at the original price.

Characteristics of a product itself affects elasticity. The more unique the product is the more willing customers to spend more money on it although the price is higher. A recent study shows that 73 percent of consumers are willing to pay more for good service and willing to pay 12 percent more for a product if accompanies by excellent customer service. Rolex is a good example because if you want to tell time you can buy a Timex for $24 to $50. However, consumers are willing to pay $10,000 for the Rolex because they perceive it to be unique and of high quality and in this case, you can set the price. On the other hand, if the product is not unique and customers can buy it somewhere at a cheaper price the consumer will go for the more affordable price. In this case the price increase can cause a drop in sales reciprocating a decrease in profit.

Then there is the income factor. This influences the demand elasticity of goods and services based on the income level of the population. For example, a decline in annual incomes may cause luxury items to be more elastic. Meaning the people may be inclined to save rather than spend money on luxury items.

Elasticity is greatly dependent on the consumer’s income. A consumer with higher income will spend $20 dollars or more at Wawa for groceries and household items without placing emphasis on price. This is a small portion of their income and the price difference is insignificant to them. The price a higher income family is willing to pay is different for a family with a smaller income. If the price is higher at a convenience store like Wawa than those at a supermarket then the low-income consumer will prefer to skip to trip which will lead to a decrease in profit.

Lastly, there is the substitute availability factor. When a product or service has many competitors, the best strategy is a price cutting. A good example would be gas. If Chevron gas station has a price of $2.49 per gallon and the Marathon down the street has $2.19 per gallon Chevron will not have as many customers as Marathon therefore, they will experience a decrease in profits.

A temporary price change can significantly affect revenue. Sales increase the quantity of product sold which outweighs the price drop and leads to revenue increase. To set correct pricing a company should consider the previous mentioned factors as well as the characteristics of demands such as elastic or inelastic.

Demand for goods and services is elastic when a change in quantity demanded is greater than the change in price. For example, is there is a 10 percent decrease in price this will cause a 20 percent increase in demand. The effect of this change is that consumers are buying more product from the company. They are buying it for lower prices which outweighs the quantity increase of the product and services. In this case the company will benefit from these changes by the increase in profits.

It the demand for a company’s output is inelastic then the change in price will have a smaller effect on the change in quantity. If the price is cut by 10 percent, this will cause an increase in demand by 5 percent. For this example, the quantity increase will not outweigh the price therefore the company’s profit will decrease. At the same time, if there is a price increase for the products, they will experience a significant decrease in demand while profits increase.

With respect to the law of demand when the price moves in one direction and quantity sold moves in the other there will be a change in revenue with the exclusion of unit elasticity. If the price and quantity change are both the same, then the total revenue will not change.

The goal of any firm is to maximize their profits which may not translate the same as maximizing revenue. Although it may be appealing to correlate the relativity between price and revenue, it is just the starting point for examining whether a price increase or decrease is a good idea.

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