Explaining Price Elasticity of Demand and Business Profits

In this video we explore the relationship between the coefficient of price elasticity of demand and the extent to which firms can make high levels of profit.

When demand is price inelastic, what effect can this have on a firm’s profit margins?

Typically, when PED is low, then firms can take advantage by raising their prices. Total revenue will increase and, depending on cost, they can also make higher profit margins (this is shown by the difference between AR-AC)

PED will be low when there are few close substitutes in the market, when consumer brand loyalty is strong and there are costs of switching from one competing product to another

When demand is price elastic, what effect can this have on a firm’s profit margins?

In more competitive markets, when there are many substitutes available for buyers and when brand loyalty is weak, then the coefficient of PED will tend to be higher

This reduces the monopoly pricing power ofexisting firms

As a result, the profit margins made by firms will be lower

In perfect competition, the coefficient of PED is infinity