Explain the relevance of PED concepts to producers in trying to maximize revenue

 

 

Qn. Explain the relevance of elasticity (price) and elasticity (cross) in business decision making

 

PED refers to the degree of responsiveness of quantity demanded to a given change in the price of a good, ceteris paribus. Quantitatively, it can be calculated by % change in qty dd/ % change in P.

PED can be useful to a producer in maximizing revenue. For instance, by changing his prices according to the elasticity of demand for his productz.

For inelastic demand, ie PED<1, producer should raise prices to maximize revenue. THis is because given the nature of the product, which is usually a necessity such as rice, consumers quantity demanded respond less than proportionate to price change. Ie, the gain in revenue from a rise in price, is more than the loss in revenue from the drop in output.

Price Demand Curve

Price Demand Curve

In figure, as price is raised from P1 to P2, output drops less than proportionate, from Q1 to Q2, the producer has a gain in revenue.

For elastic demand such as luxury goods with PED>1, the producer can apply PED knowledge, dropping prices to raise revenue. For instance, dropping price from P1 to P2 leads to a more than proportionate increase in quantity demanded, the revenue gain is more than the loss in revenue from the drop in price. Ie revenue maximized when dropping prices for elastic demand.

However, the limitations for PED are that it is subjected to ceteris paribus assumptions, time period in reality is not fixed, it is not possible for producer to collate data on consumer’s willingness and ability to consume. Lastly, producer might not have flexibility to change prices as and when he likes, for instance, if he is a franchise such as Macdonalds.

 

XED refers to degree of responsiveness of demand of a good A in response to a change in price of a good B. It can be calculated by %change in demand A/ %change in price B.

XED can be used by a producer for marketing purpose to maximize revenue.

 

For goods such as close substitutes, XED>1, if a competitor raises price, there is a more than proportionate drop in the demand of the producer’s good. For unclosed substitutes, XED<1, there is a less than proportionate drop in the demand for the producer’s goods. With such knowledge, the producers could try to use product differentiation to reduce the substitutability of his good to his competitors. In that case, the good will now be less cross elastic, ie it will not be affected significantly by competitors pricing. Applying Starbucks and Coffee Bean, if they were close substitutes, Starbucks would be seeing a huge drop in demand if coffee Bean dropped its price, it can use product differentiation, such as offering new flavors/drinks, so that consumers see them as less close substitutes, as such will not be changing preference towards Coffee Bean should they drop prices.

 

For complementary goods, with XED < 0, if the price of a complement goes up, there is a subsequent drop in the demand of a producers good. Complements are goods that are used together with one another, for instance, smartphone and apps. If the price of smartphones go up, qty demand for smartphones drop, hence derived demand for apps drop as well. In this case, recognizing complementary relationship, producers should try to bundle complementary goods together to sell them, so that the demand of related items will not drop due to a price change in its complement, since consumers are buying both products at the same time.

 

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By |2015-10-05T21:58:00+00:00October 5th, 2015|Economics resources, Micro: Demand & Supply|0 Comments

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