A good’s price elasticity of demand exactly is a measure of the degree to which it is sensitive to its cost. It is very sensitive to price increases, but not so sensitive to price decreases. If the price increases by even just a penny, it will make no difference to the price elasticity of demand, and the product will be sold. But if the price is increased by fifty cents, it would make a huge difference. So the amount demanded does have a price elasticity.
The price elasticity of demand can be determined by using a pricing strategy known as the Keunan-Krueger method. This pricing strategy was introduced by professors Robert K. Koven and Ulrich Keunan in their paper, “Pricing Problems of a Market Price,” published in the Journal of Marketing Research, Volume 3. This pricing strategy assumes that there is only a certain amount of price change that occurs with a change in the total number of units that are being bought or sold. If the total number of units is greater than or equal to a predetermined threshold price, then the price change will have no effect on the elasticity of demand.
To determine the optimal pricing strategy, a company should first determine how much revenue they are currently earning and then determine the maximum amount of revenue that they can earn over time. From this data, the slope of a line graph can be drawn to indicate the maximum point of price elasticity. From this point, the optimal pricing strategy can then be determined.
To determine an optimal pricing strategy, a company first needs to know what type of elasticity it is: is it a zero elasticity, high elasticity or low elasticity industry? Once this is known, then the optimal pricing strategy can be determined. If a company sells a product to a consumer whose income is in a fixed range, such as $40k, then it should charge the consumer a set price that does not exceed this range by more than the percent of income that they are currently making. The same would apply if a company were to sell a commodity to a consumer whose income is in a flexible range, such as $40k per year.
The most commonly used example of an elastic market is the restaurant business. If you go to a fast food restaurant, you are asked what you want to order and there are only a couple choices: You can get a burger or chicken salad. If your income is in a somewhat flexible range, you would probably be able to get away with a smaller salad. However, if your income is in a very fixed amount, such as below forty thousand dollars, then you will find that your choices become quite limited. If you have an idea about the optimal pricing, you can then price products according to the point elasticity of demand.
Point elasticity of demand is described by the equation e_p where P is the price elasticity of demand, d is the increase in the number of units being purchased and c is the change in the existing units being bought (determined by the consumer’s income). By solving for d, we can determine the price elasticity of demand. If P is lower than d, then there will be a higher amount of purchases, which will result in a lower cost for the manufacturer. Conversely, if P is greater than d, then there will be less purchases and the cost will decrease. This can be illustrated by the curve y = e_p / d where y represents the amount of profits that can be made by charging more money for a unit of goods, and the_p is the change in the cost to the manufacturer.
The relationship between tax burden and price elasticity of demand can also be determined by analyzing the relationship between elasticity and tax. The higher the elasticity of demand, the less the amount of taxation that will be applied to a product. Since some goods are more expensive to produce than others, this means that the amount of tax will also be based on the elasticity of demand, rather than on the production of the item. If there is no price elasticity of demand, then the manufacturer will be subject to a large amount of taxation on their product. Therefore, it is important that the government recognize the importance of maintaining optimal pricing, by either taxing or subsidies, so that the market does not become flooded with products that are not economically feasible.
One can also determine the optimum price through mathematical analysis. This is done by dividing the sum of all possible costs incurred by producing the item under two categories, namely exogenous factors and endogenous factors. The exogenous factors include initial investment, transportation and advertising costs, as well as the labor and raw materials necessary to produce the item. The endogenous factors, on the other hand, are wage elasticities and competition among manufacturers, as reflected by price level elasticities computed by dividing the product’s value by its unit price and multiplied by the number of units of the item being produced.