Price Elasticity of Demand

The economic market forces affect us in myriad forms, but the most visible and immediate is our response to fluctuations in prices due to the push and pull of demand and supply. We know that our tendency to purchase a good starts to dwindle as its price increases, and vice versa.

Furthermore, the tendency to shy away from the good on price increase depends on the good itself and the end consumer (good old onions come to rescue once again, some people ‘cry’ if onions are not used as a lavish ingredient in their food). This fluctuating tendency for a particular good after price changes is defined as the price elasticity of demand, at least in the economic circles.

Price elasticity of demand formula and definition

Price Elasticity of DemandPrice Elasticity of Demand = % Change in Quantity Demanded / % Change in Price

(To all the mathematical junta — will this ratio be positive or negative for majority of the cases? Why?)

By definition, the price elasticity gives us the sensitivity in the quantity sold of a particular good with changes in price, along with a condition that all the other factors affecting demand are held constant.

A good is termed as relatively inelastic when this ratio comes out as less than 1, as the price changes do not make a substantial effect on the quantity in demand. A good is relatively elastic when the ratio is more than 1, and price changes do make a dent on the demand.

Factors affecting price elasticity of demand with examples

  • Availability of alternatives: a good that is easily replaceable is more likely to be elastic, as the end consumers have a host of options to choose from
  • Luxury/everyday good: the everyday necessity is more inelastic as compared to luxuries as it is generally irreplaceable (a curd-rice lover won’t switch to chapaati that easily!)
  • Cost of shifting: the suppliers can create an ecosystem which makes it harder to leave and move on— which can render the demand inelastic to price changes (“What if iPod Classic is out of my budget, I have a MacBook and iPhone and iTunes make it all so easy!”)
  • Proportion of income going towards the purchase: the goods that take up a larger percentage of the wallet tend to have greater elasticity (you actively look for ways to save money at least for big-ticket purchases like non-luxury cars). This is also referred to as the income elasticity of demand.
  • Consumption patterns of the good: if the product is consumed habitually or if it is addictive, then it tends to be more inelastic (ask a smoker friend)
  • Brand loyalty: If you have a large loyal fan base, you can get away with an increase in prices (think of Apple again, or better yet, ask that smoker friend!)
  • Seasonality of demand: demand is relatively inelastic at peak season of consumption
  • Breadth of definition of a good: Broader the definition of a good, lower is the elasticity. Think about a mobile phone, and then the specific brands. Whose elasticity would be greater?

Mini exercise for you: How do you think each of these factors would affect MBA Crystal Ball services? Share your analysis in the comments below.

Why would producers want to know the elasticity of their goods?

First and foremost, there is a deep association between the elasticity of a good and the producer’s total revenue:

  • when the demand is inelastic, a price rise leads to an increase in revenue
  • when the demand is elastic, a fall in price leads to an increase in revenue

Apart from the general direction that is indicated by the price elasticity, there are many other considerations which go into a firm’s pricing decisions. But the price elasticity serves as a rather good starting point and a guide to:

  • Forecasting the impact of price changes on the total revenue, hence production can be planned accordingly
  • Judging the viability of passing on the direct/indirect taxes onto the consumer
  • Implementing dynamic/discriminatory pricing: it might make more sense to charge differently from varying market segments according to preferences and/or add-ons (discriminatory pricing); or a firm can change prices based on the current elasticity scenario (the dynamic pricing mechanism in the airline industry is a rather good example)
  • Guiding non-pricing decisions: when a good is highly elastic it generally has a low brand loyalty— the firm can decide on its promotional strategy accordingly as money might rather be spent on a better advertising campaign

 

If you have breezed through the article without giving much thought to the intuitive question asked at the start (which is highly unlikely), the elasticity ratio comes out as negative in almost all the cases: as price increases, the demand tapers off (the magnitude varies).

‘Almost’ is used in the preceding sentence to account for the few counter-intuitive anomalies which go against this logic — their demand increase with an increase in price.

A prime example of these type of goods is the ultra-luxury class (Gucci, Armani or Ferrari?) which have an “exclusivity factor” attached to them, and a higher price tag equates to higher exclusivity and panache!

Can you think of another class with a positive elasticity ratio?
 

Learn more about the most important topics in Economics

Introduction to Economics
Introduction to Microeconomics
Introduction to Macroeconomics
Game Theory in Economics

Back to the top: MBA Syllabus

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