Elasticities and Managerial Decision

Making
Some of the determinants of demand are
controllable and others are not. Knowledge
about elasticities will help the firm to make
optimal decisions. Look at the following
example;
And currently
Px=2, I=2.5, Py=1.8, Ps=0.5 and
A=1Elasticities can also be used to forecast
future demand.
But the firm has no control over the level and
growth of:
- consumer’s income, consumer’s price
expectations, competitor’s pricing decisions,
-and competitor’s expenditures on advertising,
product quality, and customer’s services.

However, the firm can estimate the elasticity

of demand with respect to all the forces or
variables that affect the demand for the
commodity that the firm sells.
The firm needs these elasticity estimates in
order to determine: the optimal operational
policies, and the most effective way to respond
to the policies of competing firms.
For example,
a) if the demand for the product is price
inelastic (Ep > 1), the firm would not want to
lower its price since that would reduce its
total revenue, increase its total costs (since
more will be sold at the lower price), and
face lower profits.
Similarly,
b) If the elasticity of the firm’s sales
with respect to advertising is positive, and
higher than for its expenditures on product
quality and customer’s service,

then the firm may want to concentrate its

sales efforts on advertising rather than on
product quality and customer’s service.
The elasticity of the firm’s sales with respect to
the variables outside the firm’s control is also
crucial to the firm
- in responding most effectively to
competitor’s
policies,
- and in planning the best growth strategy.

For example, if the firm has estimated that,

the cross- price elasticity of the demand for its
product with respect to the price of a
competitor’s product is very high, it will be
quick to respond to a competitor’s price
reduction. Otherwise the firm would lose a
great deal of its sales.

However, the firm would think twice before

lowering its price in such a case for fear of
starting a price war.
Furthermore,
if the income elasticity is very low for the
firm’s product, management knows that the
firm will not benefit much from rising
incomes and may want to upgrade the quality
of its product, and move into product lines
with more income-elastic demand.

Thus, the firm should first identify all the

important variables that affect the demand for
the product it sells.
Then, the firm should obtain reliable estimates
of the marginal effect of a change in each
variable on demand.
The firm would use this information to
estimate the elasticity of demand for the
product it sells with respect to each of the
variables in the demand function.

These are essential for optimal managerial

decisions in the short-run, and in planning for
growth in the long-run.
For example,
Suppose that the tasty company markets coffee
brand X and estimated the following
regression of the demand for its brand of
coffee.
QX = 1.5 – 3.0PX + 0.8I 2.0PY – 0.6PS + 1.2A
where,
QX = Sales of Coffee brand X (in millions of
Pounds per year).
PX = Price of coffee brand X
(in birr per pound)
 I = Personal disposable income
(in trillions of birr per year)
PY = Price of the competitive brand of coffee
Y(in birr per pound).
PS = Price of sugar (in birr per pound).
A = advertising expenditures for coffee
brand X (in hundreds of thousands of birr per
year)

Suppose also that this year, PX = birr 2,

I = birr 2.5, PY = birr1.80, PS = birr 0.50,
and A = birr 1
Substituting these values into the above
equation we obtain,
QX = 1.5 – 3(2) + 0,8(2.5) + 2(1.80) –
0.6(0.50) + 1.2(1)
=2
Thus this year the firm would sell 2 million
pounds of coffee brand X.

The firm can use the above information to find

the elasticity of the demand for coffee brand X
with respect to,
its price, income, the price of competitive
coffee brand Y, the price of sugar,
and advertising.

Thus, the elasticities

EP = -3(2/2) = -3
EI = 0.8(2.5/2) = 1
EXY = 2(1.8/2) = 1.8
EXS = -0.6(0.50/2) = -0.15
EA = 1.2(1/2) = 0.6
The firm can then use these elasticities to
forecast the demand for its brand of coffee
next year.

For example,
Suppose that next year the firm intends to
increase,
- the price of its brand of coffee by 5
percent (∆PX/PX = 5%),
- and its advertising expenditures by 12
percent (∆A/A = 12%).
Suppose also that the firm expects

-Personal disposable income to rise by 4

percent (∆I/I = 4%),

- PY to rise by 7 percent (∆PY/PY = 7%),

- and PS to fall by 8 percent (∆PS/PS = 8%).

Using
- the level of sales of (QX) of 2 million
pounds this year,
- the elasticities calculated above,
-the firm’s intended policies for next year,
-and the firm’s expectations about the
change in other variables given above,

the firm can determine its sales next year

QX* = 2,200,000 pounds
The company could also use this information
to determine that,

it could sell 2 million pounds of its brand of

coffee next year (the same as this year)

by increasing its price by 8.33 percent

instead of by 5 percent (by increasing PX, QX
decreases to QX*),

if everything else remained the same.

The extra 3.33 percent increase in PX would
result in,

2 (0.033) (-3) = QX (∆PX/PX) (EP)

= -0.198 or 198,000
pounds less coffee sold

than the 2.2 million pounds forecasted for

next year with an increase in PX of only 5
percent.
Using Elasticities in Decision Making –
Another Example.

The J. R . Smith Corporation, a publisher of

novels hires an economist

to determine the demand for its product.

The demand for the novel is given

by the following equation:
QX = 12000 – 5000PX + 5I + 500PC
where,
PX – is the price charged for the novel
I – is income per capita, and
PC – is the price of books from
competing publishers

Using this information, the company’s

managers want to

1) Determine what effect a price increase

would have on total revenues,
2) Evaluate how sale of the novels would
change during a period of rising incomes.

3) Assess the probable impact if competing

publishers raise their prices.

Solution
1) Calculate quantity demanded, and calculate
point price elasticity.

If demand is inelastic, raising price raises TR.

2) Calculate the income elasticity (EI).
If EI is elastic, the novel is a luxury good.

Thus as income increases, sales increases

more than proportionately.

3) Calculate the arc price-elasticity (Erc).

If Erc is positive, consumers view Smith’s

novels and books from competing publishers
as substitutes.
 Erc = 500 (6/40000) = 0.075

Hence,
a 1 percent increase in the price of other books
results in a

0.075 percent increase in demand for Smith’s

novels.