Key Diagrams - Price Elasticity of Demand and Business Profit Margins

In this short revision video we explore an important idea - namely the link between price elasticity of demand and the profit margins of a firm.

The profit margin or “mark-up” can be measured by the difference between price per unit (AR) and cost per unit (AC). When demand is highly price elastic – for example in a highly contestable market – then the profit margin tends to be low. This is because consumers are likely to be more price sensitive. A profit-seeking firm has some albeit limited pricing power.

In contrast, when a firm has significantmonopoly power and can prevent the successfulentry of challenger firms through barriers to entry. And when consumer demand for the product is price inelastic, this gives the supplier much greater pricing power. At the profit-maximising level of output, we see that price is well above average cost and supernormal (monopoly) profits are high. This analysis assumes a unregulated monopoly firm.

This is an important idea with many applications for your exams. Utilities with monopoly power for example, can achieve high profit mark-ups unless they are regulated by an industry regulator acting as a surrogate competitor. Liberalising a market to make it more contestable can reduce the supernormal profits made by existing firms. Likewise, opening a market to international trade can have a similar effect with implications for consumers.