Why is price elasticity of demand important to firms?

Price elasticity is important to firms because it influences the price the firms will charge for their products or services. Additionally, it will help businesses develop strategies, maximize profit, and reduce risk.

Expert Answers

An illustration of the letter 'A' in a speech bubbles

We'll begin with two scenarios to illustrate price elasticity of demand. First, there is a particular movie you want to buy on DVD, but the price is rather high when the movie is first released, so you decide to wait for a while before you buy. The next time you...

See
This Answer Now

Start your 48-hour free trial to unlock this answer and thousands more. Enjoy eNotes ad-free and cancel anytime.

Get 48 Hours Free Access

We'll begin with two scenarios to illustrate price elasticity of demand. First, there is a particular movie you want to buy on DVD, but the price is rather high when the movie is first released, so you decide to wait for a while before you buy. The next time you check, the price has gone up even a little further, and you notice that there are quite a few copies still on the rack. Apparently, other potential customers have also decided to wait. The store has noticed this, too, and the next time you shop, you are surprised to see that the price has dropped significantly. It is well within your payment comfort zone, so you snatch up the second to last copy. This is a prime example of an “elastic” product. The higher the price, the less demand there is for the product. As the price drops, however, the demand increases.

Now think about another scenario. You are required to make an overnight trip for business, and you need to put gas in your car. You notice that gas prices have risen some since the last time you filled up, but since your car would be running on fumes by the time you reached your destination, you make the purchase anyway. In this case, the product is “inelastic.” Demand doesn't vary too much according to the price.

Now let's think about how price elasticity affects businesses and their decisions. Returning to the first scenario, we can see that price elasticity has affected how the store sets the price of the movie. At first, thinking that the movie would be in demand even at a higher price, the store charged more for each DVD. When that didn't work and the DVDs stayed on the rack, it dropped the price, recognizing the elasticity of demand. So businesses often set and change their prices based on the elasticity of demand. Further, stores and firms might develop marketing campaigns to lead consumers toward accepting higher prices.

In the second scenario, the gas station raises its prices according to factors other than elasticity of demand. However, that still affects the business, for as prices go up, it needs to develop strategies to help satisfy grumbling customers. A station might, for instance, develop a new advertising campaign or a customer rewards program to help offset higher prices. It might even drop prices on other products.

Knowing the price elasticity of demand for their products helps firms set proper prices, plan ahead for product releases, monitor consumer trends, and develop useful business and advertising strategies.

Approved by eNotes Editorial Team
An illustration of the letter 'A' in a speech bubbles

The price elasticity refers to the degree of responsiveness of demand as a result of a change in price.

The price elasticity of demand is important to firms because it helps them in pricing their products. The firm needs to know whether their product has an elastic or inelastic demand.

A product with elastic demand is more responsive to a change in price. Such goods have numerous substitutes; therefore, the consumer can go for another brand if their favorite company is charging more for the product. If the firm finds out that their good has elastic demand, they might try to differentiate the product from others. Differentiation can help them charge a higher price for a while, but in the long-run consumers will still go for the most affordable item. As a result, most firms tend to focus on producing more elastic goods. Since they can’t increase the price as much as they’d like to, they have to produce more in the hopes that they will sell more and increase revenues.

On the other hand, a good with inelastic demand is less responsive to changes in price. You can increase the price, and the quantity demanded won’t change by much. If a firm’s products have inelastic demand, the firm can practice price discrimination in different markets. The firm can charge more in a neighborhood with high-income individuals.

Approved by eNotes Editorial Team
An illustration of the letter 'A' in a speech bubbles

Price elasticity is important to firms because it will influence the price they will charge for various products or services. If a product has an elastic demand, it means that the amount demanded will change as the price of the product changes. Businesses will need to closely monitor how the demand for their products change as the price changes. For example, if the price of milk doubles, it is likely that the demand for milk will drop since it is a product with an elastic demand.

If a product has an inelastic demand, businesses don’t need to be as sensitive to changes in price mainly because people will need to have that product or service regardless of its price. A good example of this would be the cost to visit a doctor. If a person was really sick and in urgent need of medical care, it is likely that person would pay whatever price was charged to visit the doctor. A person probably wouldn’t shop around for the best rate. A similar situation exists with oil. As oil prices rise, people will still buy gasoline because they need to get from place to place. While they might reduce oil consumption to some degree, people still have a need for the gasoline and will purchase it.

Knowing the price elasticity of a product or service will impact the price the business can charge for it. It also will allow a business to develop marketing and pricing strategies that will allow it to potentially maximize its profits and hopefully reduce its risks.

Approved by eNotes Editorial Team
An illustration of the letter 'A' in a speech bubbles

Price elasticity of demand is a measure of change in quantity demanded of a commodity relative to a change in its price. If the demand is inelastic, an increase in price results in increased revenue. If the price rise results in decreased revenue, the demand is elastic.

Knowing the price elasticity of demand, a firm can decide on an optimum price level of their commodity to achieve their revenue targets. Price elasticity information can help them decide how much price reduction is necessary to increase revenue to a certain target, or what level of price increase will be optimal (since extra revenue from a price increase may be wiped out by decreased demand). 

The knowledge of price elasticity of demand also helps firms in devising their marketing strategies and targeting niche segments. An example is high net worth individuals whose demand for luxury is inelastic and hence hotels advertise suites to them. On the other hand, budget travelers have an elastic demand and hence are targeted for 'Standard' rooms.

Approved by eNotes Editorial Team