Explain why it is important for firms to understand the level of elasticity for each product they offer.
Explain what part PED has in understanding the behavior of firms in an oligopoly market, use appropriate diagrams and examples.
By and large, the concept of product elasticity plays a crucial role in determining the best price to balance the revenue of an organization as well as the demand for the products they produce. Demand elasticity can be defined as the sensitivity of demand for a good as a result of changes in other relevant economic variables relating to the good in question (Gosh & Motta, 2014). Elasticity of demand plays a critical role in helping a firm to simulate the potential change in demand of a good. As a result of changes in price of the good, or prices of other goods in the market whilst many other factors. However, this paper identify the importance of the level of elasticity for each product they offer and extensively discuss the role of Price Elasticity of
Demand in understanding the behavior of firms in an oligopoly market.
The price elasticity of demand can be defined as the measure of the relationship existing between the quantities demanded of a good as a result of a change in the price of the product. The price elasticity of demand is used to analyze the price sensitivity of a product. Elasticity can be categorized broadly into two sections. That is elastic demand, as well as inelastic demand.
In a situation where the demand is elastic, a small change in the price of a product will result in large change in the demand of the quantity consumed (Boyes, 2011). On the other hand, if the demand is less elastic, it implies that it requires large increase or decrease of price effect for it to be reflected (inelastic demand). During extreme situation, the curve becomes perfect elastic when the curve is horizontal or perfect inelastic when the curve is vertical (Mankive et al., 2007)
Elasticity of demand is an important concept used by firms and governments in understanding concepts relating to taxation, the theory of firm, and distribution of wealth in the society, marginal concepts in production of goods and services as well as the consumer theory (Schneider et al., 2013). Elasticity of firms plays an important role in helping firms to set optimal prices for different goods and services they produce. Firms simulate the price of a product they produce by varying the price over time and come up with ideal price. And come up with an ideal optimal price which balances both the firm’s revenue as well as the product demand in the market.
A firm also employs the concept of elasticity in consumer theory to analyze impact of advertising on demand for particular goods and services. This is very important in understanding the consumer of a firm product even before engaging in intensive advertisement or a less intensive advertisement strategy. The strategy chosen depends on the impact of advertisement on the demand of the product.
On the same note, elasticity of demand is very paramount in international trade. This is because elasticity of demand helps a country to fix the prices for their imports or exports depending on the demand of the product globally. Government also uses the concept of elasticity when coming up with policies in relation to taxes. The government analyses the incidence of tax burden before coming up with tax policies. Government taxes an elastic product more as compared to inelastic product due to its sensitivity.
In an oligopolistic market both elastic and inelastic concept of demand is used jointly to describe the market situation. An oligopoly refers to a market structure in which there are few firms which dominates the market (Gosh &Motta, 2014). In an oligopolistic market, a firm faces two demand curves for the product they produce. That is elastic demand curve and inelastic demand curve.
In higher prices rather than equilibrium the firm faces a relative elastic demand. This tendency is because when the price of a good produced by a firm in an oligopolistic market increase, the good becomes uncompetitive resulting to a fall in demand (Esteves, 2014). On the other hand, when the price of the good is lower than the equilibrium the firm faces a relatively inelastic demand. This is because when a firm decreases its prices, the demand for their product increases rapidly. Consequently, in such situation, other firms in the market do not want to lose their customers and, therefore, reduce their prices (Rios et al., 2013). This situation where the market faces two demand curve result in what is referred as a kinked demand curve.
A firm in an oligopolistic market faces a kinked-demand curve as a result of cut throat competition arising from other oligopolistic firms in the market. If a firm in an oligopolistic market increases the price of its product above the equilibrium price, other firms in the market will not follow the suit by increasing the prices of their products (Neubecker, 2006). The demand curve in an oligopolistic market is more elastic above the equilibrium price. Since a rational consumer is more likely to switch to lower priced goods which are provided by other firms in the oligopolistic market, therefore, the demand of the goods provided by the firm charging higher price is likely to fall.
On the other hand, if a firm in an oligopolistic market reduces the price of its goods below the equilibrium price. Then, other firms in the market will also reduce their prices. Hence the demand curve below the kink is less elastic. This is because of the tendency of other firms to reduce their prices as well. Because of the interdependence among firms in an oligopoly market, the price goods and services provided by such firms are less elastic to changes in price of the product (Gosh &Motta, 2014). Given that, each firm matches the price of its product to the price of products produced by the competitors.
In Conclusion, the concept of elasticity of a good is important for all firms in the market. Firms use price elasticity concept to set competitive prices and develop strategies to maximize profits and at the same time maintain demand curve. Therefore, the concept of price elasticity is important for firms to make critical decision concerning consumers taste and preferences, effects of taxes on demand of goods, setting international prices among other important application in the theory of firm.
Boyes, W. J. (2011). Managerial economics. Boston, Mass: Houghton Mifflin.
Esteves, R. B., & Reggiani, C. (2014). Elasticity of demand and behaviour-based price discrimination. International Journal of Industrial Organization, 32, 46-56.
Ghosh, A., & Motta, A. (2014). Budget Constrained Consumers and Oligopoly Pricing. UNSW Australian School of Business Research Paper, (2011).
Mankiw, N. G., & Taylor, M. P. (2007). Microeconomics. London [u.a.: Thomson.
Neubecker, L. (2006). Strategic competition in oligopolies with fluctuating demand. Berlin: Springer.
Rios, M. C., McConnell, C. R., & Brue, S. L. (2013). Economics: principles, problems, and policies. McGraw-Hill.
Schneider, E. (2013). Pricing and equilibrium. Routledge.