Price Elasticity and Pricing Policy (Penetration or Skimming)
The most obvious thing about the level of sales revenue to a firm is that they want more and more of it! The problem that most firms therefore come up against is then how do you get more of it? The crass answer at this point is to sell more of your product, and that is absolutely right - but how do you?
Price Elasticity of Demand
Obviously marketing has a key role to play in this process, but a vital part of a firm's market strategy has to be the price they charge for their product. Will it be best for them to cut their price to get more revenue, or to increase their price??? The answer to this lies with the price elasticity of demand.
| PRICE ELASTICITY OF DEMAND = |
% change in demand
% change in price |
|---|
If the firm cuts its price by 10%, and the demand for their product increases by 20%, then the price elasticity of demand will be 2. We call the demand for this product ELASTIC. This figure literally means that the increase in demand was double the decrease in price. In this situation you would clearly want to cut your price as cutting it has generated a lot more business, and so although you're getting less money for each one you sell, you're selling plenty more to make up for it.
However, say that when the firm cut its price the same amount (10%), the demand for their product only went up by 5%. This would mean that the price elasticity of demand was only ½. We call the demand for this product INELASTIC. The figure this time means that the increase in demand was only half the change in price. Here the firm would not choose to cut price (unless their competitors had) as they would lose out. They would be selling a few more, but not enough to make up for the fall in price and their sales revenue would go down.
Market Skimming / Penetration
However, the firm also need to consider other aspects of their pricing - do they want to aim for a large market share with a low price? In this case they would want to consider market penetration as a pricing strategy. This would mean setting a low price (and correspondingly lower profit margin on each unit), but selling a higher volume. This depends considerably on whether the product is elastic in demand (see above). Alternatively they may want to remain as a niche market product and set a high price (with a higher profit margin on each one sold) - this is known as market skimming. Both of these will have major implications for both their sales revenue and their level of profit. Remember that high sales revenue does not necessarily mean high profit.