Marginal Revenue and Price Elasticity of Demand

What is Price Elasticity of Demand?

Price elasticity of demand shows what happens to price when the demand for a product changes. It is obvious that demand and prices are related to each other. When the price increases, usually, the demand for the product goes down. Alternatively, when the price of demand for a product goes up, the price shall come down. This means that price and demand have an inverse relationship. When there is a rise in one of the factors, the other factor goes down. When this inverse relationship holds good, the product is said to have price elasticity. Luxurious items such as high-end electronic items have enough price elasticity.

On the other hand, items that do not show the price-demand relationship are said to have an inelastic relationship. An example of price inelasticity is the price of cooking gas. People have no other choice but must resort to buying gas even if the price of the product goes up. Moreover, people have no other choice than to cut back consumption when the price of cooking gas goes up.

Therefore, even when the price increases, the demand does not go down. Such inelastic conditions are however limited to highly essential products and many governments control the prices of these essential items so that people don’t have to suffer when the price of the items goes up.

Price elasticity is, therefore, the nature of prices going up and down with increasing and decreasing demand respectively. One can check which items have elasticity by checking if the prices of the products change with changing demand and this will show which items are more price elastic than others.

What is Marginal Revenue?

The term margin always indicates something extra. In the case of marginal revenue, the term indicates the extra revenue generated by changing the price. It is well known to everyone that changing prices has an inverse effect on the demand for products. As discussed above, the demand for products usually goes up when the price goes down. Companies can use this idea to increase revenue from sales of their products. What the companies do is, reduce the price of the items they produce, and with the increased sale, the revenue of the items increase. This offers greater revenue and profits. The extra income generated in this process is known as marginal revenue.

For example, a pizza-selling restaurant may sell each pizza at a price of Rs 200. It may sell 10 pizzas every hour to get an hourly revenue of Rs 2000. If it decreases the price by Rs 10, it sells 12 pizzas an hour. So, the revenue the restaurant earns now is 2,280 per hour. So, there is an increase of Rs 280 in revenue per hour for the restaurant. This Rs 280 is known as the marginal revenue of the restaurant.

In practice, however, companies do not reduce the prices abruptly to increase revenue. They start with the best-increased price and wait for the demand to drop down. When demand reaches a certain lower level, they reduce the prices of the items to increase revenues.

Relation between Price Elasticity and Marginal Revenue

When the item is price elastic, elasticity may play a crucial role in earning marginal revenue. Companies usually understand whether their products are price elastic or not and use the principle to maximize their revenues.

For example, a lollipop of Rs 2 may sell only 500 units a week providing revenues of Rs 1,000. When the prices are slashed to Rs 1.50, it may sell 1,000 units providing total revenue of Rs 1500. The marginal revenue of Rs 500 is notable in this situation.

• It is observed that for items that are price elastic, even a small change in the price changes the demand considerably. Therefore, it is important to keep an eye on which products are price elastic for the companies to drive more revenue by using the idea of price elasticity of demand.

• Usually more items in the market are price elastic in nature in comparison to products that are not price elastic. The items that are not price elastic include highly essential products and services that are controlled by the government and authorities. It is done so to stop businesses from exploiting people because people have no other option but should buy the items at any cost.

Relation between Price Inelasticity and Marginal Revenue

• The converse of the theory is also applicable in the case of goods and services that are price inelastic. For price inelastic items, the marginal revenue may not increase due to a decrease in the prices of the commodities.

• In fact, in some cases, the opposite may happen. It has been observed that in some of the cases of price inelastic items, the revenue goes down when the price of the items is slashed.

• The more an item is price inelastic, the more the chances of it being sold when prices are decreased. The items that have a longer useful life are prone to fall into this category.

For example, toilet papers usually show price elasticity. Let’s suppose that a roll of toilet paper is sold for Rs 100 and it sells 100 rolls. So, the total revenue earned from the sale is Rs 10000. When the prices are reduced to Rs 90, only 80 rolls may get sold bringing revenue of Rs 7,200. So, there is a negative revenue of Rs 2,800 in the case of toilet paper which shows high price inelasticity of demand.

Key Takeaways

• The demand and price of items are related to one another.

• In the case of price-elastic goods, the demand for items increases when the price of the item is reduced.

• Price elastic demand shows an inverse relationship between price and demand.

• Companies may use price elasticity in their favor to increase the overall revenue earned from the product’s sale.

• Some products show price elasticity.

• Price inelastic items may show negative demand for the products the prices of which are reduced.

Conclusion

The price elasticity of demand and marginal revenue are intricately related to each other. It is therefore important to understand the relationship to use the idea to maximize the revenues. Companies look for ideal opportunities to increase or decrease the prices of their products depending on the price elasticity theory. That is why it is considered so important in business circles.

FAQs

Qns 1. What type of relationship exists between revenue and price elastic demand of products?

Ans. An inverse relationship exists between revenue and demand for price elastic items.

Qns 2. Is it possible to have negative revenues while prices are reduced for an item?

Ans. Yes. In the case of price inelastic items, there may be negative revenues generated after the reduction of the price of an item.

Qns 3. How do companies use price elasticity in their favor?

Ans. Companies may use price elasticity in their favor to increase the overall revenue earned from the product’s sale.