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Price Elasticity

Price elasticity tells how much of an impact a change in price will have on the
consumers' willingness to buy that item. If the price rises, the law of demand states that
the quantity demanded of that item will decrease. Price elasticity of demand tells you
how much the quantity demanded decreases. Elastic demand means that the
consumers of that good or service are highly sensitive to changes in price. Usually, a
good which is not a necessity or has numerous substitutes has elastic demand. Inelastic
demand means that the consumers of that good are not highly sensitive to price
changes. If the price of an inelastic good, say cigarettes, rises by 10 percent, maybe
sales will only decrease by 1 percent. Consumers will still buy that good, typically
because it is essential or has no substitutes.

Why Elasticity Matters


Price elasticity of demand and total revenue are closely interrelated because they deal
with the same two variables, P and Q. If your product has elastic demand, you can
increase your revenue by decreasing the price of that good. P will decrease, but Q will
increase at a greater rate, thus increasing total revenue. If the product is inelastic, then
you can actually raise prices, sell slightly less of that item but make higher revenue. As a
result, it is important for management to know whether its product has inelastic or elastic
demand.

(Equation) Total revenue = price * quantity demanded.


When demand is elastic, if the price increases by one percent, the quantity
demanded will decrease by more than one percent. Total revenue will decrease.
When demand is inelastic, if the price increases by 1%, the quantity demanded
will decrease by less than 1%. Total revenue will increase.

When demand is unit elastic, if the price increases by 1%, the quantity demanded
will also decrease by 1%. Total revenue will be unchanged.

(General Example) Referencing figure 2 total revenue is calculated for price


increase for an inelastic demand curve, and again for an elastic demand curve.

MR=MC
Marginal revenue and marginal cost can be used to find the profit-maximizing output
level

Logic behind MC and MR approach


An increase in output will always raise profit as long as marginal
revenue is greater than marginal cost (MR > MC)

Converse of this statement is also true

An increase in output will lower profit whenever marginal revenue


is less than marginal cost (MR < MC)

Guideline firm should use to find its profit-maximizing level of output

Firm should increase output whenever MR > MC, and decrease


output when MR < MC

Profit rises as output expands for a while, then becomes stand still and then starts to
decline with further increase in output. Profit is maximized where marginal profit is zero.
Any increase or decrease in output from this peak level will cause marginal profit to be
equal to zero. Marginal profit is zero, when marginal revenue equal marginal costs.

Supernormal Profits

When will firms be able to make supernormal profit rather than normal profit?
Normal profit is defined as the minimum level of profit necessary to keep a firm in
that line of business. This level of normal profit enables the firm to pay a reasonable
salary to its workers and managers. The definition of normal profit occurs when Average
Revenue AR=ATC (average total cost)
Supernormal profit is defined as extra profit above that level of normal profit.
Supernormal profit occurs where AR>ATC. Supernormal profit is also known as
abnormal profit. Abnormal profit means there is an incentive for other firms to enter the
industry (if they can)
Perfect Competition.
The theory of perfect competition suggests that supernormal profit can only be earned in
the short term. Perfect Competition involves

Perfect information
Freedom of Entry and exit
Therefore, if a firm is able to make supernormal profits, other firms will be aware of this
fact. Because there is no barriers to entry, firms will be encouraged to enter the market
until price falls. Firms will enter and prices will fall until normal profits are made.

This is why only normal profits will be made in the long run.
However, most markets dont have these features of perfect information and freedom of
entry and exit. Most markets have a degree of barriers to entry and exit. There are sunk
costs which deter entry. Therefore, even if firms are making supernormal profit, new
firms may not be able to enter and compete.

Diagram showing supernormal profit in imperfect competition


For example, Tesco is making supernormal profits 3.54bn (BBC) in 2011. But, it is
difficult for a new firm to compete in the supermarket industry. Tescos has significant
economies of scale and strong brand loyalty. Therefore it is very difficult for other firms to
enter. Therefore, in the long run, firms like Tesco are able to continue making
supernormal profits.
Other industries may have even greater barriers to entry. Shell make profits in the region
of $27bn (most profitable company). This is clearly supernormal profit. But, there are
strong barriers to entry in this market.