Does raising prices always result in more profit?

Review on Revenue and Profit Equations

An increase in the price of the good or service will change a firm’s revenue. Consequently, it will appear to be profitable or lost. The revenue and profit can be calculated by the following equations:

Revenue = Price x Quantity

Profit=Revenue-Total Cost= Price x Quantity- variable cost x Quantity- fixed cost

The difference between the revenue earned and the producing cost is the gross profit. Obviously, we can increase the profit though raising price, lowering the variable cost, lowering fixed cost and enhancing the quantity. To be simple, here we analyse the IT service business only based on their changes of demand responds to changes of price. Other things equal, we know by the law of demand that a higher price usually results in decreasing their demand. In reality, most companies have to decide both how much to charge for their service and the quantities that they can provided. They can choose highest price, average price or lowest price and it mainly depends on the relationship between the price and the demanded. This relationship referred to price elasticity of demand.

Determine Price Sensitivity

As we have pointed out, a higher price typically means lower sales. In order to generate more revenue and profit, most companies may think about increasing price. However, this depends on how sensitive your products or services to the price i.e. price elasticity of demand and answer questions: in what circumstances, raising price would lead to higher profits and what circumstances lead to a loss of revenues and profits.

 represents price elasticity of demand,  represents the percentage change in price while  indicates the percentage change of quantity demanded. For products or services with >1, i.e. elastic demand, that is, the change of demands are much faster than the change of price. In this circumstance, increasing 1% of the price would result in greater than 1% of decreasing demands. Thus, increasing price would lead to a loss of revenue and profits. For products or services which demands are extremely sensitive to the price, the company may be better off at a much lower price with substantially greater demands instead of higher price. In contrast, with <1, i.e. Inelastic demand indicates that price increase might be feasible because demands is not that sensitive to the price. Therefore, increasing price would lead to higher revenue and profits for products or service.

Empirical Analysis of IT Service Business

Being an IT service business, it provides a wide range of technology solutions and associated services ranging from computer repairs and networking services to custom software programming. If you are running a big business offering advanced professional consulting and technology service, it would be quite different from small companies that only provided repair and maintenance services. So, we have to estimate when the price elasticity of demand would become greater than 1 and when it is less than 1 for IT service business? In depends on how the positioning the product or service in the market. Let’s give an example to illustrate this point.

IT service company A is one of the best IT service firms in the world. The company had a large number of loyal customers because its leadership products or services. Company A is less sensitive to price because they care most about providing top services.

IT service company C is small and only provided repair and maintenance services. Company C has no production difference and they consistently offered the same services or products at a better price. Therefore, company c regularly evaluates their competitors’ price in order to attract more customs. If their competitors run a promotion, they will follow correspondingly.

IT service company B is between A and C. There are lots of competitors and their products or services are only a little better than the alternatives. Company B not only focuses on product leadership, also focuses on price. In order to maintain their competitive position, they regularly run promotions and develop a better products or services that can get a higher price.

The price strategy would be different from IT service company A, B and C. Due to Company A’s price elasticity of demand is less than 1, therefore, they can charge higher than their competitors for their products or services. Company C’s price elasticity of demand is greater than 1 and their products or service are homogeneity with their competitors. If they increase the price, their sales will plummet as most of their customers would transfer to the competitors who can provide the some products or services with lower price. Company B regularly adjusted prices to the market prices. They may be able to implement a small price increase strategy in order to get more revenue and profits, but it depends how much more their customers are willing to spend.

Conclusion

By analyzing price elasticity of demand for each kind of company, we can determine how much to charge for our products and services. IT service companies can determine the price elastic of demand by performing experiments that above and below current price. If they want to launch a new price strategy, they should evaluate the strength and potential risk of this new strategy and estimate how much it had impact on revenue and profits due to price change. For products or service with inelastic demand, it might be feasible to get higher revenues and profits by increasing price, while for products or service with elastic demand, raising price is risk, it may result in a loss of revenues and profits.

References

Frijters, P., Dulleck, U. & Torgler, B. 2010. Introductory Economics for Decision Makers, 2nd edn. Cengage Learning, South Melbourne

School of Economics & Finance

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