Economics – Price elasticity, income elasticity and cross elasticity of demand | e-Consult
Price elasticity, income elasticity and cross elasticity of demand (1 questions)
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Answer:
A highly price elastic demand curve indicates that consumers are very sensitive to changes in price. A small price increase will lead to a proportionally large decrease in quantity demanded. This has significant implications for a firm's pricing strategy.
Pricing Strategy Implications:
- Avoid Price Increases: Given the elasticity, raising prices would likely result in a substantial drop in quantity sold, leading to lower total revenue. The firm should generally avoid price increases.
- Focus on Cost Reduction: Instead of relying on price increases, the firm should prioritize reducing production costs. If costs can be lowered, the firm can maintain profitability even with lower prices.
- Consider Promotional Strategies: The firm could employ promotional strategies like discounts, sales, or loyalty programs to stimulate demand without significantly impacting revenue. These strategies aim to shift demand slightly and maintain sales volume.
- Product Differentiation: If the product is differentiated from competitors (e.g., through branding, features, or quality), the demand may be less elastic. This allows for some price flexibility.
Revenue and Profitability Implications:
- Revenue Impact: A price increase will lead to a decrease in total revenue. A price decrease will lead to an increase in total revenue, but the increase will be less than proportional to the price decrease due to the elasticity.
- Profitability Impact: If costs are kept constant, a price decrease can improve profitability. However, if costs are high, even a price decrease may not guarantee profitability. The firm needs to carefully analyze the relationship between price, cost, and demand elasticity to maximize profit. A firm with low cost structure can benefit from a price decrease.
In conclusion, a firm facing highly price elastic demand should prioritize strategies that maintain or increase sales volume through cost reduction or promotional activities, rather than relying on price increases. The goal is to maximize revenue and, ultimately, profitability within the constraints of the elastic demand.