Price Elasticity of Demand study notes from tutor2u

Understanding how demand for a product might change as price changes is essential to an effective marketing strategy.

 

First, a quick acronym - price elasticity of demand is often to just "PED": much quicker to write, particularly in an exam, so we'll use it here.

 

PED measures the responsiveness of demand for a product following a change in its own price.

 

The formula for calculating the co-efficient of elasticity of demand is:
Percentage change in quantity demanded   divided by
the percentage change in price

 

Since changes in price and quantity usually move in opposite directions, we usually do not bother to put in the minus sign. We are more concerned with the co-efficient of elasticity of demand [however, in the exam be precise and use the minus sign].

 

By calculating Ped, a business can assess how a change in price will affect the demand for its products. This is really useful information for any marketing plan, but also has implications for other aspects of the business (e.g. finance and operations).

 

Firms can use PED estimates to predict:

• The effect of a change in price on the total revenue & expenditure on a product

 

• The likely price volatility in a market following changes in supply – this is important for commodity producers who may suffer big price movements from time to time

 

• The effect of a change in an indirect tax (e..g VAT, fuel or other duties) on price and quantity demanded and also whether the business is able to pass on some or all of the tax onto the consumer

 

• Information on the PED can be used by a business as part of a policy of price discrimination (also known as 'yield management'). This is where a business decides to charge different prices for the same product to different segments of the market e.g. peak and off peak rail travel or prices charged by many of our domestic and international airlines

 

• A business contemplating a tactical price-war or planning a promotional discount based on price (e.g. 50% off for a limited period) will want to know how responsive customer demand will be to the pricing tactics used

Understanding the values of PED

 

1. If Ped = 0 demand is said to be perfectly inelastic. This means that demand does not change at all when the price changes – the demand curve will be drawn as vertical.
2. If Ped is between 0 and 1 (i.e. the percentage change in demand from A to B is smaller than the percentage change in price), then demand is inelastic.
3. If Ped = 1 (i.e. the percentage change in demand is exactly the same as the percentage change in price), then demand is said to unit elastic. A 15% rise in price would lead to a 15% contraction in demand leaving total spending by the same at each price level.
4. If Ped > 1, then demand responds more than proportionately to a change in price i.e. demand is elastic. For example a 20% increase in the price of a good might lead to a 30% drop in demand. The price elasticity of demand for this price change is –1.5.

Factors affecting Ped

 

1. The number of close substitutes for a good – the more close substitutes in the market, the more elastic is demand because consumers can easily switch their demand if the price of one product changes relative to others.
2. The cost of switching between products – there may be significant costs involved in switching between products. In this case, demand tends to be relatively inelastic. For example, mobile phone service providers may insist on 12 or 18-month contracts being taken out.
3. The degree of necessity or whether the good is a luxury – goods and services deemed by consumers to be necessities tend to have an inelastic demand whereas luxuries tend to have a more elastic demand.
4. The % of a consumer's income allocated to spending on the good – goods and services that take up a high proportion of a household's income will tend to have a more elastic demand than products where large price changes makes little or no difference to someone's ability to purchase the product.
5. The time period allowed following a price change – demand tends to be more price elastic, the longer that we allow consumers to respond to a price change.
6. Whether the good is subject to habitual consumption – when this occurs, the consumer becomes less sensitive to the price of the good in question because their default position is to buy the same products at regular intervals.
7. Peak and off-peak demand - demand tends to be price inelastic at peak times and more elastic at off-peak times.
8. The breadth of definition of a good or service – if a good is broadly defined, i.e. the demand for petrol or meat, demand is often inelastic. But specific brands of petrol or beef are likely to be more elastic following a price change.

The effect of PED on Business Revenues
PED can be used to predict what will happen to total revenues based on a change in price:
Here are some examples:

Potential issues with the concept of price elasticity of demand:
It is important to understand that the calculation of Ped is just an estimate and that it might change over time. Markets change – customers become more or less sensitive to price changes. The tastes and preferences of consumers change; new methods of distribution are developed; consumers become more aware of pricing information. All of these (and other factors) affect Ped. Management need to be aware of the factors that influence demand and act accordingly. But keeping an eye on Ped remains important.