Answer to Question #130192 in Economics of Enterprise for Sibongile

Question

Explain the type of pricing strategy that you as the manager of a company would implement for Good X and Good Y with the following price elasticity of demand co efficient.use diagrams to motivate your answer. Good X 2.3 and Good y 0.6.

Answer 1

Elasticity of demand is one of the factors affecting pricing strategies. Good X , whose price elasticity of demand is 2.3, is elastic in demand whereas good Y, whose price elasticity of demand is 0.6, is inelastic in demand. We will assume that the company in question seeks to maximize revenue and profits.

Good X must therefore be priced slightly low since quantity demanded is highly sensitive to a price change. A slight change in the price of good X will result in a more than proportionate change in quantity demanded. Therefore, to maximize revenue, good X must be priced slightly low so as to gain from a huge increase in sales volume. This is shown by the graph below.

As shown on the graph above, when demand is elastic, a slight change in price, P1-P2,results in a more than proportionate change in quantity demanded, Q1-Q2. It is therefore beneficiary to slightly reduce the price and gain from a huge increase in quantity demanded.

Good Y must be priced high in order to maximize revenue. By virtue of being inelastic in demand, quantity demanded is less sensitive to a price change. As a result, a huge increase in price will reduce quantity demanded by less than a proportionate amount. This is illustrated on the graph below.

As shown on the graph above, a huge change in price between P1 and P2 results in a less than proportionate change in quantity demanded between Q1 and Q2. Thus, it is more beneficiary to price high and skim market revenue without significantly affecting sales volumes.

Therefore, in general, goods elastic in demand must be priced low whereas those inelastic in demand must be priced high in order to maximize revenue. The graph below illustrates the relationship between price elasticity of demand and total revenue.

As shown on the graph, the firm enjoys increased total revenue by lowering the price and sale more when demand is elastic. When demand is inelastic, a reduction in price to sell more will result in a fall in total revenue. Total revenue is maximized when price elasticity of demand is unitary.

This concludes that, for the firm to maximize revenue, the demand elastic good X should be priced low whereas the demand inelastic good Y must be priced high.