Price elasticity of demand can be determined in a number of ways, such as the total outlay method. This method measures the price elasticity by looking at the effect of changes in price on the total revenue earned by the producer. This method observes the movement in total outlays following price changes. This method allows for easy determinacy of whether demand is relatively elastic, relatively inelastic, or unitary elastic to price changes. Total outlay is found by multiplying price by the quantity that would be demanded at that price. In effect, the total outlay (or total expenditure) by consumers on a certain product is equivalent to the total revenue sellers of the product would receive at that price.
Consider the following table as an example of using the total outlay method to measure the elasticity of demand:
Relatively elastic demand occurs if total outlay moves in the same direction as the price change. As shown in Table 6.2, at a price of $5, consumers demand 50 units, therefore total outlay is $250. When the price rises to $6, demand falls to 45 units, and total outlay increases to $27. total outlay has moved in the same direction as the price change – the price increase would lead to an increase in total revenue for firms, therefore demand is said to be relatively inelastic.
At a price of $8, consumers demand 35 units, therefore total outlay would be $280. If the price rises to $9, demand falls to 30 units, and total outlay decreases to $270. Total outlay has moved in the opposite direction to the price change – the quantity demanded is highly responsive to price changes, therefore demand is said to be relatively elastic.
At price $7, consumers demand 40 units, therefore total outlay is $280. When the price rises to $8, demand falls to 35 units, but total outlay remains the same at $280. total outlay has remained the same, therefore demand has unitary elasticity over this price range.
An understanding of elasticity of demand is important to both business firms and the government.
Business firms need to understand price elasticity of demand for the goods they sell in order to decide on their optimal pricing policy, that is, the price at which goods may be sold at a satisfactory price for consumers and producers. If demand was relatively elastic, the firm would know that lowering the price would expand the volume of sales, therefore increasing total revenue. Conversely, if demand was relatively inelastic, the firm could increase the price, which would also lead to an increase in total revenue, since the drop in sales would be less than proportionate therefore there would not be a loss in revenue. Appreciation of the elasticity of demand in different price ranges is important for determining the best pricing policy for a firm and in deciding whether or not to change prices. This importance explains why businesses often take part in statistical market research so as to ascertain consumer preferences, and in particular the price elasticity of the demand for their product.
The government must understand price elasticity of demand when pricing the collective goods (those provided for the community eg. Public transport fares). Additionally, it also needs to be able to forecast the effects of changes in the level of any indirect taxes, such as sales taxes, excise duties and special levies that it imposes on goods such as alcohol, tobacco products and petrol. These taxes and charges have the effect of raising the price of the goods affected, and the government needs to be able to measure the responsiveness of demand in order to accurately estimate the amount of revenue they will raise.
Governments and business firms need to understand price elasticity so they can set a price that maximises their respective revenues. Therefore, the price elasticity of demand relates strongly to the actions of the government and business firms and this determinacy relies on approaches such as the total outlay method, which calculates the total revenue earned by the producer, measuring the responsiveness or sensitivity of quantity demanded due to changes in price.
