Uses of Price Elasticity of Demand in Business Decision Making

Elasticity of demand is the sensitivity of quantity demanded of a commodity in response to the change in factors related to that commodity.

Elasticity of demand may be of different types, depending upon the factor that is responsible for causing the change in demand. Among them, price elasticity of demand is one of the most common types and is also the most relevant to business.

Price elasticity of demand can be a useful tool for businessmen to make crucial decisions like deciding the price of goods and services. It plays vital role in other business procedures too. These uses are described below in brief.

Determination of price

The primary objective of any firm is to earn profit or increase revenue. Therefore, increasing price of its products to maximize profit is one of the primary concerns of producers.

However, during the course of increasing price, the producers must not forget that demand and price share inverse relationship. They must be aware that demand falls with rise in price. And thus, they must increase price of their commodity to that level where their desired or optimal profit is still achievable.

For example: In the table given below are shown three cases (I, II & III) of a restaurant that sells burger.

Case I Case II Case III
Cost of production per unit $7 $7 $7
Price per unit $10 $10.2 $11
Demand per day 100 units 90 units 85 units
Total cost of production 7 X 100 = $700 7 X 90 = $630 7 X 85 = $595
Revenue 10 X 100 = $1000 10.2 X 90 = $918 11 X 85 = $935
Profit 1000 – 7000 = $300 918 – 630 = $288 935 – 595 = $340

In the above table, we can see that when price of the burger was $10 per unit, its demand in the market were 100 units per day, causing the firm profit of $300.
When the firm increased the price to $10.2, its demand fell by 10 units per day.

As a result, the firm gained profit of $288, causing reduction of $12 in initial profit. In the same way, when the price is increased to $11 per unit, there is once again decrease in demand. The new demand in market is 85 units per day and the new profit is $340.

From the example, it is clear that producers must always analyze elasticity of their product and must evaluate the impact of changes in price on the total revenue and profit of their firm.

Monopoly price determination

The situation where a single group or company controls all or almost all of market for a particular good or service is called monopoly. The monopolistic market lacks competition. Thus, the goods or services are often charged high prices in such market.

A monopolist while fixing the price of the market has to determine whether its product is of elastic or inelastic nature.

If the product is inelastic (less or no effect on demand with change in price), the producer can earn profit by setting high price. However, if the product is elastic (highly affected by even slightest change in price), the producer must set low or at least reasonable price so that the consumers are attracted to buy the goods.

For example: Fuel is necessity of consumers. Therefore, monopolist who runs the market of fuel can generate profit even by setting high price of fuel.

On the other hand, tablet (gadget) is a luxury good. If the monopolist who produces tablet, set high price of its product, he may not be able to sell its products. But, with a slight drop in the price (setting lowest reasonable price), he can collect large number of consumers and increase the profit of the company.

Price determination under discriminating monopoly

The situation where single group or company charges different prices for the same commodity at different market is known as discriminating monopoly.

Suppose there is a company that produces air filtering masks. Right now, it is selling in a competitive market where there are many similar products. In this market, any increase in the price of the masks will drive the consumers to buy other substitute products. Thus, the demand in this market is highly elastic.

Now if the same company starts selling the masks in a different country where there aren’t any competing products, even with a high price, people will be willing to buy it. Thus, the demand is inelastic and the company can sell its product at a premium price.

In this way, we saw that the same product can be elastic in one market and inelastic on the other. So, businesses need to study the elasticity based on the market and make pricing decisions accordingly.

Price determination of joint products

Joint products are various products generated by a single production procedure at a single time. Sheep and wool, cotton and cotton seeds, wheat and hay, etc. are some examples of joint products. We cannot separate the cost of producing wheat and hay, as producing wheat will automatically produce the hay as well.

However, since they are two different products, we cannot sell them at the same price in the market. Price elasticity of demand plays important role in determining the prices of these joint products.

Let us suppose, there has been bumper production of cotton this season. As a result, huge amount of cotton as well as cotton seeds have been produced.

Cotton has wide scope in the market as it can be used for different purposes. The producers of cotton can gain maximum profit by setting high price of cotton, as demand of cotton in market is not easily altered. But cotton seeds have limited scope, so it is an elastic product. If the business does not decrease the price, then demand will be less.

By setting a high price for cotton (inelastic product) and low price for cotton seeds (elastic product), the business can maximize its revenue.

This way, two or more products which are produced from single manufacturing process may also have different nature of elasticity. And, producers must evaluate the degree of elasticity of each product in order to extract maximum profit from all products.

Wage determination

Labor is one of the major factors of production, and wage is the fixed regular payment made to the labor in return of their input. Degree of elasticity of commodity has potential to affect the wage to be paid to the labor.

If a commodity is of inelastic nature, the labor can force the employer to increase their wage through extreme ways like strike. As a result, the company will have to consider the demands of labor in order to meet the demand of consumers for the inelastic goods.

However, if the commodity is of elastic nature, labor unions and other associations cannot force the employers to raise wage as the producers can alter the demand of their products.

International trade

We have already known that change in price cannot bring drastic change in demand of the product in case of inelastic commodity. But even a slight change in price can cause huge effect on demand of elastic commodity.

We have also known that higher price can be charged for inelastic goods and lowest possible price must be set for elastic goods.

Taking into account the above information, a country may fix higher prices for goods of inelastic nature. However, if the country wants to export its products, the nature (elasticity/inelasticity) of the commodity in the importing country should also be considered.

For example: Rice maybe an inelastic product for China and thus exports around the world at the price “x”. But, if rice is price elastic in the US, China will be forced to decrease the price from the initial value of “x” to be able to sell the product in American market.

Importance to finance minister

Price elasticity of demand can also be used in the taxation policy in order to gain high tax revenue from the citizens. One of the ways would be for the government to raise tax revenue in commodities which are price inelastic.

For example: Government could increase the tax amount in goods like cigarettes and alcohol. Given how these are the commodities people choose to purchase regardless of the price tag, the tax revenue would ­significantly rise.