How can firms and governments use price elasticity of demand (PED) when making decisions?

The use of economic theory in decision-making by firms and governments is very important. Its use ensures that firms choose the quantities of goods they produce and their selling price (in the case of firms operating in imperfect competition) at a level where the profit earned is maximized.

Similarly, its use ensures that the benefits of government policies such as price controls (price floors and price ceilings) are greater than the deadweight loss experienced by the economy.

Price elasticity of demand (PED) measures the level of responsiveness of the demand for a good when there is a 1-percent change in the price of the good. When PED is less than 1, demand is inelastic. PED greater than 1 indicates that demand is elastic, and PED equal to 1 is unitary.

PED and The Firm

a) When demand is elastic, firms should choose to reduce their selling prices in order to increase their profits. This is because elastic demand is very sensitive to price changes, and according to the demand theory demand increases as price decreases. Therefore, the price reduction would be outweighed by the rise in demand, so the firm would earn increased revenue. Products with an elastic demand include luxury items, movie tickets, beverages, and food items.

b) In contrast, when demand is inelastic, firms should choose to increase their selling prices in order to increase their profits. This is because inelastic demand is not very sensitive to price changes, as such demand would decrease (due to the demand theory), but only slightly. Therefore, the price increase would outweigh the slight decrease in demand, so the firm would earn increased revenue. Products with an inelastic demand include most medications.

c) In the case of unitary demand, any price change is met with a proportional change in demand. Simply, the percentage changes in both price and demand are equal. 

PED and Governments

In some markets, such as farming and real estate, government enforces price controls. Such controls may result in excess demand or excess supply; however, the government can prevent these excesses with the use of PED knowledge.

d) When demand is inelastic, the government should set a price floor (the minimum price at which a good can be sold). This would cause firms operating in this market to increase their offering price above the original equilibrium price, which is similar to the firms' action mentioned above in part b.

e) When demand is elastic, the government should set a price ceiling (the maximum price at which a good can be sold). This would cause firms operating in this market to offer a reduced price that is below the original equilibrium price, which is similar to the firms' action in part a.