Price Elasticity of Demand - Essay Example

Price Elasti of Demand Price Elasti of Demand Firms enter into business with the key goal of maximising profit among otherminor objectives. Profit has been defined as the excess of revenues to total costs, while revenues are directly proportional to sales and price. Given that price and sales are inversely related, then a profit maximising entity ought to seek the optimal combination of the two. This decision requires knowledge of price elasticity of demand among other factors. Notably, price elasticity of demand refers to the responsiveness of quantity demanded to price changes in proportionate terms and is of course negative unless in special cases. Elasticity of demand explains the extent to which consumers are willing to relinquish their consumption of a particular product due to price increase and vice versa. Upon setting goals and objectives of the firm, the management ought to strategise and plan operations that facilitate goal achievement. As noted earlier, revenues can be raised by either raising quantity supplied via expansion or altering prices. Quantity supply increment is associated with increase in costs and thus requires careful analysis and hence a long-term decision. On the other hand, due to the negative effect that price has on sales; its increment does not necessarily result to increased revenue, but rather depends on the proportionate change in quantity demanded. For that reason, decision maker ought to consider elasticity of demand before initiating a price alteration. As matter of fact, increase in price may either raise or lower total revenue, though it has no effect on cost. Moreover, planners ought to understand the determinants of elasticity and work, to their advantage, either to increase or reduce it. In an inelastic demand situation, a change in price results to a less than proportionate change in sales. A rational firm may therefore increase price as it adds to revenues. However, as price the consumer surplus reduces and hence consumer’s responsiveness to price increases (Guru, 2010). At the point where elasticity becomes unitary, it makes no economical sense to raise price, since the impact on revenues is negligible if not zero. Alternatively, reducing prices on elastic commodities increases revenues and vice versa. Remarkably, in an elastic situation, the change in price is offset b the more than proportionate change in quantity demanded. Among many other factors, elasticity ought to be a key variable in pricing policies. Secondly, elasticity of demand can be used to predict availability and closeness of the products substitutes. Highly inelastic products tend to have very close substitutes. Competition is always a threat to any firm and thus knowledge on availability of close substitutes is vital in determining quality and differentiation decisions. Note that, if the substitute effect results from consumer’s perception, then the manager can easily eliminate the effect via product differentiation rather than pricing (Piros & Pinto, 2013). Among many determinants of elasticity, the degree of necessity as well its habitual nature. Inelastic demand implies high necessity or habitual consumption and thus the management can easily cut on promotional expense. In effort to increase revenue, some monopolists opt to incorporate price discrimination in their pricing policy. This process requires identification of differences in price elasticity in different markets. Remarkably, price can only be raised in markets of high price inelasticity. The difference in elasticities enables the seller to satisfy the market with the same product at different prices. Though market segmentation and separation are key attributes to discrimination, the initial setup of the policy is attracted by price elasticity analysis. Different market structures exhibit different levels of price elasticities. As matter of fact, the responsiveness to price of any commodity is determined by level of competition. Price elasticity ranges from two extremes, i.e. perfect elastic and perfect inelastic which signify the two market structures extremes; perfect competition and pure monopoly respectively. There are fives levels of elasticity which can easily be illustrated by the convex demand curve. In a perfectly inelastic state, consumers have a fixed demand that is not influenced by price changes. The firm can thus adjust prices upwards to increase revenues. Perfect inelastic is thus a source of monopoly power and it reduces consumers purchasing power significantly. This condition is mostly theoretical as there is no product that is totally irresponsive to price. As elasticity increases, the monopoly power reduces. At fairly, inelastic condition, the firm has minimal control over the prices. In oligopolistic conditions, the few large companies control can easily increase price. The absence of many substitutes as well as possession of quantifiable market share reduces the reduction in quantity demanded upon price shoot up. Brand names and differentiation that exists in oligopoly markets explains the rigidity. As competition increases, elasticity moves from less than one (in absolute terms) to unitary. In a monopolistic competition structure, there are many buyers and sellers who lack complete information on the quality and satisfaction levels of available products. Customers can easily shift their consumption from one product to another. Increasing price reduces sales significantly, while reducing price increase sales more than proportionately (elasticity is more than 1). The ability of the firm to control price, raises price above the market equilibrium price and hence create economic profits for the seller. A perfectly elastic demand provides no incentive to alter price. As evident in perfect competition market structure, a change in price either upward or downward reduces sales to zero. Buyers, via collective demand determine the market price which firms take as given. In a nutshell, note that economics deals with the satisfaction of human wants. Consumers have a bargaining power, and passively participate in every firm’s decision making. The objective of maximising profits is always constrained by the goal of customer satisfaction. The extent of customers bargaining power is measured by elasticity of demand. Firm’s ability to alter price depends on the elasticity of demand. Consequently, the ability to change price depends on the market structure. Therefore, elasticity of demand can also be used to determine the type of industry a firm operates in. References Friedel, E. (2014). Price elasticity: Research on magnitude and determinants. Gary, R. J., & Bolton, R. N. (2009). mplication of market structure for elasticity structure. Retrieved from http://www.ruthnbolton.com/Publications/ElasticityStructure.pdf Guru, S. (2010). Role of Price Elasticity of Demand in Decision-Making. Retrieved January 26, 2015, from http://www.yourarticlelibrary.com/economics/elasticity-as-demand/role-of-price-elasticity-of-demand-in-decision-making/36766/ Jain, T. R., & Khanna, O. P. (2008). Business economics. New Delhi: V K Publications. Johnson, A. C., & Helmberger, P. (1967). Price elasticity of demand as an element of market structure. the american economic review, 57(5). Retrieved from http://www.jstor.org/discover/10.2307/1814404?sid=21105707743213&uid=4&uid=70&uid=2129&uid=2 Mccarthy, E. J. (1960). Basic Marketing: A Managerial Approach. Montgomery, A. L., & Rossi, P. E. (1999). Estimating Price Elasticity with Theory-Based Priors. Journal of Marketing Research.. Piros, C. D., & Pinto, J. E. (2013). Economics for investment decision makers: Micro, macro, and international economics. Hoboken, NJ: Wiley. Sarkar, S. (2007). Innovation, market archetypes and outcome: An integrated framework ; with 15 tables. Heidelberg: Physica-Verl. Thomas, C. R., Maurice, S. C., & McGraw-Hill, inc. (2008). Managerial economics. Boston: McGraw-Hill. Read More