Demand for most products tends to increase as price is lowered and to decrease as price is raised. This general pattern is the basis of the standard downward sloping demand curve portrayed in economic texts.
There are two underlying reasons for this pattern, sometimes termed “the law of downward sloping demand.’’
- The first is that as price increases the potential buyer is “poorer” than before the price increased.
- Secondly, as price increases the buyer is likely to seek to substitute other goods for the one whose price is rising.
Thus tea or hot chocolate may be substituted for coffee. There are many exceptions to this general rule. Luxury or status items are the most obvious. It might be, for example, that as the price of a high-status brand of automobile falls, fewer of the cars are demanded because the auto has lost some of its luster as a status symbol.
Economists and business people know that as prices vary demand may change. To the degree that demand changes it is said to be elastic. To the degree it remains the same it is said to be inelastic. It should be noted that demand may be more inelastic at certain prices than at others.
Thus consumers might continue to purchase steak as the price of steak increases until it reaches some no-longer-acceptable level. At this price, demand for steak may not keep pace as prices rise. For this reason, economists often speak of “arc” elasticity or inelasticity, noting that to get a view of inelasticity or elasticity of demand for a product it is necessary to specify the portion of the total demand curve under discussion.
The degree to which a product fulfills a basic human need is often an index of its inelasticity of demand. A classic example is the demand for insulin. If a diabetic person requires one dose of insulin per day to remain alive that person will seek one treatment per day regardless of the price. If the price were to increase slightly, or double, triple, or go up ten-fold, the patient still would demand just one treatment per day.
Notice, too, that if price should fall the patient would still want just one treatment daily. Within reasonable bounds it is safe to say that no price is too high to dissuade purchasers and no price so low as to induce additional product use.
Notice that price inelasticity of demand “cuts both ways.” Neither higher prices nor lower prices much affect demand. In the case of insulin and other medicines price affects demand not at all until the price gets so high as to put the product out of the buyer’s economic reach.
Even if this should occur the buyer would be likely to beg or steal to have the product he needs. This is a case of “perfect” inelasticity of demand.
Although the case of insulin is a bit extreme, many products face demand situations that are quite insensitive to price. Household electricity is one example. The typical householder uses the electricity he feels is necessary for a comfortable life.
Toast is made and laundry washed with little real thought given to the “few cents” worth of electricity these tasks consume. If the price of electricity rises a bit, as it does from time to time, does the householder cut back on the use of electricity?
How often does he decide not to toast the morning English muffin, eating it untoasted to reduce the monthly electric bill? Some care might be given to turning off the lights when a room is unoccupied, but few buyers of electricity will not make toast, not watch television, and not wash their laundry because the price of power rose.
Conversely, should the price of electricity fall somewhat, would the householder eat more toasted muffins, wash more laundry, or watch more television because electricity is now a “better buy?” Probably not. Thus the demand for household electricity is, in general, price inelastic.
A similar phenomenon is noticeable when industrial goods are analyzed. Demand for industrial or organizational goods is generally found to be price inelastic. This is because of several factors found in the industrial buyer’s purchase situation.
First, the industrial buyer is generally a “rational buyer” who has calculated carefully what he needs to purchase. If such a buyer has analyzed the organization’s needs and found that two new boilers are necessary to properly run the business, the buyer is unlikely to be impressed with a salesperson’s offer of “buy four, get the fifth one free.”
Secondly, the industrial buyer will purchase nothing at all unless he believes that the product will be sold. When Jeeps are selling well the Jeep manufacturer will pay a higher price for the required number of tires, steering wheels and transmissions because the demand for the final Jeep product is strong.
These increased costs can simply be passed along to Jeep buyers. The third factor contributing to the price inelasticity of industrial goods is that most industrial goods constitute a comparatively small part of the final product sold.
In the case of a new Jeep, each fender, steering wheel, and even each transmission is but a small percentage of the total selling price of the new Jeep. Therefore, the industrial buyer (Jeep/AMC) is very unlikely to refuse to buy these parts if suppliers raise their prices.
It is obvious that many products will be demanded, if other conditions are right, at almost any price until some upper limit of price is reached. Yet these products do differ in the degree to which they are inelastic. Our householder might eat untoasted English muffins and wash clothes by hand if the monthly electric bill jumped from $200 to $700 or $1,000. The insulin user who will die without his quotidian dose is even less likely to change purchase habits than the householder is to hang a clothes line and eschew using the electric dryer.
Economists use a simple formula to measure elasticity of demand (E). E is expressed as a ratio, the percent that quantity demanded (Q) has risen or fallen divided by the percent that price (P) was raised or lowered.
Several presentations of this formula exist and can be found in any economics text, but the problem remains the same: how much change in demand resulted from the change in price?
The formula yields a numeric “answer” which can be used to compare the inelasticity of demand among several products, or during different periods of time, or under different economic conditions.
If the price of product A were cut by 20 percent and quantity demanded were observed to increase by 10 percent the formula E = % change in Q/% change in P would be shown as E = 10/20. That is, the change in price was greater than the observed change in demand. E = 10/20 = .5.
If the price of product B were reduced by 50 percent and demand were seen to rise by 10 percent the formula would show E = 10/50 = .2.
Note that the 20 percent price cut for product A produced a demand increase of 10 percent while a 50 percent price cut for product B yielded the same demand increase of 10 percent.
Demand for product B is more inelastic, or less elastic, than is demand for product A.
For product A, E = .5; for product B, E = .2. Thus, the smaller the figure yielded by the formula the more inelastic the demand.
It will be noted that the value of E is less than 1 because the change in quantity demanded is less than the change in the price. This is the very meaning of inelastic demand.
For comparison’s sake, suppose that a change in price led to exactly the same proportional change in quantity demanded; e.g., E = 50/50 = 1.
This shows that demand is neither elastic nor inelastic and is usually termed “unity.” But if the change in demand is greater than the change in price, if it shows great sensitivity or response to price, elasticity will be greater than 1.
For example, price is cut by 10 percent and quantity rises by 50 percent or E = 50/10 = 5.
When the change in price is less than the observed change in quantity demanded, E must always be greater than 1.
This discussion has dwelt on price in elasticity of demand, by far the most familiar form of the concept.
Others exist, however. One is income inelasticity, which can be exemplified by the fact that as income rises comparatively few additional purchases of potatoes, salt and plain white bread are likely to result.
Mathematical formulas illustrating income inelasticities and other inelasticities are common in economics and business books. Readers will note, however, that they are all modifications of the concept shown above as E = % change in Q/% change in P.
Making use of the concept of inelastic demand in a business situation can range from the intuitive application of the concept to exerting a concerted effort to use data, formulas, and other means to develop an assumed demand curve and concommitant coefficient of elasticity.
Since inelasticity of demand is demonstrated in the assumed demand curve, some methods of estimating that schedule should be mentioned. Among the tools used for this purpose are:
- survey of executive opinion,
- survey of customers,
- survey of sales force,
- trend analysis, and
- analysis of substitutes.
The survey methods (of executives, customers, and sales force) each bring with them attendant risks and benefits. If the organization’s executives are seasoned veterans of the marketplace wars, it simply makes good sense to get their opinions on the nature of the demand the firm faces.
They may know, for example, that customers are sensitive to price changes or, conversely, that customers seem to purchase what they need almost without regard to price.
The survey of executives may be formal or informal but, either way, it makes sense not to pass over this potentially rich mine of information.
The survey of customers is appropriate to certain situations, especially the sale of industrial products. This is so because organizational buyers are usually better able than consumers to judge their buying intentions and are believed to be more “rational” in their approaches to purchasing.
Surveying sales force members can be defended on the grounds that these individuals are closest to their customers and should be able to make reasonable estimates of customer reactions to price changes. The risks are that, for their own reasons, salespeople are often tempted to underestimate their future sales totals.
Trend analysis also makes good sense if the organization has sufficient data available to plot sales totals and these have been affected by price changes. The problem, of course, is that basing the future on the past is always risky since conditions might have changed greatly.
Analysis of substitutes is a technique whereby price inelasticity of demand is judged in terms of other options open to the buyer. Suppose the seller is able to determine that a buyer, suddenly deprived of the seller’s product, would have to purchase another product at twice what the seller now charges.
This suggests that the seller could raise the price currently charged without much fear of losing the customer since the customer’s alternative is to pay another supplier twice the current price. Of course, the cost in goodwill lost and the risk of driving the customer to seek additional sources of supply must be considered as well.
It is known, for example, that as income rises a given percentage of each new dollar is spent on air travel rather than bus travel. These general facts are of some use to firms in the air and bus travel industries and to suppliers of those companies, but provide only a starting point for the development of company-specific estimates of elasticity/ inelasticity of demand.
There are several tools available that business people may use to determine the demand schedules they confront and the degree of price inelasticity shown by those schedules. Unfortunately, competitor firms may also employ those same tools and adjust their marketing strategies to fit market conditions and competitive actions.
Price inelasticity suggests that prices may be raised with little resultant loss of sales, but the prices of one firm cannot be raised if competing firms are then able to call attention to their own lower prices.
In short, it is one thing to discover that demand for a particular good or other product appears to be relatively price inelastic and quite another to determine how to put the information to use.
Identification of situations of price elasticity is one step in a long and complicated managerial process, a process that relies on cogent judgment far more than it does on formulas or other tools. Like so many other marketing management tools, the concept of inelastic demand is a starting point, not an end in itself.
Knowing that demand appears to be inelastic is just a beginning. What to do about this condition is the real marketing challenge.
The concept of inelastic demand is important to individual organizations and to the economy as a whole. Many companies face inelastic demand situations in the marketing of some or all of their products, as earlier examples have shown.
Too, the macroeconomy embraces numerous situations where demand is surprisingly insensitive to price. Among these is the demand for medical services. Except for the impoverished, when faced with a medical emergency most people want nothing but “the best” for themselves and their families.
News stories demonstrate this daily by reporting the willingness of some individuals to go anywhere and try anything to overcome their particular infirmities.
Mathematical formulas and graphic depictions of demand schedules can be used to discover and analyze instances of inelastic demand. Yet it would appear that even if these are not employed specifically, managers of organizations intuitively use the concept in their decision making.
Applications To Small Business
Many managers of small businesses are drawn to their fields of endeavor by what they perceive to be an inelastic demand for that particular good or service. That is, they feel that their product will always be needed, virtually without regard to price, because it is so basic.
Local roofing company owners, operators of small grocery stores, and other entrepreneurs are frequently heard to remark “If the roof leaks you have to fix it” or “People always need food.”
Unfortunately, it is this kind of thinking that attracts other entrepreneurs to the same businesses, increasing the level of competition and driving prices and profits down. What may have been a case of inelastic demand for a product type thus becomes a widely varying demand for the product of a single firm.
Small business operators, and others for that matter, should avoid being unduly influenced by the “inelasticity fallacy.”
Business operators should attempt to analyze the demand situation they face. It has been pointed out by many experts that whether or not a manager tries to draw or calculate a demand schedule that demand schedule still exists.
Thus attention to determining its true nature with as much accuracy as possible is a recommended course of action for both small and larger businesses. It is entirely possible that the small business manager may find that demand for his product is in fact price inelastic.
Such inelasticity may be seasonal as it is for the costume rental shop two days before Halloween or the tuxedo rental shop during the Spring months. Demand may be inelastic for certain products, but not others. The retailer may note that people dicker over the price of necklaces but not over the price of diamond engagement rings.
In short, consideration of instances of inelastic demand and its ramifications can yield considerable payoff to the small business. Thinking beyond intuitive reaction to the phenomena is strongly endorsed by small business consultants.