How price elasticity of demand affects total revenue

Price elasticity of demand (PED) measures how much the quantity demanded changes in response to a price change. It plays a key role in predicting how adjustments in price will influence a firm's output levels and overall sales income. The impact on total revenue depends on whether demand is elastic, inelastic, or unit elastic, especially for a demand curve that slopes downwards.

Effects of price changes on total revenue

For a downward-sloping demand curve, the relationship between PED and total revenue can be summarised as follows.

For example, if demand is elastic, lowering the price leads to a proportionally larger increase in quantity demanded, boosting total revenue.

The relationship between PED and marginal revenue

Marginal revenue represents the additional income gained from selling one more unit of output. Its connection to PED helps explain how changes in output affect total revenue.

How PED influences marginal revenue

• When PED > 1 (elastic demand) - Marginal revenue is positive, meaning total revenue rises as output increases.
• When PED = 1 (unit elastic demand) - Marginal revenue equals zero, and total revenue reaches its maximum point.
• When PED < 1 (inelastic demand) - Marginal revenue becomes negative, causing total revenue to fall as output increases.

Operating in the elastic section of the demand curve allows for positive marginal revenue and growing total revenue.

Strategies for revenue maximisation based on PED

Revenue maximisation happens when a firm achieves the highest possible total revenue, often by adjusting prices according to the elasticity of demand. This point typically occurs where marginal revenue is zero.

Approaches to maximising revenue using PED

• In elastic demand scenarios - Firms should consider reducing prices to stimulate a significant rise in quantity demanded, leading to higher total revenue. This strategy works well in competitive markets where customers are sensitive to price changes.
• In inelastic demand scenarios - Increasing prices is more effective, as the drop in quantity demanded is small, resulting in greater total revenue. This is common for essential goods where buyers have fewer alternatives.
• Penetration pricing - Firms might deliberately set prices low to produce beyond the profit-maximising output, aiming to capture a larger market share in expanding markets. This accepts short-term lower revenue per unit for long-term gains in sales volume.

Revenue maximisation compared to profit maximisation

While revenue maximisation focuses on achieving the highest sales income, profit maximisation prioritises the greatest difference between total revenue and total costs. These objectives can lead to different pricing and output decisions.

Key differences between revenue and profit maximisation

Point of maximisation:

• Revenue is maximised where marginal revenue equals zero.
• Profit is maximised where marginal cost equals marginal revenue.

Potential for supernormal profits:

• Even if a firm maximises revenue, it can still earn supernormal profits (where total revenue exceeds total costs by more than a normal return).
• However, this does not guarantee the highest possible profit, as revenue maximisation might involve higher output levels that increase costs disproportionately.

Business implications:

• In growing markets, firms might prioritise revenue maximisation through strategies like penetration pricing to build market share.
• This may mean producing more than the profit-maximising quantity in the short term.

Firms must balance these goals based on their market position and long-term objectives.

The kinked demand curve model in oligopoly

In oligopolistic markets, where a few firms dominate, the kinked demand curve model explains price stability. It assumes that competitors react differently to price changes, creating a 'kink' in the demand curve.

Features of the kinked demand curve

• Above the kink (elastic demand) - If a firm raises its price, competitors are unlikely to follow, leading to a large drop in sales as customers switch to rivals. This section of the curve is relatively elastic.
• Below the kink (inelastic demand) - If a firm lowers its price, competitors will match it to avoid losing market share, resulting in only a small increase in sales. This section is relatively inelastic.
• Revenue maximisation at the kink - The kink point represents the price where revenue is maximised.
• Price stability - Firms have little incentive to alter prices, since increases risk significant sales loss and decreases offer minimal gains. This leads to stable prices in oligopolies, even without formal agreements.

This model illustrates how interdependent behaviour in oligopolies promotes consistent pricing.