elasticity of demand

Overview

Elasticity of demand (or price elasticity of demand) is the measure of sensitivity of quantity demanded of a product to a price change of the product. Elasticity of demand is expressed as the ratio of the percentage change in the quantity demanded of a product to the percentage change in the price of that product.

Elasticity of demand = E = (Percentage change in quantity demanded) / (Percentage change in price)

If the percentage change in quantity demanded is greater than the percentage change in price (E>1), the demand is said to be elastic. If the percentage change in quantity demanded is less than the percentage change in price (E<1), the demand is said to be inelastic.

If the percentage change in quantity demanded is equal to the percentage change in price (E = 1), the demand is said to be unitarily elastic.

The elasticity of demand for a product depends upon the following factors:

  1. Whether there are close substitutes available for the product in the market place. The more close substitutes available, the more elastic the demand.
  2. The portion of consumer’s income being spent on the product. The greater the portion of income spent on the product, the more elastic the demand schedule.
  3. Whether the product is a luxury item or a necessity. Luxury items tend to have a more elastic demand schedule than necessary items.
  4. The number of product uses. The greater the number of product uses, the more elastic the demand schedule tends to be.
  5. The time frame within which the evaluation takes place. In the short run, most demand schedules tend to be inelastic.

Examples

Products which have a number of close substitutes, products which require a larger monetary outlay, products that are perceived as luxury items, products that have many uses, all tend to have elastic demand schedules. Conversely, products which have no close substitutes, products that require a smaller monetary outlay, products that are necessary, and products that have fewer uses all tend to have inelastic demand schedules.

The demand schedule for gasoline would tend to be inelastic because of the lack of close substitutes available (there are many brands of gas but no substitute for it). The housing market will fluctuate drastically to changes in interest rates (price of loans) because of larger monetary outlays on the consumers’ parts to acquire the houses.

The demand schedule for medicinal products (necessities for people who are sick) will tend to exhibit inelastic tendencies when compared with demand schedules for diamonds and jewelry (luxury items) which will tend to be elastic.

Benefits

Understanding the nature of elasticity of demand for a particular product or service will enable the management to make sound pricing decisions. The increases and decreases in total revenues due to price changes can be anticipated, explained, and controlled if managers can determine the elasticity of demand for their products or services.

Total revenues and consequently, the resultant profits could be adversely affected if the wrong price changes are implemented.

Implementation

In effectively implementing the elasticity concept, one must establish the relationship between price changes of products and the corresponding changes in the total revenues generated. Total revenue is calculated by multiplying the number of units sold of a product and the unit price of that product.

Once data has been collected regarding the price changes of the product and the revenue streams associated with these price changes, the ensuing analysis will enable the decision maker to determine the elasticity of demand for the product.

If the price and total revenue move in the same direction, then the demand schedule is inelastic. That is, as price is increased, total revenue generated also increases and as the price is decreased, the total revenue generated also decreases.

If the price and total revenue move in the opposite direction, then the demand schedule is elastic. That is, as the price is increased, the total revenue generated decreases, and as the price is decreased, the total revenue generated increases.

Evaluation

Once the elasticity of demand has been determined for the product, management must determine the strategies and tactics necessary for product performance improvement. These include:

  1. the evaluation of the nature of the close substitutes available in the market for the product,
  2. the reevaluation of product pricing strategy based on the demand elasticity of the product,
  3. repositioning the product if necessary in the market, based on the new pricing strategy.

Conclusion

In spite of the fact that elasticity of demand provides management with the ability to better price and market their products, it often the measurement of elasticity of demand that may present a problem.

Elasticity measures a product’s sensitivity to price changes in the past and, therefore, its usefulness for predictive purposes may be limited. The usefulness of elasticity of demand for decision making should be approached with caution.

Elasticity of demand does not reflect the qualitative aspects of the product. Therefore, all around effective marketing decision-making may be hampered. Elasticity of demand may not be used to extrapolate into the future because of its dynamic nature.

And finally, it is a statistic that reflects consumers’ behavior patterns of the past and therefore does not lend itself to predicting consumer behavior patterns for the future.

Applications to Small Business

A number of small businesses, manufacturers and retailers alike, handle products that are very sensitive to the market forces of supply and demand. The elasticity of demand is a function of a number of product characteristics such as: substitutability, product uses, and the type of product (convenience or luxury item).

Therefore, in investigating the elasticity of demand for a product, management will have to evaluate in depth the competitive forces in the market and the target market the particular product is aimed at. This evaluation will enable management to determine the most effective marketing strategies for the product and thus result in improved product performance in sales and profits.

The data for determining elasticity of demand should be most readily available from the company’s existing sales and performance records. By analyzing these records, management can identify products that can generate increased revenues and with proper cost controls the overall profit picture of the firm should be improved.

 

Synonyms: demand elasticity, price elasticity of demand

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