Firms need to be aware of the price elasticity of demand (PED) for their products (i.e. where they are on their demand curves) to determine the level of profit maximization. For most products (all non-perfectly competitive goods), firms face a normal downward-sloping demand curve which implies PED falls as firms make more output. To sell more, the firm needs to lower the price, and, thus, demand and average revenue (AR) fall accordingly. Marginal revenue, which is twice as steeply sloped as AR, also falls as output increases and goes beneath the x-axis, representing diminishing returns and falling revenue as output grows too big. MR falls faster than AR because revenue is lost as firms have to lower prices to sell more product.
As shown by this graph, firms should lower prices if in the elastic part of their demand curve until unit elasticity is achieved. Similarly, firms should raise prices if in the inelastic part of their demand curve until unit elasticity is achieved. Unit elasticity is the key point, where total revenue (TR) is maximized. This relationship is critical for firms determine and give employment to many economists!
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