Price Elasticity and Decision-Making in Business

Subject: Economics
Pages: 6
Words: 1763
Reading time:
7 min
Study level: PhD

Businesses normally face a lot of price demand curves in their day-to-day operations, although a few rarely know the implications of such demand curves. It is however important for businesses to have a clear picture of what such demand curves mean, in order for them to make important decisions regarding strategy and policy formulation (Schenk, 2010, p. 1). For example, if a pizza parlor increases its prices, say by 5%, the implications of such a price increase on the revenues of the business need to be established before the decision is made. Practically, the determination of this fact depends on how the consumers react to the price increase; for example, will the consumers stop buying the pizzas completely, or would they significantly reduce their purchases? Such questions, regarding the implications of price changes and consumer behavior, define price elasticity (Schenk, 2010, p. 1).

However, this relation is not only unique to businesses, but to governments as well. This is because governments also engage in the provision of goods and services, especially for the good of the general populace. However, the difference between price elasticity determination between governments and businesses is that, businesses are primarily motivated by the goal of making profits but governments are not. Price elasticity is therefore only an important facet of the macroeconomic policies of the government (Schenk, 2010, p. 1).

This research paper seeks to establish the importance of determining price elasticity to both businesses and governments in the decision-making process. In this regard, this paper will identify the implications of price elasticity study to both groups of investors. This will be done systematically and in two categorizations of both business and government.


Determining the Right Course of Action

The concept of price elasticity is usually important for businesses in determining the right course of action because consumer elasticity (with regards to price differentials) eventually determines whether the aim of the business, in decreasing or increasing prices, would eventually be realized (Jain, 2010, p. 157). For example, if a business decreases its prices with the aim of increasing the demand for goods and services; it is unlikely to realize this goal if its target customer group is not price elastic. This is especially the case if the changes in prices are insignificant. Obviously, this would imply that the organization needs to go back to the drawing board to come up with another strategy of increasing its demand (for example through marketing strategies and the likes).

Decisions on Competitor activity

Businesses which engage in the provision of a number of goods and services are normally influenced by the effect of cross price elasticity (which implies the relationship of an increase or decrease in the price of a given good or service on another substitute good or service) (Hussain, 2010, p. 102). The inclusion of price elasticity concept is very important in the estimation or quantification of competitor pricing strategies. In the same manner, such an analysis can be quite important in determining the effect of a price change on a given complimentary product (Hussain, 2010, p. 102). For instance, if the price of shoe polish goes up, there will be a significant impact on the sale of shoe brushes, and in the same manner, if the price of toothpaste goes up, the sale of toothbrushes would be affected. In this context Socyberty (2009) explains that “For example a firm can formulate pricing strategies if they have complementary products depending on the cross elasticity of demand to increase sales and improve profitability by analyzing the cross elasticity of demand” (p. 7). In the same manner, Socyberty (2009) further makes reference to wage differentials by stating that:

“The cross elasticity of demand is also useful in analyzing wage policies on different groups. For example if cross elasticity for different groups of young people, say male and female, then it may show the impact of setting wage levels on the replacement by females by men and the degree they are replaced” (p. 9).

Decisions on Maximization of Revenue through Price Discrimination

Price discrimination normally occurs when businesses sell their goods or services at different prices in various markets. This is an important business strategy of profit maximization because different markets have different potentials and different consumers have different uses for different products as well (Jain, 2010, p. 157). Businesses can perfect the art of price discrimination in profit maximization by incorporating the concept of price elasticity. Price elasticity is important because it enables businesses to maximize revenues in inelastic markets because they will be able to maintain high revenues, even when they increase their prices (Jain, 2010, p. 157). Low prices are also likely to be charged where the market is elastic, because a slight increase in prices could eventually result in a significant dip in sales.

For instance, electricity companies normally charge high rates for electricity consumption (for domestic consumers) as opposed to industrial consumers. This is because domestic consumers have an inelastic demand for electricity, but industrial consumers have an elastic demand. This means that if an electricity company increases the price of electricity for domestic consumers, demand is still going to be maintained, probably because domestic consumers cannot do without electricity (this implies an inelastic demand). However, if the same strategy is applied to industrial consumers, companies may stop consuming electricity and resort to other sources of energy, like fuel, coal and the likes. From this analysis therefore, we see that the concept of price elasticity enables businesses to formulate important decisions on how to maximize their revenues on potential markets and still maintain good sales in elastic markets (Jain, 2010, p. 157).


Determining the Right Course of Action

Determining the right course of action from the inclusion of price elasticity concept is not unique to businesses alone, because governments also rely on the concept of price elasticity to determine the right course of action in formulating macroeconomic policies (Jain, 2010, p. 157). For example, if the government intends to reduce the consumptions of socially inappropriate goods and services, such as alcohol, prostitution or gambling (through high taxation); it ought to incorporate the concept of price elasticity because it needs to establish whether the targeted industry is responsive to tax increases or not (Socyberty, 2009). If it is not responsive, there is an increased likelihood that their strategy would not work. Price elasticity in this context therefore enables governments to establish whether their strategic decisions (with regards to high taxation) will work or not.

Decisions on How to Maximize Revenues

Price elasticity is actually very important to governments because governments are primarily motivated by the aim of increasing revenues through taxes, in order to support various social activities (Deepashree, 2006, 3). This function is especially important in times when the government is facing significant budgetary deficits because it needs to carry out important social duties to the general populace. In such a situation, governments normally resort to increase taxes on the consumption of goods and services (Deepashree, 2006, 3). However, this does not always work if there is no skill applied on the concept of price elasticity.

Economists note that taxes should be increased only on goods and services which are least inelastic (in terms of demand) and those which have high elasticity should remain untouched (or taxes should be lightly imposed) (Deepashree, 2006, 3). This is an important managerial concept because highly elastic demands, in the consumption of goods and services, would not amount to an increase in goods and services because if heavy taxes are imposed, consumers would simply stop the consumption of such good and services. Governments would therefore fail in their strategy to increase revenue. However, when heavy taxes are imposed on goods and services (which have an inelastic demand) revenue increases are likely to be realized because the consumption of goods and services will not be affected by a price increase.

Maintaining a Favorable Balance Of Trade

International trade is normally affected by the elasticity or inelasticity of exports and imports. Governments strive to maintain a favorable balance of trade between imports and exports, through the devaluation or valuation of their domestic currencies (Deepashree, 2006, 4). The balance of trade primarily refers to the difference between exports and imports (Deepashree, 2006, 3). An unfavorable balance of trade is therefore realized if the imports exceed the exports, and normally in such cases, economists advocate for a devaluation of the currency to correct the situation (Deepashree, 2006, 4). This kind of strategy is likely to make exports cheap and in turn make imports quite expensive. This strategy is therefore likely to promote more exportation of goods and discourage the importation of goods (Deepashree, 2006, 4). However, such a strategic decision is only useful if price inelasticity is factored into the overall macroeconomic strategy; otherwise, such a strategy would be fruitless. This is true because if the price elasticity of demand for exports is elastic (and for imports is inelastic); a devaluation strategy would not work.

Distribution of Tax Burden

Governments across the globe are normally engaged in the allocation of various types of indirect taxes (like sales tax, excise duty and the likes) on various goods and services (Jain, 2010, p. 157). However, this ought to be carefully done, considering various population groups have different capabilities of absorbing tax. From this point of view, it is important for governments to factor-in the concept of price elasticity. If the price of a good is inelastic, the tax burden on the consumers would be enormous, but the price of goods would increase in the long run because the demand for the good would not decrease because of its inelasticity (Jain, 2010, p. 157). This warrants a redistribution of the tax burden because many people would be affected by such tax disparities. The concept of price inelasticity therefore enables governments to redistribute the tax burden.


The concept of price elasticity is quite important to both businesses and governments. This study basically points out the fact that both governments and businesses can utilize the concept in determining the right course of action for their governmental or business endeavors. However, on a more fragmented front, businesses can utilize the concept of price inelasticity in making important decisions regarding competitor activity and maximization of revenues through price discrimination. Governments on the other hand can utilize the concept when making important decisions regarding the distribution of tax burden, how best to maximize revenues (through taxes) and how best to maintain a favorable balance of trade. These factors comprehensively define the importance of price elasticity and decision-making to both businesses and governments.


Deepashree. (2006). Microeconomics and Macroeconomic Environment for Ca Pe I. London: Tata McGraw-Hill.

Hussain, T. (2010). Engineering Economics. New York: Laxmi Publications, Ltd.

Jain, T. K. (2010). Business Economics (for BIM). New York: FK Publications.

Schenk, R. (2010). Price Elasticity.

Socyberty. (2009). The Concept of Cross Price Elasticity of Demand and Its Usefulness to Business and Government.