Elasticities are of most interest to larger
firms and to trade and industry organisations.Such firms are, by definition,
important players in the market and their
sales
constitute a significant portion of total demand.
If the firm is one of many and each firm
accounts for a minute part of the
market, each
firm’s demand curve will be very flat and its price elasticity of
demand will
be very high. In such circumstances, there is a ‘going price’ in the
market. If a
firm charges above this price, customers will vanish. If it reduces the
price below
the going rate, it is inundated with customers. Such a firm is unlikely
to be
interested in having its demand curve estimated. The product’s income
elasticity
of demand is also of little concern to the firm since its share of the total
market is so
small.
Firms are always trying to escape the bind
of perfect competition, to make their
demand
curves inelastic to some degree, to enhance their market range so that
they can
raise their prices above the going rate. This is what finding a market niche
means. Once
the niche has been found, price elasticities become highly relevant.
Firms with
well-established market niches must constantly review possibilities of
market
segmentation in order to exploit any opportunities for revenue increases.
Although
firms may not express it that way, they are, in effect, seeking to separate
high and low
price elasticity segments of the market. This is the basis of the
distinction
between business and economy-class air travel, between ‘reserved
stand’ seats
and terraces in a football match, between the dress circle and the
stalls in
theatres.
Take, for example, the case of the owner of
a football stadium who is organising
a special
charity match. The objective is to maximise gate receipts for the
good cause.
The question is what price, or profile of prices, to charge in order to
achieve this
objective. The additional costs of opening the stadium and operating
it for the
match are small in relation to the expected revenue. For simplicity, let
us assume
that they are zero. The problem then becomes one of maximising sales
revenue.
Suppose that the market demand curve is
estimated as DD in Figure 4.3. What
price will
maximise revenue? To answer this question, we need to construct the
marginal revenue curve. Marginal revenue
is the net change in total sales revenue
resulting
from the sale of an extra unit of a good. It equals the price obtained from
sale of the
marginal unit less revenue lost as a result of having to reduce the
price on existing sales. Hence the marginal revenue curve is
below the demand curve in
Figure 4.3;
that is, the marginal revenue received by the producer for each extra
ticket sold
is less than the price charged for that ticket.
Sales revenue will be maximised when
marginal revenue equals zero. In the
case of a
linear demand curve, such as Figure 4.3, this happens when OQ tickets
are sold. At
that point, marginal revenue has fallen to zero and elasticity of
market
demand is equal to unity.10 If price were lowered any further, more tickets
would indeed
be sold, but total sales revenue would fall.
That might seem to be the end of the story.
However, suppose the market could
be segmented
further. Instead of charging a uniform price, different prices could
be charged
to different groups of spectators. Essentially, we offer slightly superior
seats in the
stadium at a much higher price to one segment of the market which
is less
price-sensitive than the other segments. When the markets are segmented, the
definition of the market to which the elasticity applies becomes rather
complicated.The relevant elasticity in the case of the football stadium is not
tickets as
such, but
rather each particular type of ticket. Segmentation is enforced easily by
checking
tickets against seats and ensuring that the lower-price ticket holders
cannot
occupy the high-price seating. The lower the price elasticity of demand of
a group, the
higher the price it will be profitable to charge. Hence the effort to
segment the
market, and to reinforce the loyalty of each segment by relatively
inexpensive
ploys, such as frequent-flyer miles allowance to business class airline
travellers,
greeting passengers by name, provision of free in-flight programmes
and roomier
seats.
In attempting to understand the effects of
price changes on volume sold,
however,
customer reactions are not the only factor for a firm to consider.
Competitor
reactions also need to be taken into account. If competitors feel
threatened
as a result of the price cut, they may follow with cuts of their own.
This could
lead to a price war. Competitor reactions are also relevant in estimating
the
consequences to the firm of raising its price. If they keep their price
constant,
the firm may
lose customers. If they do follow, the net effect on demand
may be very
small – at least in the short run. In the longer run, the price increase
may
stimulate new entrants.
These considerations underline the
inevitable uncertainty surrounding the
price–volume
relationship at firm level. The demand curve facing the firm is
unknown,
apart from one point: the present sales volume and price. It is unlikely
to have the
nice smooth features of the textbook market demand curve. Also, it
will be
likely to change over time and to be sensitive to the stage of the business
cycle. To
add to the complexity, it can change over the course of the product
cycle of the good itself.
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