How does the price elasticity of demand affect a firm\'s pricing decisions? Give

Question

How does the price elasticity of demand affect a firm's pricing decisions? Give a real-life example of an actual company and a product or service that substantiates your response to this question.

Max Points: 7.0

Jane spends all her income on hot dogs and caviar. Her demand curve for caviar is inelastic at all prices for caviar. Unfortunately, the accident at Chernobyl has caused the supply of caviar to fall and the price to rise. What has happened to Jane's consumption of hot dogs? Explain. (Note: You should assume that the accident at Chernobyl had no effect on the price of hot dogs or Jane's preference for caviar.)

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Explanation / Answer

1. The price elasticity of demand affects a firm's pricing decisions by determining the optimal profit margin. Price elasticity of demand describes the rate of change of demand in response to a change in price. The higher it is, the higher demand changes in respond to price; lower means very little change. For a good with low elasticity, it is easier to profit off marking-up the price because demand falls little in response to a price increase. For a high elasticity, prices should approach equilibrium because straying from equilibrium results in a higher change in demand than in price. For example, Heinz determines the price of a bottle of ketchup (an elastic good for most consumers) based on the point at which they can earn the largest profit margin, based on the optimal price and quantity sold. If the product is priced too low, they will sell more bottles of ketchup, however they are sacrificing potential additional profit they could have earned by charging a higher price for the ketchup. On the other hand, if they price their ketchup too high, the will not be able to sell as many bottles of ketchup because consumers will likely purchase a different brand of ketchup at a preferable price. So, Heinz needs to determine the combination of price and quantity that will create the optimal profit margin.

2. Jane's demand for caviar is inelastic, so she will purchase the same quantity of caviar regardless of the price. Since the Chernobyl accident has caused the price of caviar to increase, this means that Jane will be required to pay more for the same quantity of caviar she normally consumes. So now that Jane is spending more on caviar, this means that she has less income to spend on hot dogs. Since Jane has less money to spend on hot dogs, she will be forced to consume fewer hot dogs. As a result, her demand curve for hot dogs will shift to the left.

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