Managerial economics merge microeconomic theory with quantitative tools to help managers in making managerial decisions to solve various organizational problems (Michael, 1997). Major microeconomic analysis that helps managers in making decisions is Elasticity analysis (ibid, 1997).
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Price Elasticity of Demand (PEoD) measures the rate of change in quantity demanded caused by a change in price (Humphrey, 1992), that is, PEoD = %? Qd %? P Where, %? Qd - Change in quantity demanded over original demand quantity %? P - Change in price over original price Managers use PEoD to see how demand of a certain good or service is sensitive to a change in its price. If the rate of price elasticity is high, it shows more customers are sensitive to changes in prices, that is, consumers of that good or service will buy less quantity if price increased and buy more quantity of the commodity if the price reduces.
The demand of the commodity (good or service) can be termed as price elastic (Schenk, 2007). Very low price elasticity indicates that changes in price of that commodity have little influence on demand. Even if price falls or rise customers will buy the same quantity of the commodity and the customers’ decision on the quantity they demand is independent on change of price. This commodity can be termed to be price inelastic (Michael, 1997). Managers use this price elasticity analysis to make pricing decision (Samuelson, 2001).
If a good or service is price elastic setting price of the commodity at lower price below the industry’s average price will greatly increase demand of that commodity, increase revenue, increase market share, reduce the direct cost of production due to economies of scales and thus profitability (Ibid, 2001). On the other hand, if a change in product price has little influence on demand, then managers will not use price as a tool to increase market share, but will consider other factors like quality of product, packaging and promotion (Humphrey, 1992).
Price elasticity of supply measures the rate of change in quantity supplied due to a change in price (Humphrey, 1992). That is, Price elasticity of supply (PEoS) = %? Qs %? P Where, %? Qs – Change in quantity supplied over original quantity supplied %? P – Change in price over original price level If PEoS is greater than 1, then the supply is price elastic, i. e. quantity supply of a good will change when its price changes (Humphrey, 1997). When there is increased demand of input in a firm, managers can increase price of input they buy to get more supplies.
If the PEoS is equal to 1, the supply is unit elastic, that is, for each unit of price changes supply changes at certain units (Humphrey, 1997). For example, for each increase in $5 increase in iPod prices, iPod suppliers increase their supply with 5,000 units. If the PEoS is less than 1, the supply is price inelastic (Humphrey, 1997). In this case change in price of a good or service does not influence quantity supplied. Managers do not need to compete or price to raise their supplied good, but look into other factors that can attract and retain reliable and competent suppliers (Michael, 1997).
Income elasticity of demand measures the rate of change in quantity demand in respect to change in a consumers’ income (Samuelson, 2001). That is, Income Elasticity of demand = %? Qd %? I Where, %? Qd – Change in quantity demanded over original quantity demand level %? I – Change in income over original income level Managers use this elasticity analysis to see how sensitive the demand of a good or service is to change in consumers’ income (Humphrey, 1997). If the IEoD is greater than 1, then the good or service income elastic thus a luxury good, that is change in consumer’s income influences greatly the demand of a certain good or service.
In this case if income of consumers goes down, a manager can look into giving his/her customer credit financing options or sell through hire purchase agreements (Samuelson, 2001). If it goes up, managers have to supply customer with more goods and of high quality even though at premium price (Schenk, 2007). If IEoD is greater than zero but less than 1, the good is income elastic thus a normal good. In this case, the consumer’s income has little influence on the quantity demanded (Ibid, 2007).
If IEoD is less than zero, then the good is income elastic and thus an inferior good (Michael, 1997). In this case, an anomalous change in quantity demanded when the customer’s income change. That is, there can be decrease in demand despite an increase in consumer’s income. Managers have to check on other factors that affect quantity of demand (Ibid, 1997). Cross-price elasticity of demand (CPEoD), measures the rate of change in quantity demanded of one product, due to change in price of another product (Bordley, 1986). CPEoD = %? Qdx
%? Py , where %? Qdx – Change in quantity demanded of product x over its original demand level %? Py – Change in price of product y over its original price level Managers use CPEoD to see how sensitive the demand of one product is to the price change of another product (Bordley, 1986). If CPEoD is greater than zero, then the two goods are substitutes. This is because change in price of one product affects the demand of another product. For example, an increase in price of Zesta causes a decrease in demand of margarine.
If CPEoD is equal to zero, then the two goods are independent and no relationship exists between the two goods (Ibid, 1986). If CPEoD is less than zero, then the two goods are compliments and they have an inverse relationship. Conclusion The study of microeconomic environment in which an organization exists and operates is very important. Demand and supply of a commodity are the core variables of trade. Thus, analyzing their responses due to changes of variable like price and income helps managers to make an informed decision concerning their business.
For all profit-making organizations, profitability and growth are a major objective of these organizations. To achieve profitability and growth, organizations must increase their revenue while reducing their cost. To increase revenue, management must attract more customers and thus increase their product’s market share. As observed, elasticity analysis is an important tool that managers can use in making decisions that help in increasing the quantity of their products’ demand. Through this, they can set targets that help them in implementing their sales strategies.
Bordley, R. (1986). Retailing Cross-Elasticity to First Choices/Second Data. Journal of Business and Economic Statistics. Humphrey, Thomas, M. (1992). The Origins of Supply and Demand Geometry. Economic Review. Federal Reserve Bank of Richmond. Michael, R. Baye. (1997) Managerial Economics and Business Strategy. Fifth Edition. Samuelson, Paul, A. , William D. (2001). Economics, 17th Edition, McGraw-Hill. Schenk, Robert. (2007). Efficiency and Markets
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