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Demand and Forecesting Economics MBS First Year

Demand and Forecesting Economics MBS First Year

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Published by Store Sansar

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Published by: Store Sansar on Sep 08, 2010
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Applications of the Price Elasticity of Demand
The concept of elasticity of demand plays a crucial role in the pricingdecisions of the business firms and the Government when it regulates prices.The concept of price elasticity is also important in judging the effect of devaluation of a currency on its export earnings. If has also a great use infiscal policy because the Finance Minister has to keep in view the elasticity of demand when it considers to impose taxes on various commodities. We shallexplain below the various uses, applications and importance of the elasticityof demand.Elasticity of demand is mainly useful in Pricing Decisions by Business Firms.The business firms take into account the price elasticity of demand whenthey take decisions regarding pricing of the goods. This is because change inthe price of a product will bring about a change in the quantity demandeddepending upon the coefficient of price elasticity. This change in quantitydemanded as a result of, say a rise in price by a firm, will affect the totalconsumer’s expenditure and will therefore, and affect the revenue of thefirm. If the demand for a product of the firm happens to be elastic, then anyattempt on the part of the firm to raise the price of its product will bringabout a fall in its total revenue. Thus, instead of gaining from the increase inprice, it will lose if the demand for its product happens to be elastic. On theother hand, if the demand for the product of a firm happens to be inelastic,then the increase in price by it will raise total revenue. Therefore, for fixing aprofit maximizing price, the firm cannot ignore the price elasticity of demandfor its product.Price elasticity of demand can be used to answer the following types of questions:1.
What will be the effect on sales if a firm decides to raise the price of itsproduct, say by 5 percent?2.
How large a reduction in price of a product is required to increasesales, say by 25 percent.It has been found by some empirical studies that business firms often fail totake elasticity into account while taking decisions regarding prices, or theygive insufficient attention to the coefficient of price elasticity. No doubt, the
main reason for this is that they don’t have means to calculate priceelasticity for their product, since sufficient data regarding past prices andquantity demanded at those prices are not available. Even if such data areavailable, there are difficulties of interpretation of it because it is not clearwhether the changes in quantity demanded were the result of changes inprice alone or changes in some other factors determining the demand.However, recently big corporate business firms have established theirresearch departments which estimate the coefficient of price elasticity fromthe data concerning past prices and quantities demanded. Further, they arealso using statistical techniques to isolate the price effect of the quantitydemanded from the effects of other factors.
Applications of Cross Elasticity of Demand forBusiness Decision Making
The concept of cross elasticity of demand is of great importance inmanagerial decision making for formulating proper price strategy.Multiproduct firms often use this concept to measure the effect of change inprice of one product on the demand for other products. For example, MarutiUdyog decides to lower the price of Maruti-800; it will significantly affect thedemand for Maruti Vans and Maruti Esteem. So it will formulate a properprice strategy fixing appropriate price for its various products. Further,Gillete Company produces both razors and razor blades which arecomplements with high cross elasticity of demand. If it decides to lower theprice of razor, it will greatly increase the demand for razor blades. Thusthere is need for adopting a proper price strategy when it produces productswith high positive or negative cross price elasticity of demand.Second, the concept of cross elasticity of demand is frequently used indefining the boundaries of an industry and in measuring interrelationshipbetween industries. An industry is defined as a group of firms producingsimilar products (that is, products with a high positive cross elasticity of demand. For example cross elasticity of demand between Maruti Esteem,Dawoo Ceilo, and Opel Astra is positive and quite high. They thereforebelong to the same industry (i.e., automobiles). It should be noted thatbecause of interrelationship of firms and industries between which crossprice-elasticity of demand is positive and high, any one cannot raise theprice of its product without losing sales to other firms in related industries.Further, the concept of cross elasticity of demand is extremely used in theUnited States in deciding cases relating to antitrust laws and monopolisticpractices used by firms. If so happens that in order to reduce competitionthat one dominant firm try to merge with each other to form a cartel toenjoy monopolistic profits. These actions are held illegal by Antitrust or anti-monopoly laws. An interesting attempt was made in India by Casa-Cola andit further made efforts to take over ‘Pure Drinks’, venture it could havesignificantly reduced competition. With this its competition would have beenwith other multinational rival firm Pepsi-Cola.

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