1.2.4 Price Elasticity of Demand

Price Elasticity of Demand

Key Definitions

Price Elasticity: Used to measure the extent to which demand for a product changes when its price is changed

Price-Elastic: A product with a demand that is highly price sensitive, so the price elasticity is calculated to range from -1 to negative infinity (above 1)

Price-Inelastic: A product with a demand that is not very price sensitive, so the price elasticity is calculated to range from -0.01 to -0.99 (below 1)

Product Differentiation: The degree to which a consumer sees that your brand is different to another brand through the features and the unique selling point.

Substitutes: A product from a rival company that is similar to an already existing product that it could be bought or used as an alternative to the original.

Branding: The way a business makes either itself, or its goods and services memorable through promotional activity and USP.

Pricing Strategy: The way that a business prices its products based on numerous factors, including competition and demand.

External Constraint: Something that is outside of a firm's control that can prevent it from achieving the goals it has set itself. 

Price Elasticity of Demand

On a short term basis, the factor that has the most influence over the demand is the price of the product. The most important question a business needs to consider is "how much will demand change when the price is changed?" Some products are more price sensitive than others, meaning that if the price increases by just 3% the demand for the product would experience a sheer drop in demand for it. 

The following formula is how the price elasticity of demand is calculated:

Price Elasticity = % change in the quantity demanded
                   % change in price

Price elasticity measures the percentage effect on demand of each change in price. For example, if a 10% increase in price of a product led to a 20% decrease in demand, the price elasticity of the product would be 2. However, as the price elasticity is always negative, the answer would actually be -2. It's always negative because a price increase pushes down the demand, and a price cut pushes the demand up. The "-2" indicates that for 1% increase in price, the demand will decrease by 2%, and the same can be said for the other way around.

Determinants of Price Elasticity of Demand

There are 3 main determinants of the price elasticity of demand:

1. The Degree of Product Differentiation

This is the extent to which consumers see one product as different to its rival products, such as Coke being different to Sprite. If there is little product differentiation then it is easy for consumers to just switch to the cheaper alternative, such as if Coke were to become more expensive but Pepsi stayed at the same price. However the opposite happens if Coke were to become more expensive, but Sprite were to stay the same price, as there would be no alternative here. Basically, the higher the product differentiation, the lower the price elasticity of demand. 

2. The Availability of Substitutes

If 2 products are seen as similar, it can be said that one product is the substitute to the other if one is not avaliable. If Coke were to increase the price of their drinks, consumers would easily switch to the cheaper option, which would be Pepsi. If there were more substitutes avaliable then customers, being typically price sensitive, would tend to choose the cheaper option. In a place where there is Coke being sold with no direct competitor being sold as an alternative, Coke would be able to push their prices up without losing too many customers. 

3. Branding and Brand Loyalty

Products with the lower price elasticity of demand are the type of products that consumers will buy without a second glance at a price tag. Some people automatically reach to buy Coke, even when Pepsi is avaliable as a cheaper alternative, because they prefer Coke, or they prefer the brand image associated with Coke. Companies with strong branding create a strong, positive brand image that people are attracted to, and they are able to create customers that will buy their products purely out of brand loyalty. 

Classifying Price Elasticity

Price-Elastic Demand

Products that have price-elastic demand have a price elasticity of above 1 (or-1). This means that the percentage change in demand is greater than the percentage change in the price that initially created the change in demand. The higher the price elasticity figure, the more price elastic the demand. 

Cutting the price of a product with a price-elastic demand will boost the total revenue earned by a business, and this is because the extra revenue gained from the increased sales volume will massively offset the revenue lost from the original price cut. On the other hand, increasing the price on a product with a price-elastic demand will lead to a fall in total revenue.

Price-Inelastic Demand

Products that have price-inelastic demand have a price elasticity of below 1 (or -1). This means that the percentage change in demand is lower than the percentage change in the price that initially created the change in demand. This basically means that changing the price of a product will have little-to-no impact on the demand for the product as the product may be seen as something the customer has to have (either because it is a necessity, or just because it is fashionable). 

Increasing the price of a product with a price-inelastic demand will boost the total revenue earned by the business as there will only be a small decrease in the number of sales. 

The table below shows how to differentiate between price-elastic products and price-inelastic products:

	Product with a Price-Elastic Demand	Product with a Price-Inelastic Demand
Characteristics	Undifferentiated            Many Competitors on the market	Differentiated            Few competitors
Impact of a Price Cut	Sales rise sharply, leading to an increase in revenue	Sales rise, but not by much  so revenue falls
Numerically	Greater than -1, often between -1 and -5	Between -0.1 and -0.99
Impact of a Price Rise	Sales fall sharply, leading to a decrease in revenue	Sales fall, but not by much so revenue increases

The Value of Price Elasticity to Decision Makers

Being able to predict the price elasticity of demand is a hugely valuable aid to marketing decision makers as it can help the business to make better decisions when it comes to advertising, forecasting and pricing. The information about a product's price elasticity of demand can be used for two main purposes:

1. Sales Forecasting

A business that is considering a price rise will want to know how the change in price will impact the demand of their products. Producing a sales forecast using the price elasticity of demand will help the business to make possible accurate production, personnel and purchasing decisions. The information gained can be passed on to operations and HR to get the staff prepared to produce, for example, more stock for sale if the conditions of the forecast are favourable. 

2. Pricing Strategy

There are many external factors that determine the demand, and therefore profitability or a product. Some can't be controlled, like the weather, however other factors, such as the price of the product, can be controlled - and the price is a crucial factor that affects the demand and profitability of a product. Information on the price elasticity of demand can be used as well as the internal cost information to forecast the implications of a price change on the revenue income. 

Strategies to Reduce Price Elasticity

Businesses always prefer to sell products that are price-inelastic as charging more for price-inelastic products guarantee an increase in short term profits. A business with price-elastic products will always feel vulnerable, as a rise in costs may be impossible to pass on to customers, and if they are tempted to cut the price on these products the sales may boost so sharply that competitors are forced to respond - which could result in a price war. 

It is important to remember that price elasticity is never set in stone. The price elasticity is not an external constraint, it is easily influenced by the avaliability of product substitutes - if there are a lot of substitutes that can offer the same benefits to consumers the price elasticity of the product will be high. There are 2 key ways to reduce the price elasticity of demand:

1. Increase the Product Differentiation

This is the degree to which consumers see one product as different to another product offered by rivals. Some products are totally different to one another, whilst other products are differentiated by their brand image. Increasing the differentiation can reduce price elasticity as it will make the product seem to be something that the customer has to have, so customers are willing to pay whatever they have to in order to buy and own it. 

2. Reduce the Competition

This would reduce the price elasticity of demand, and can be done in various ways including through predatory pricing - deliberately charging low, loss-making prices in order to force competitors out of the market. By doing this, the predator is able to reduce the number of substitutes avaliable on the market, meaning they can raise the price of the products and the customer would be forced to pay the higher prices or go without the product. The same effect can be achieved by takeover bids.