A direct relationship does not exist between a company’s incoming revenue and the prices of its products. Higher prices do not always lead to higher profits for a business. When prices change, a company must consider the economics concept called elasticity to determine the true impact of the change on total revenue. Therefore, a change in price can either cause total revenue for the company to increase or decrease.
Elasticity of Demand
The elasticity of demand indicates a give-and-take relationship between the price of a product and how much consumers will pay for it. Thus, depending on the elasticity of a specific product, when a company raises its prices, the same amount of customers may no longer purchase the product at the new, higher price. The change in total revenues from these products, then, must take into account the resulting change in sales demand from the price change.
The Price-Demand Relationship
A change in price does not always have to result in an increase in revenue. When a company makes the decision to lower prices, the company must also consider that it may acquire additional customers with the change, especially if the decrease in price is substantial enough to include a new market. In this case, the immediate decrease in revenues per item may be offset by the increase in customers resulting from the lower prices.
Determining the Effect on Total Revenue
In order to fully predict the projected effect a change in prices will have on total revenue, a company can conduct preliminary research into the market, and any new markets that may result from the price change. By determining what consumers in these markets will pay, and considering the price change and also what these customers will pay, a company can more accurately predict the actual net effect of price changes on total revenue.
The ultimate consideration when predicting how a price change will affect total revenue is the elasticity of the market. This elasticity will depend on the market as a whole and any specific target markets. A highly elastic market is one in which individuals do not respond to the change in price. In other words, customers will continue to purchase the products in the same quantities after the price increase in an elastic market. In an inelastic market, the change in price produces a noticeable change in the quantity of items purchased. Therefore, a price increase in an elastic market would lead to an increase in a company’s total revenue. However, a price increase in an inelastic market would result in decrease in total revenue.
- "Price Theory: An Intermediate Text"; David D. Friedman; 1990
- California State University, Northridge: Price Theory Lecture 1: Basic Notions and Concepts
- "Principles of Economics"; N. Gregory Mankiw; 2008