American Business


28-01-2010, 18:25

Elasticity of demand

In most market situations, business managers raise or lower price as they judge in their best interest. Elasticity of demand is a quantitative way to measure consumers’ sensitivity or responsiveness to price changes.
Starting from the current price a firm charges, elasticity of demand is measured by the percentage change in quantity demanded in response to a percentage change in price. If, for example, price is raised by 10 percent and quantity demanded decreases by 10 percent (the law of demand states the higher the price the lower the quantity demanded and vice versa), the increase in revenue from the higher price is exactly offset by the decrease in quantity demanded. Total revenue for the firm will remain the same, though profits may increase because the firm is now selling less quantity of their product and receiving the same amount of revenue. When a price change results in no change in total revenue, the elasticity-of-demand coefficient is one or unitary.
The elasticity-of-demand coefficient is the absolute value of the percentage change in quantity demanded divided by the percentage change in price.
Elasticity of demand

The elasticity-of-demand formula initially appears quite daunting, but looking closely it is just a percentage divided by a percentage. If the percentage change in quantity demanded is greater than the percentage change in price, demand is said to be elastic, or people responded significantly to the price change. However, demand is inelastic if consumers do not respond much when a business changes price.
For example, if a firm raises its price by 10 percent and quantity demanded goes down by 5 percent, the elasticity of demand is the absolute value of 5/10 or 0.50. This is less than 1.0 and considered inelastic. If, instead, when the firm raises price by 10 percent, the quantity demanded decreases by 50 percent, the elasticity coefficient is the absolute value of 50/10 or 5.0. This is considered very price-elastic; when the firm raises prices by 10 percent, people significantly reduce their quantity demanded.
The assumed primary goal of a business is to maximize profits, which are the excess of total revenues over total costs. Since elasticity of demand measures relative changes in quantity demanded in response to a change from an initial price, it can be used to estimate what happens to total revenue when price is changed. In the example of inelastic demand above, a 10-percent increase in price resulted in a 5-percent decrease in quantity demanded. The firm is now selling 5 percent less of their product but receiving a price that is 10-percent higher than what they were charging previously. The increase in price has more than offset the decrease in quantity sold. Their total revenue, therefore, is increased. In the example of elastic demand, the firm is charging 10-percent more for their product, but the number of products sold decreased by 50 percent. They are getting a higher price but losing a lot of sales. Their total revenue has decreased.
An easier way to remember the relationship of price elasticity is this axiom: For inelastic demand, price and total revenue move in the same direction, and for elastic demand, price and total revenue move in opposite directions.
Large companies often hire economists and market research professionals to estimate the price elasticity of demand for their products, but small-business owners can also use this concept. There are four rules of thumb used to make an educated judgment whether the demand for a product will be sensitive or insensitive to price changes.
  • necessities versus luxuries
  • short time frame versus long time frame
  • few competitors versus many competitors
  • inexpensive items versus expensive items

Generally people are more likely to purchase necessity goods even if the price of those goods rise, but they are less likely to buy luxury goods when those prices go up. For example, airlines keep some seats open on flights for lastminute business travelers who need to get to some destination to conduct business. Business travel is price-inelastic, while vacation travel is generally priceelastic; when the price of vacations increase, more people will decide not to travel for their vacation.
People are less likely to respond to a price change initially but more likely to change given time to adjust. When oil prices rose in the early 1970s, American consumers did not respond significantly to the price increase. But when they were ready to trade in their cars, they bought smaller, more fuel-efficient cars, reducing their demand for gasoline. Thus, over time consumers were more responsive to oil-price increases than they were in the short run.
If monopolists raises prices, especially for necessity goods like electricity or water, people will reduce their quantity demanded very little, as they have few or no other choices. But if one fast-food company raised their price, consumers would fairly quickly substitute competitors’ products. When there are few substitutes, demand tends to be price-inelastic, and when there are many substitutes demand tends to be price-elastic.
If the price of an ice cream cone goes up by 50 percent, most people will buy it anyway. But if the price of a new car goes up by 50 percent, many will keep driving their old clunkers. What one person considers expensive could be considered inexpensive to someone with significant income, but generally consumers are more sensitive to price changes for expensive items than inexpensive items.
Using these four rules of thumb, business managers can estimate the degree of response to a price change. Smallbusiness managers learn over time which customers are sensitive to price changes and also how much of a price decrease they need to make in order to sell end-of-the-year items. Though a theoretical concept associated with economics, price elasticity of demand has many practical uses for business managers.