Further on Price Elasticity of Demand: Shifting; flattening and/or steepening; increasing competition, rotating the demand curve to a flatter position (price elasticity at each price increases)
When demand curve shifts to the right, price elasticity decreases with each price --- (greater ability to increase revenue with price increase)
Product differentiation (advertising) aims to reduce competition/ substitution effect --- (greater ability to increase revenue with price increase)
As just explained, the relationship of the price of a good to the quantity demanded, (QD) of that good is normally negative and thus has an inverse relationship – when price rises, the quantity demanded of that good falls and price falls, quantity demanded of that good rises. The degree to which QD responds to price depends upon substitution effects & income effects. As we saw, most goods are normal, so more often than not, the income effect does reinforce the substitution effect.
TR = P X QD
The total revenue a firm receives from selling a product depends upon the product of Price times Quantity Demanded (P X QD)…price times quantity demanded equals revenue (P X QD = Revenue). Now you have to stop and pause and think about this.
… All else equal (ceteris paribus),
Profits = Revenue – Expense (cost)
When revenue rises, profits rise
When revenue falls, profits fall
…ignoring cost for the moment…
Again, technically, the percentage change in quantity demanded divided by the percentage change in the price that caused the change in the quantity demanded
(QD1 – QD2)/QD1 / (P1 – P2) / P1
Note: In other words we have to rule out all the factors that influence the quantity demanded. If we don’t, then we don’t have price elasticity of demand – that has to be understood.
So if you are trying to do this in real life – measure price elasticity, you would have to have complicated statistical routines which were able to mute the effects of all the changes that influence quantity demanded other than the price of that good itself.
Now we should stop here and point out when we say the demand curve we are talking about the relationship of the price of that good to the quantity and demand of that good, everything else held constant (see figure: higher price…movement from QD1 to QD2).
The aim of advertising is to reduce the substitution effect; thereby causing the demand curve to become steeper or more parallel to the price axis, and thus reduces price elasticity demand of each price (this is the opposite of what we saw earlier).
So we have several reasons why price elasticity can change, one is that when you move along the demand curve (almost all the demand curves, linear and curvilinear up to a point where they become hyperbolic), it means that you change the price; price elasticity decreases because you go down the demand curve and increases as you go up.
Starting from the quantity axis (X-axis) you go through an inelastic range, where a price increase causes revenue to rise but at a decreasing rate. You reach the midpoint where price elasticity is unitary (or one), where price increases in that narrow range (or decreases) do not change the revenue. Then into the upper half of the demand curve (be it a linear curve or curvilinear), where price increases cause total revenue to fall. That’s the basic concept of price elasticity for a given demand curve.
Further on Price Elasticity of Demand: Shifting; flattening and/or steepening
· When competition increases, rotating the demand curve to a flatter position, price elasticity at each price increases
· When demand curve shifts to the right, price elasticity decreases with each price
· Product differentiation (advertising) is, in effect, a reduction in competition, reducing the substitution effect; convincing people that other goods are not as substitutable and that causes the curve to rotate and become steeper and more parallel to the price axis
· This is extremely important because the basic business decision to know what to produce, how much to produce, when to expand, when to contract production, etc., depends upon the relationship of revenue, cost, and profits (Profit = Revenue – cost)