Revenue and Price Elasticity of Demand

Price Elasticity of Demand and Revenue

One important question for a company is what price it should charge for its output. Would it make sense to raise prices? To lower prices? To answer this question, it's important to consider how many sales would be gained or lost due to the changes in price. This is exactly where price elasticity of demand comes into the picture.

If a company faces elastic demand, then the percent change in quantity demanded by its output will be greater than a change in price that it puts in place. For example, a company that faces elastic demand could see a 20 percent increase in quantity demanded if it were to decrease price by 10 percent.

Clearly, there are two effects on revenue happening here: more people are buying the company's output, but they are all doing so at a lower price. In this, the increase in quantity more than outweighs the decrease in price, and the company will be able to increase its revenue by decreasing its price.

Conversely, if the company were to increase its price, the decrease in quantity demanded would more than outweigh the increase in price, and the company would see a decrease in revenue.

Inelastic Demand at Higher Prices

On the other hand, if a company faces inelastic demand, then the percent change in quantity demanded its output will be smaller than a change in price that it puts in place. For example, a company that faces inelastic demand could see a 5 percent increase in quantity demanded if it were to decrease price by 10 percent. 

Clearly, there are still two effects on revenue happening here, but the increase in quantity doesn't outweigh the decrease in price, and the company will decrease its revenue by decreasing its price.

Conversely, if the company were to increase its price, the decrease in quantity demanded wouldn't outweigh the increase in price, and the company would see an increase in revenue.

Revenue Versus Profit Considerations

Economically speaking, the goal of a company is to maximize profit, and maximizing profit is not usually the same thing as maximizing revenue. Therefore, while it may be appealing to think about the relationship between price and revenue, especially since the concept of elasticity makes it easy to do so, it's only a starting point for examining whether a price increase or decrease is a good idea.

If a decrease in price is justified from a revenue perspective, one must think about the costs of producing the extra output in order to determine whether the price decrease is profit maximizing.

On the other hand, if an increase in price is justified from a revenue perspective, it must be the case that it is also justified from a profit perspective simply because total cost decreases as less output is produced and sold.