How does a firm maximize their total revenue?
What happens when a firm raises its price in a market in which the price is in the inelastic range of the demand curve?
To maximize total revenue, a firm needs to understand the relationship between price and quantity demanded. Total revenue is calculated by multiplying the price of a product or service by the quantity sold.
To find the price that maximizes total revenue, a firm should follow these steps:
1. Analyze the demand curve: Understand how the quantity demanded changes with the price. A demand curve shows the relationship between price and quantity. If demand is elastic, an increase in price will significantly reduce the quantity demanded. If demand is inelastic, a price increase will have a less significant impact on quantity demanded.
2. Determine the price elasticity of demand: Price elasticity of demand measures the responsiveness of quantity demanded to a change in price. It is calculated by dividing the percentage change in quantity demanded by the percentage change in price. If the resulting number is less than 1, demand is inelastic; if it is greater than 1, demand is elastic.
3. Identify the inelastic range of the demand curve: In the inelastic range of the demand curve, price elasticity of demand is less than 1. This means that a price increase will result in a smaller percentage decrease in quantity demanded. In this range, consumers are less sensitive to price changes because they perceive the product as essential or having limited substitutes.
4. Increase the price: In the inelastic range, increasing the price will lead to a smaller decrease in quantity demanded. As a result, total revenue will increase because the increase in price offsets the reduction in quantity sold.
5. Monitor the impact on total revenue: It is important to evaluate the change in total revenue after increasing the price. If total revenue increases, the firm has found the price that maximizes revenue within the inelastic range. If total revenue decreases, the price increase has gone beyond the optimal point.
In summary, a firm maximizes its total revenue by raising its price within the inelastic range of the demand curve, where consumers are less responsive to price changes. By understanding price elasticity of demand and making careful adjustments, a firm can find the price point that optimizes its revenue.