How many times it happened to you that while visiting the superstore for purchasing an item e.g. Coke you have purchased an alternative of that item e.g. Pepsi, merely due to the fact that price of the original item you wish to purchase was high.
Or let’s state another scenario; imagine you went to market for purchasing a particular medicine e.g. special medicine for treatment of cancer that have no substitute and purchased that medicine no matter how high the price was.
What is common in both the scenarios?
In one situation you have rejected the item due to its higher price but in a completely different situation you have purchased the item no matter how higher it cost.
The phenomenon that explains this relationship of customer’s willingness to buy as the price of the product changes is known as LAW OF DEMAND and quantification of this response is known as PRICE ELASTICITY OF DEMAND.
STILL CONFUSE? LET ME PUT IT ANOTHER WAY…
Law of demand states that fall in the prices will cause the demand of goods to rise and vice versa whereas the price elasticity of demand measures (note the word “measures”) that how much quantity of demand changes in response to the change in prices. Suppose price of 1KG apples has increased from $10 to $15; as a result the store keeper noted that his sales of apple has reduced from 100KGs to 60 KGS (law of demand); the percentage change of reduction in demand is 1.25 or 25% (Price elasticity of demand). That means for every $1 change in price the change in quantity will be 25% more than price i.e. 1.25.
MORE CONFUSE!! LET ME EXPLAIN ALL THE TERMS IN DETAIL…
STARTING FROM HOW 1.25 OR 25% IS CALCULATED
THEN MOVING TOWARDS!!
THE INTERPRETATION OF 1.25 OR 25% AND THE FACTORS DETERMINING THIS 1.25 OR 25%
AT THE END, A VERY SPECIAL, YOU WILL NOT SEE IN MANY BOOKS
THE ADVICE FOR BUSINESS OWNERS HOW TO PRACTICALLY APPLY THE CONCEPT OF PRICE ELASTICITY IN ORDER TO ENHANCE THEIR SALES
Computing the Price Elasticity of Demand:
So how will we know that what is the demand elasticity of a particular product?
Where does a product lie on the price elasticity range from less than 1 (inelastic) to greater than 1(elastic)?
The answer to the question is in the following formula:
For instance, suppose that a company manufactures and sales air conditioning (ACs) units. On average in one month it sells 200 ACs where the price of each AC is $ 2,000.
The company changes the price from $ 2,000 to $ 2,100. As a result the demand falls and company manages to sale only 180 ACs.
Calculating the price elasticity
- 5 percent ((2,000 – 2,100) / 2,000) change in the price of product caused the amount of the product to fall 10 percent ((200-180) / 200) than elasticity of demand will be
Price Elasticity of Demand = 10 percent / 5 percent = 2
Interpreting the results
In the above example the elasticity of demand we calculated is 2, which means that the change in demand is proportionally twice to the change in the price of a product.
It means if price of ACs change by 1 percent there will be 2 percent fall in demand of ACs.
General Point / Discussion
You have noted in the above example that the original result was negative 2 since percentage change in price is negative 5 percent whereas percentage change in demand is positive 10 percent.
The sign of these percentages will always be opposite in every scenario.
What is the Reason of these opposite signs?
The reason is law of demand…
Law of demand states that as the prices rise the demand will reduce and as the prices reduce demand will rise; thus a negative relationship between the price & demand.
Negative answer confirms this relationship mathematically.
Anyhow, using the mathematical term “Absolute value” we, for practical purpose, simply drop the minus sign and take all the results positive.
A problem in price elasticity demand formula!
Consider the above example again. We have divided the change in price ((2,000 – 2,100) / 2,000) by 2,000… What if we divide the change in price ((2,000 – 2,100) / 2,000) by 2,100?? The result will be completely different.... i.e. 4.7% instead of 5% Same is true for change in demand as well… Change in demand ((200-180) / 180) will be 11% instead of 10%.... Now using the same formula Price Elasticity of Demand = 11 percent / 4.7 percent = 2.34 the new price elasticity of demand will be 2.34 instead of 2. Why the result is not same? Logically speaking, the result should be same… After all the change is same whether it should be calculated from point base A to base B or from base B to base A… This is the inherent problem of the above mentioned formula of price elasticity. The elasticity from point A to B will be completely different from point B to A.
Let me put this problem with another example!
Consider the following numbers:
Point A: Price = $2 Quantity = 100
Point B: Price = $3 Quantity = 67
From point A to B, the price rises about 50 percent and the quantity falls by 33 percent, showing that the price elasticity of demand is 33 / 50 = 0.66. Contrary to this, going from point B to A, the price falls about 33 percent and there is raise in quantity about 50 percent, resulting that the price elasticity is 50 / 33 = 1.5. This problem arises because in both calculations percentage changes are calculated from different bases.
To cater the problem!!!
A Better way to calculate the Percentage changes and Elasticity is suggested
To avoid this problem Midpoint method is used to calculate price elasticity. Contrary to the standard procedure in Midpoint formula method we compute a percentage change by dividing the changes with the midpoints at initial and final stages. Again consider our main example. $2,050 is the point between $2,000 and $2,100, according to the midpoint formula method, a change from $2,000 to $2,100 is about 4.9 percent (2,000-2,100)/2,050×100=4.88 Similarly a change from $2,100 to $2,000 will be 4.88 percent fall. As you have noticed the midpoint formula method gives the similar answer irrespective of the direction of change. Therefore this formula is a better way as compared to standard method for calculating the price elasticity of demand.
Like all measures of quantification, Price elasticity of demand ranges between less than 1(inelastic) and greater than 1(elastic)
Elastic demand (Greater than 1)
Demand of goods will be elastic if the change in demand of goods as a response of changes in the price is greater than change in price.
In other words
Change in demand > change in prices
It means that quantity moves proportionally more than the price of product. Consider the graph below: In response to 22% change in price quantity demanded has fallen by 67%.
Inelastic demand (less than 1)
Demand is said to be inelastic if the quantity demanded responds only slightly to changes in the price.
In other words
Change in demand < change in prices
It means that quantity moves proportionally less than the price. Consider the graph below: In response to 22% change in price quantity demanded has fallen by 11% only.
Unit elastic demand (equal to 1)
If the percentage change in quantity demanded is equal to the percentage change in price, elasticity will be equal to 1 in such condition demand is said to be unit elasticity. In other words
Change in demand = change in prices
It means that quantity moves proportionally equal to the price. Consider the graph below: In response to 22% change in price quantity demanded has fallen by 22% as well.
Perfectly inelastic demand (demand change equal to 0)
Where change in quantity demanded does not move at all i.e. the change is zero then the demand curve is perfectly inelastic. It will be vertical.In other words
Change in demand = Zero
In inelastic demand curve change in price is unable to cause any changes in quantity demanded. As the graph shows change in price by 22% does not have any impact on the quantity demanded.
Perfectly elastic demand (price change equal to 0)
Demand curve is said to be perfectly elastic when without changing the price the demand keeps on changing by itself. In other words
Change in price = Zero
In perfect elastic demand, curve will be horizontal. It means that even a slightest change in price causes enormous changes in quantity demanded. Consider the graph below:
Factors that influence / determine the elasticity and inelasticity
Goods having close substitutes have more elastic demand because customer can easily switch the product with its substitute good.
For example: Pepsi and Coca cola are very close substitutes of each other. A small rise in the price of Pepsi assuming that the price of coca cola remains same causes the quantity of Pepsi sold to fall by large amount. Contrary to this, electricity is a utility without any close substitute so the demand of electricity is less elastic. A small rise in its price will not cause a heavy damage to its quantity sold.
Necessities compared to Luxuries:
Necessities of life tend to be less elastic, while on the other hand luxuries are more elastic.
For example: When the price of wheat rises the demand will never decrease dramatically because it’s a most common food in daily routine life. Contrary to this, when the price of Ferrari rises; its demand will decrease substantially.
Because wheat is basic necessity and Ferrari is luxury. Whether the good is necessity or luxury the interest of buyer always matters the most.
This point is somewhat academic nature!!!
Elasticity of demand in market depends upon how we draw the boundaries of market.
Market having narrow boundaries has more elastic demand comparative to the markets defined broadly because it’s easy to find out substitutes for narrowly defined goods.
For example: food is a broader category, so it is very difficult to find its substitute that is why it has very less elastic demand. On contrast, ice cream a narrow category has more elastic demand because ice cream can easily be replaced with different kinds of deserts.
Variation of Trends:
Another important fact which highly affects the elasticity demand of any product is its trend or fashion.
If the product is trending or is in fashion it has less elastic demand because a small change in the price of such product will not cause big changes in quantity demanded due to its fashion importance or trend.
In contrast, out of fashion or trend product has more elasticity because it has no fashion importance and its demand will be highly affected due to price variation.
How small businesses can excel their business using elasticity of demand concepts
Practical application of price elasticity: Prediction of Total Revenue
Being a businessman (seller) your natural questions will be
- What is my total revenue by selling the product?
- Will my revenue increase or decrease by changing the price?
- How demand will affect the revenue I earn?
What is total revenue?
Total revenue is the product of Price and quantity sold (P × Q). The graphical presentation of Total Revenue can be depicted as follows:
Total amount paid by buyers and received by sellers in market is equal to the total area of the box under the curve. As shown if Price is $5 and Quantity demanded is 100, the total revenue is $500.
How price or demand affects the total revenue?
Know, how elastic the demand of your product is?
If the demand is elastic; is greater than 1 (> 1)
An increase in price will cause the demand to fall sharply (larger than the price change) therefore there will be decrease in total revenue. For example: if the price increases from $6 to $8 (change is 28.57%), the quantity demanded will fall more say from 100 to 70 (change is 35.29%) than the total revenue will fall from $600 (6 * 100) to $560 (8 * 70). Increase in price will lower the total revenue because fall in quantity demanded is respectively larger than rise in price.
If the demand is inelastic; ranges from 0 to 1:
On the other hand, if the demand is inelastic, than an increase in price will cause an increase in total revenue because change in price will not cause the demand to fall sharply but it will remain more or less same. For example: an increase in price from $6 to $8 (change is 28.57%) results in the fall of quantity demanded from 100 to 80 (change is 22.22%) and total revenue will rise from $600 (6 * 100) to $640 (8 * 80). Increase in price will raise the total revenue because fall in quantity demanded is respectively smaller than rise in price.
Other Common Elasticity of Demand:
Every business owner wants to predict their customers’ behavior… But how customer will behave is not a simple 2 + 2 formula that always results in 4. It is a complex phenomenon and cannot be predicted entirely. However to describe the behavior of a customer in market, with more confidence, economists, in addition to price elasticity use other elasticity of demand as well.
Income Elasticity of Demand:
A product seller targets a specific class of customers. Every class of customers has their income capacities for example upper middle class will have more to spare than lower middle class. Similarly elite class can spend more than upper middle class. This income capacity of a consumer can also affect the quantity demanded therefore income elasticity of demand is used to measure how change in income of a consumer affects the quantity demanded. For such purpose following formula is used:
Normally quantity demanded and income is directly proportional to each other. Normal products have positive income elasticity, higher the income more quantity demanded it is. But some inferior goods are inversely proportional to quantity demanded that’s why they have negative income elasticity such as heavy vehicles for common man etc. Necessities have smaller income elasticity because consumer has no choice rather than to purchase it even if they have lower income. Contrary to this, luxuries have comparatively high income elasticity because consumers having lower income realize that they can do well even if they do not purchase such good.
Cross Price Elasticity of Demand:
A product seller faces the competition as well. The product you are selling, in many cases, has an alternative substitute or it can be complement to another product. You might be interested to know (I am sure you will be)… How change in price of one product (yours) can affect the quantity demanded of other product (competitors)? Cross price elasticity of demand is the solution… Cross price elasticity measures how the change in price of one product alters (rises / falls) the demand of another product and can be calculated by following formula:
The result of cross price elasticity can either be positive or negative…
When will Positive answer come and what does it mean?
If the products are substitutes of each other than the cross price elasticity of demand is positive because increase in the price of one product will cause an increase in the demand of other product.
When will Negative answer come and what does it mean?
On contrast, cross price elasticity of complement products (which are usually used together such as mobile phone and battery) will be negative showing that increase in the price of mobile phones will cause a decrease in the demand of mobile phones and therefore a decrease in demand of batteries as well.