Importance of Price Elasticity of Demand in Business Decision Making

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
• 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 .
 Pricing Decisions
• The business firms take into account the price elasticity of demand when they take decisions
regarding pricing of the goods. This is because change in the price of a product will bring
about a change in the quantity demanded depending upon the coefficient of price elasticity.
• This change in quantity demanded as a result of, say a rise in price by a firm, will affect the
total consumer’s expenditure and will therefore, affect the revenue of the firm. If the
demand for a product of the firm happens to be elastic, then any attempt on the part of the
firm to raise the price of its product will bring about a fall in its total revenue.
• Thus, instead of gaining from the increase in price, it will lose if the demand for its product
happens to be elastic. On the other hand, if the demand for the product of a firm happens
to be inelastic, then the increase in price by it will raise its total revenue. Therefore, for fixing
a profit-maximising price, the firm cannot ignore the price elasticity of demand for its
product.
 Use in International Trade:
• The price elasticity of demand is also crucially important in the field of international
economics. The Governments of the various countries have to decide about whether
to devalue their currencies or not when their exports are stagnant and imports are
mounting and as a result their balance of payments position is worsening.
• The effect of the devaluation is to raise the price of the imported goods and to lower
the prices of the exports. If the demand for a country’s exports is inelastic, the fall in
the prices of exports as a result of depreciation will lower their foreign exchange
earnings rather than increasing them.
• This is because, demand being inelastic, as a result of the fall in prices quantity
demanded of the exported products will increase very little and the country would
suffer because of the lower prices.
 Importance in Fiscal Policy:
• The elasticity of demand is also of great significance in the field of fiscal policy.
The Finance Minister has to take into account price elasticity of demand of the
product on which he proposes to impose the excise duty or sales tax if the
revenue for the Government is to be increased.
• The imposition of an indirect tax, such as excise duty or sales tax, raises the
price of a commodity. Now, if the demand for the commodity is elastic, the
rise in price caused by the tax will bring about a large decline in the quantity
demanded and as a result the Government revenue will decline rather than
increase. The Government can succeed in increasing its revenue by the
imposition a of commodity tax only if the demand for the commodity is
inelastic.
 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
 To classify normal and inferior goods
• Any products that are manufactured by the producers can be classified into two types – normal goods
and inferior goods.
• Normal goods – Goods whose demand is directly proportional to the income of the consumers are
known as normal goods.
Simply, goods whose demand rises with a rise in income and whose demand falls with fall in income
is known as normal goods e.g jewelry. The coefficient of income elasticity of these goods is always
positive.
• Inferior goods – Goods whose demand is inversely proportional to the income of the consumers are
known as inferior goods.
In other words, inferior goods are such goods whose demand falls with the rise in income and vice
versa e.g. budget smartphones. The coefficient of income elasticity of these goods is always negative.
• Knowledge about the nature of products is important to any producers in order to make further
decisions related to the goods in the right manner
 To know about stage of trade cycle
• We have already known that demand for normal goods is directly proportional
to the income of consumers while demand for inferior goods is inversely
proportional to the income of consumers.
• We see people prefer riding the public bus when their income is low, but with
comparatively high income, same people start using a cab for transportation. In
this situation, public bus is an inferior good while the cab is a normal good.
• Demand for normal goods increases during prosperity and decreases during
regression. Conversely, demand for inferior goods increases during regression
and decreases during prosperity. However, demands for goods that are
necessary for our day to day lives are not much affected during prosperity as
well as during regression
 For forecasting demand
• Income elasticity of demand can be used for predicting future demand of any goods and
services in a case when manufacturers have knowledge of probable future income of the
consumers.
• For example: Let us suppose, ‘Wheels’ is a car manufacturing company which
manufactures luxury cars as well as small cars. The company has calculated that income
elasticity of luxury car (normal good) is +4 while income elasticity of small car (inferior
good) is -5.
• Let us also suppose that the company has undertaken a research and has found that
consumer income will rise by 3% in an upcoming year.
• Through the above information, Wheels can forecast by how much the demand for
luxury car and the small car will undergo a change in the upcoming year. This information
can save the company a lot of money by preventing overproduction or underproduction.
 To determine price
• Having knowledge of income elasticity of any product is
essential in order to correctly price them.
• The demand for income elastic goods or goods with positive
income elasticity tends to fall with fall in income of the
demanding consumers. Thus, a reduction in the price of the
commodity may help in increasing the demand and
compensate them for the reduction in price by generating
more sales and revenue.
 Forecasting change of demand
• Cross elasticity can be used by a businessman (producer) to predict the future
demand of his product in case when he has the idea of probable future price of
substitute or complementary goods.
• Let us suppose that there’s a company which manufactures Limes (cold drink) and
there is another cold drink in the market called Oranges. The cross elasticity of
demand between Limes and Oranges is +1.5.
• Let us also suppose that the manufacturer of Limes received the information that
the price of Oranges is about to fall by 10% in the upcoming month.
• From the above information, the manufacturer of Limes can predict by how much
the demand of its product will fall as a result of fall in price of Oranges, and thus
will be able to make necessary decisions to keep up its revenue.
 Classification of market
• Cross elasticity of demand is also helpful in classifying the type
of market.
• Higher the value of cross elasticity of demand between the
products, greater will be the competition in the market, and
lower the value of cross elasticity, the market will be less
competitive. In the same way, if cross elasticity is zero or
almost zero, there is monopoly or zero competition in the
market.
 Classification OF Goods
• Goods are classified into substitute and complementary. If
cross elasticity of demand between any two goods is positive,
the goods may be considered as substitute for each other. If
the cross elasticity is greater, the good are closer substitute. If
it is infinite, they are perfect substitute. If the cross elasticity of
demand for any two related goods is negative, the two goods
may be considered as complementary for each other. If the
negative cross elasticity of demand is high, the degree of
complementarily is also high. GOODS
 Pricing policy
• Price of one product can directly affect the price of another if they
are related to each other. That is why large firms which produce
more than one product must evaluate cross price elasticity between
each of their products in order to efficiently price them.
• For an example: Le t us suppose Oral-D is company which produces
toothpaste as well as toothbrush (complementary goods). The rise in
price of any one of these products causes fall in demand of that
product as well as the other. Therefore, the company must be careful
while deciding whether or not to increase the price of any product
USES OF ADVERTISING ELASTICITY OF DEMAND
1.Helps in determining the level of prices-
The level of prices fixed by one firm for its product would depend on the amount of
advertisement expenditure incurred by in the market .

2.Helps in formulating appropriate sales promotional strategy-

The volume of advertisement expenditure also throw light on the sales promotional strategies
adopted by a firm to increase its total sales in the market
Thus, it helps a firm to stimulate its total sales in the market .

3.Helps in manipulating the sales-

It is useful in determining the optimum level of sales in the market. This is because the sales made
by one firm would also depend on the total amount of money spent on sales promotion of other
firms in the market .
 IN THE DETERMINATION OF OUTPUT LEVEL
• For making production profitable, it is essential that the
quantity of goods and services should be produced
corresponding to the demand for that product. Since the
changes in demand is due to the change in price, the
knowledge of elasticity of demand is necessary for determining
the output level.