Question

In at least 200+ respond to the following (please include any references used)

Companies face pricing decisions on an almost daily basis and while the market itself through the equilibrium point tends to set the market price, companies have some maneuverability within that market price (it is really more of a market price range, so to speak). However, changing their price will have consequences on the quantity demanded known as the price elasticity. How do companies determine how elastic (or inelastic) their product(s) are? What are some of the issues that can arise if they are not correct in their elasticity?

Answer 1

Elasticity of demand for a commodity can be defined as the responsiveness of the quantity demanded to a change in one of the variables on which the demand for the commodity depends. These variables can be the price of that commodity (price elasticity of demand), income of the consumers (income elasticity of demand) or prices of other commodities (cross elascity of demand).

Since we are specifically asked about price elasticity of demand (PED), let's focus on this type of elasticity alone.

The reason why companies want to determine how elastic the demand for a commodity is because it's important to establish the perfect price for that commodity. If commodies are underpriced, the company may undergo a heavy loss and it would become to recover operational costs. Likewise, it would not be an ideal situation for companies if the commdities are overpriced, as they may lose out to their competitors.

a) With concepts being covered, let's now move on to the first question; how to determine the PED (price elasticity of demand):

Mathematicaly, PED= [% change in quanity demanded] / [% change in the price],

For better clarity, let's work on a problem. The price of a commodity is reduced from $20 to $15. Due to this, the demand rises from the existing figure of 1000 units to 1200 units.

P1 = $20, P2 = $15 (prices before the reduction and after it, respectively)

Q1 = 1000 units, Q2 = 1200 units (prices before the reduction and after it, respectively)

Now, % change in quanity demanded =

           

putting all the information in the eqation, we get=

        

So, % change in the quanity demanded is (200/1000)x100 = 20%,

Likewise, % change in the price =

        

Again, after putting the values of P1 and P2 into the equation, we get;

So, % change in the price = -25% (negaitive sign indicates reduction in price)

As, PED= [% change in quanity demanded] / [% change in the price],

Price elasticity of demand for this problem will be (20%)/(-25%) = -0.2

In broader sense, there can be five forms of elasicity based on the value of PED (neglect the negative sign for now);

1. Perfectly elastic: PED = ∞, when even a slight change in the price can bring about huge change in the quanity demanded
2. Perfectly inelastic: PED = 0, when the change in price doesn't affect the quanity demanded.
3. Relatively elastic: PED >1, high resposiveness
4. Relatively inelastic: PED<1, low responsiveness
5. Unit elastic: PED=1

B) Issues that can arise if PED values are not calculated correctly

• Wrong estimation of price-demand relation: If PED is not calculated correctly, the companies would never know how much the demand for a commodity falls or rises after the price for the same increses or decreases. This may prove to be the biggest roadblock in their pricing strategy.
• Losing out to their competition: The unjustfied prices woul lead them to heavy losses and less market share.