Explain how an understanding of elasticity can help business owners determine the most profitable prices to set for their products.
Elasticity of demand of a product is the change in the quantity demanded by customers for a unit change in the price of the product. How many units of a product the business owners can sell does not remain the same as the price of the product is changed. A business owner would be wrong in assuming that if X units of a product can be sold for $M, the same X units can be sold if the price is increased to $2M. Increasing the price by 100% does not lead to an increase in revenue of 100%.
The number of units of a product that are sold generally decreases with an increase in price of the product. The exact decrease in demand for a unit change in price is different for various types of products and this is called price elasticity of demand. As an illustration, an increase in price of something that is essential for survival like food or medicines may lead to a very small decrease in the quantity demanded. On the other hand if a tour operator were to increase the price of a holiday package customers may prefer to not spend the extra amount and instead of going on the holiday decide to spend their free time doing something else.
This makes it essential for business owners to determine the price elasticity of demand of what they are selling. The price of the product being sold can only be increased by a certain level to ensure an increase in revenue; if the price is increased by a larger amount the decrease in demand that follows may actually substantially decrease the revenue earned. Conversely, though a decrease in price of the product usually leads to an increase in demand, the actual increase in revenue is dependent on the price elasticity of demand. Decreasing the cost of a product that has a small price elasticity of demand could affect revenue adversely as the demand is increased by only a small amount for a unit change in price.