The Price Elasticity of Demand and How it Influences Business Decisions - Essay Example

The paper “The Price Elasticity of Demand and How it Influences Business Decisions" is an informative example of an essay on marketing. In considering the pricing of goods and services for a business, it is essential to consider the measure of price elasticity of demand.  This equation determines the level of demand that will be generated for a product when the price fluctuates in regard to the same product.  This knowledge allows a business to judge how a price change will influence consumer decisions when choosing which business with which to purchase.  In looking at commodities from a larger perspective, this is measured in a sense of demand in regard to percentage.  In studying this percentage change, one can determine the sensitivity to price fluctuation as it will affect the overall volume of business.  A simple form of an equation that is used to determine this ratio is:

e= (percentage change in quantity) / (percentage change in price)

This ratio can help to determine the potential for a business to attain a profitable state. 

A product is considered inelastic when consumers are less interested in price consciousness than in attaining the product.  As exampled by Schenk (2009), when a price increases 10% and the consumer response is to decrease their purchases by 20%, the computed value of the elasticity coefficient is at a -2.  “In practice, the negative value is ignored, and price elasticity is referred to as a positive number” (Daly 2002, p. 24).  This would show a strong response to a price change.  However, if the same increase results in only a 5% change in consumer purchases, then the elasticity coefficient becomes ½.  At this ratio, the demand is shown to be inelastic.  A product is inelastic when the elasticity coefficient remains below one.

When consumers have strict limits on how much they are willing to spend on a product, it is considered to be elastic.  In an environment where a price is inelastic, a business has the luxury to determine the most profitable price to charge for their product, however with a product that is elastic, strict attention must be paid to the price and the costs of producing it and bringing it to the market in order to ensure the product maintains profitability.

“A set of graphs shows the relationship between demand and total revenue. As price decreases in the elastic range, revenue increases, but in the inelastic range, revenue decreases”(Price 2009)

An example of the effect of price elasticity of demand is made by Daly in reference to AOL, a formerly popular Internet connection service.  “In 1988, America Online (AOL) president Stephen Case feared mass customer defection when he increased the price of AOL’s basic service by 10% from $19.95 to $21.95 per month.  To his amazement, there was no detectable effect on subscriptions due to the price increase”(Daly 1996, p. 25).  In this case, the product had such demand that it was worth it to the consumer to pay more for the product in order to maintain service.  Of course, this did not remain the case. By 1997, AOL was enjoying the dominance in the market of 8 million subscribers, with everyone wanting to hear the popular voice, intoning ‘You’ve Got Mail’.  However, as the market became increasingly competitive and advances in service changed the nature of the market, this inelastic status did not remain (Giddens & Griffiths 2006, p.624).

In the example of AOL, the popularity of the service diminished the effect of a price change.  Holding this dominant position meant that consumers would adjust to raised prices and maintain their subscriptions because the benefits outweighed the cost.  However, as the service lost ground through growing competition and services that offered better speed and quicker, more dependable access, rates on AOL were not relevant to consumer choices.  Since technological advances outweigh price issues, maintaining high standards of product availability was the only way to compete.  However, the competition is overwhelming and it was destined to see a significant decline.

As in evidence, price elasticity of demand is not the only criterion for determining a successful price for a product.  However, by using this ratio, a company can determine if the price must be strictly considered, or if a state of inelasticity will allow for other issues to be addressed without regard to price in order to properly compete.  When a price increase presents an issue, knowing how consumer demand will be affected by a rise in price relates to how profitability can be experienced.