Generating revenue is a necessary part of running a successful business. Total revenue is the total amount of money a company takes in by selling goods and services. A company's total revenue must exceed its costs in order to achieve profitability; if a company cannot at least make up its costs in revenue, it will lose money, which can result in business failure over time. Price elasticity of demand is an economic concept that influences the total revenue a business generates.
What is the Elasticity of Demand?
Price elasticity of demand describes how much a change in price will affect the level of demand for a certain product or service. If a certain good or service has high price elasticity, demand will tend to fall quickly if the price of the good or service increases and demand will increase quickly if the price of the good or service falls. On the other hand, for goods and services with low price elasticity, an increase in price will cause a relatively small drop in demand and a price cut will result in a relatively small increase in demand.
Elasticity of Demand and Total Revenue
The total revenue a business earns equals the total amount of goods and services sold times the price of those the goods and services. Price elasticity affects the total revenue in that it governs how much more or less revenue a business will make by changing the prices of products or services. For example, if a company currently sells 100 shirts a month at a price of $10, its total monthly revenue is $1,000. If it increases the price of shirts to $12, the company might still sell 95 shirts a month if the demand for shirts is relatively inelastic. At the new price level, the company earns $1,140 in total revenue a month. On the other hand, if consumers are very sensitive to the changes in the prices of shirts, the company might only sell 60 shirts a month at the $12 price. In this case, the company's total revenue would fall to $720 a month.
When a business increases the price of a product, two conflicting effects come into play that determine whether the price change increases or decreases total revenue: the price effect and quantity effect. The price effect is the impact of the increased amount of revenue the business makes for each unit sold. The quantity effect is the impact of decrease in the quantity sold due to lower demand. If the total positive impact of the price effect exceeds negative impact of the quantity effect, a price increase will raise total revenue. In the previous example, the price effect of earning $2 more per shirt for 95 shirts outweighed the lost revenue of selling five fewer shirts, but the positive impact of selling 60 shirts for more $2 per shirt did not outweigh the negative impact of selling 40 fewer shirts.
Goods that are considered necessities people need to work or live normally tend to be inelastic, meaning consumers will not alter demand for the good much, despite price changes. Goods like gasoline, milk and other food staples tend to be inelastic.