Price Elasticity and Decision Making

Subject: Financial Management
Pages: 6
Words: 1841
Reading time:
7 min
Study level: PhD


The theory of price states that, market price is the interaction between two considerations that are opposing. One side is the considerations of demand basing it on marginal utility and other side is supply considerations basing on marginal cost. An equilibrium price is equal to marginal utility from the side of the buyer and marginal cost from sellers’ side. This concept is acceptable by all economists and constitutes mainstream economics. The relationship that exists between price and demand is always measured using price elasticity. Price elasticity of the demand is percentage change in demand divided by percentage change in price. If the change in demand is more than change in price, the good is said to be price elastic and if change in demand is less than change in price, it is said to be price-inelastic.

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Price elasticity gives important information to firms on how increase in price affects total firms revenue. If there is price elasticity of demand that is less than one, total revenue is caused to increase by the increase in price. However, with price elasticity of demand that is greater than one, price increase result to a decrease in total revenue. Similarly, price elasticity of supply is how supply responds to change in price. Price mechanism is where price is set by the market and depend on competition in the market. (Winston, 2005 pp 13-17).

Perfect competition occurs where the firm is a price taker. In monopoly market, there is some power for the market to decide price and seller has some control of the price. Change in price makes consumers and firms show economic behavior, for example, firms’ are encouraged by rise in price to increase supply but consumers look for alternative products to act as substitutes. Firm may have price discrimination for some products where they sell same product in different markets at different prices. For a firm to be able to price discriminate there must be separation between markets because price discrimination may break down if the markets have leakage about the prices of goods.

Price elasticity help in setting prices of goods and services because price elasticity of demand affects management yield and total revenue. For example, if monopoly firm sets prices for the services and demand in the peak period is inelastic and demand in off peak period is elastic, revenue and yield can be maximized by setting low prices during off peak period and higher prices during peak period or use of price discrimination.

In addition, through considering factors that affect price elasticity of demand a firm is able to set prices basing on information on price elasticity. For example, a firm is aware that switching cost may affect price elasticity due to increase of switching costs of services thereby making the demand to be inelastic and charge higher prices because it may not be possible for customers to switch to other firms quickly due to the higher costs of switching. The service providers of telecommunication maintain market share because switching costs affect price elasticity of demand and increase in switching costs restrict their customers from choosing services from competitors (Taylor, 2000 pp 10-15).

When the market is competitive, firms are able to consider price as being a competitive strategy if there are similar substitutes and products and price elasticity will be elastic and affect sales. That is, firms must put into consideration market structure because price elasticity of demand is affected and affect the level of yield in the firm. Firms use price elasticity to clarify relationship that exists between variable that are economically significant. For elasticity to become useful, it is important to know what they measure. Estimation of elasticity is determined by idiosyncrasies of particular market where information is derived. A single elasticity cannot hold market all times because price elasticity varies if analysis is begun at different price level. Quantity demanded will change to respond to change in price but there will be different relative sizes of change. It is important for one to know where estimate of elasticity applies and the price level in the market and changes when estimates are made.

The firm is able to know revenue maximizing strategy in order to know how to strengthen a firm and maximize profits in the long-run. Economic theory says that firms strive to maximize profits. However, to be able to achieve the best results, goals are approached indirectly instead of directly. Firms may set goals being their highest priority by ensuring consumers are satisfied, offering high quality goods and services and trying to maximize revenue. This helps to achieves huge long-term profits compared to the firm that use direct means of maximizing profits.

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Price elasticity is important in regulating profit percentages. If profit is expressed as percentage, it may be high and result to a strong reaction. As a result, percentages of profit have no great variation and do not become too high especially incase of large contracts and large defense firms that are not monitored intensely. When revenues are higher, there are numerous advantages because there are more resources in terms of capital equipment, fully developed infrastructure and personnel. A firm that is rich in resource is able to have future programs because growth in revenue is related to job security especially if other firms are experiencing decline in revenue. Revenue growth save jobs and result to higher profits because, percentage profit varies little and is also uncorrelated with price. (Karl, 2004 pp 33-37).

Analyzing why the concept of price elasticity is important to the government

price elasticity of demand is important for the government when imposing taxes because, imposition of tax lead to increase in price thereby affecting supply of the products and in case they are elastic, consumers will decrease their purchases and price will increase as a result of tax imposition and less tax is paid in case of inelastic price elasticity. There should be no imposition of tax on elastic goods because they do not collect sufficient taxes in comparison with imposition of tax on goods which are inelastic. For example, there is imposition of tax by government on alcohol and its demand depend on habits rather on the selling price which makes demand become inelastic instead of elastic. For monopoly, supplier of business services such as transport tolls and rail, higher prices is charged during peak periods and low prices during off peak because, in peak periods, there is inelastic price elasticity of demand when compared with off peak periods.

When the market is monopolistic, more competition is introduced and the government regulates prices in order to protect customers from practices of price maintenance and also anti competitive practices by monopolies for the market to become more competitive and demand become elastic. If the government fails to intervene, customers may be charged higher prices for goods and services offered to them making them unaffordable to purchase. When there is competition, there will be many firms within the same line of business and each firm will try to offer high quality products and reduced price so that they can be able to attract many potential customers who would be willing and able to purchase the products and enjoy their services in the long-run. (Sadd, 2005 pp 24-28).

Price elasticity ensures that under contract common law, there is legal obligation for the manufacturers that face damages due to breach contract if the binding contract has been breached and the person affected can be able to sue for damages or court order specific performance in honor of the contract. The government ensures that, legal procedures are followed in any contract that has been made between two or more parties in carrying out business so that no party can be charged higher price for the goods rather that the agreed set price according to the value of the commodity.

The importance of price elasticity is to enable the government intervene the price through imposing price ceiling and price floor which depend on the situation. In a particular item, if price elasticity of demand is inelastic, the item is likely to be a necessity. If the sellers after considering certain factors set the price too high, the government intervenes through imposing price ceiling. The price ceiling set help in protecting the customers because, if the item is a necessity, they can not be able to do without it and due to the limited supply of funds and unlimited need for the item, the government has to set the price that is affordable to all consumers so that they can be able to purchase the product all the time as the need arise.

When price elasticity of demand for an item is elastic, that item is termed as luxury. Sometimes, high price of a luxurious good makes its demand to decrease and the suppliers will be affected. In such a situation price floor will be imposed by government to be able to protect suppliers. Thus, through knowing price elasticity of demand, government is in a position to understand how price impact on consumers demand and therefore is able to intervene. (Landau, 2006 pp 13-18).

Price elasticity help the government to spend taxes and ask for credit if the tax collected is not enough. Setting up taxes makes prices to go up and there is reaction by population to the rise in tax in different ways. Tax makes people poorer and they tend to buy things that are cheaper leading to substitution effect. In cases where elasticity of demand becomes greater than one, fewer goods will be bought and if it is less than one, more taxed goods will be bought.

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Price elasticity of demand measures the degree of responsiveness due to little change in the demand. When the price of a commodity changes a little, it can either increase quantity purchased or reduce it. This is important to the government because, it enables the government to determine love of commodity and know whether the price need to be increased or decreased and help in determining whether price legislations need to be applied.

There is conceptual link in classical economists mind in tax policy and price elasticity. During nineteenth century, much revenue was raised by European government from taxes on domestic and foreign goods and taxes raising final prices of goods. If government seeks to raise huge amounts of revenue this way, it should have understanding of the idea of price elasticity being crucial in order to determine effects of removing, imposing, lowering or raising taxes charged on specific commodities. Classical economists say that government tax policies should consider price elasticity in different goods in concluding about the goods to be taxed and the tax rate to be applied. (Barber, 2002 pp 23-27).


Barber J. (2002): Elasticity: Kluwer Academic Publishers, pp 23-27.

Landau L. (2006): Theory of Elasticity: Butterworth-Heinemann, pp 13-18.

Sadd M. (2005): Elasticity; Theory, Applications and Numeric: Elsevier Butterworth, pp 24-28.

Karl C. (2004): Principles of economics: Wiley and sons, pp 33-37.

Winston M. (2005): Microeconomic Theory: Oxford University Press, pp 13-17.

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Taylor L. (2000): Consumer demand, analysis and projections: Harvard University Press, pp 10-15.