Elasticity of demand is a measure of the change in demand for a good in relation to a change in another economic factor, such as price. The elasticity is visible by dividing the percentage of change in the quantity of a good by the percentage of change in another economic variable. A higher elasticity of demand for a specific economic factor means that consumers respond more to changes in this factor, such as increases in income or prices.
- Generally, a positive price elasticity of demand means that if prices of a product are increased, the demand for the product will go down.
- Conversely, if the price of a product is reduced, consumers will be inclined to buy more units of the product.
A product is inelastic if changes in price do not affect the demand for the product or only cause a small change in the demand for a good. Examples of goods with inelastic demand are necessities such as fuel and food.
A business owner or manager must be aware of the supply and demand characteristics of his products. He must understand the economic variables in the marketplace and the economic factors and variables that will affect the demand for his products. Once he understands the basics of how changes in price lead to changes in the demand for a product, he now has to consider how an individual business should apply these principles to a pricing strategy.
The Importance of Elasticity
If a company wants to increase its revenue, it is essential that management knows whether the demand for its products is elastic or inelastic. If the demand for a product is elastic, then its revenue can increase by decreasing its price. Even though the price will go down, the quantity sold will increase at a higher rate. It is, thereby, increasing total revenue. If the demand for a product is inelastic, prices can actually increase. Then, revenue will go up even though fewer units of the product are sold.
Consumers typically will not reduce their purchases of food when prices go up. However, they may shift their purchases to other foods which are cheaper. For example, poultry, pork and beef are all meat products. However, the decline in the price of poultry over the past several years has increased its demand and reduced the demand for pork and beef.
Cross Elasticity of Demand
The cross elasticity of demand measures how the demand for one product reacts to price changes in another product. This happens frequently when analyzing the market for complementary products which are frequently purchased together.
For example, if the price of hot dogs goes up, this will result in a decline in demand for hot dogs. However, it will also lead to a decline in the demand for hot dog buns. Coffee and cream are similar examples. If a grocery store decreases the price of a pound of coffee, sales of coffee will rise and the demand for cream will also go up.
Maximizing the profit in a business requires making accurate estimates of the demand for its products. This involves finding that ideal balance between price and demand by identifying the wants and needs of the customer. Mistakes made in this analysis can result in lower profits from having idle staff sitting around and incurring extra storage cost from excess inventory.
What Can Cause a Shift in the Demand Curve for Your Products?
Demand for products changes as income of consumers goes up and down. People will reduce purchases of luxury items as their income declines, or they may substitute less-expensive items, such as cheaper clothing instead of high-end designer items.
It is hard for consumers to reduce purchases of food and gas during economic hard times. But they may change the mix of their purchases to lower-priced products. They can’t decrease their purchases of gasoline if prices go up. Yet, they can certainly search more for the station with the lowest gas prices.
Reducing prices for products with elastic demand will theoretically increase purchases. However, lowering prices too far could create the perception of an inferior product in the minds of consumers. Customer must perceive that the product has enough value and is worth buying.
A consideration in formulating a pricing strategy must include an analysis of the effects of changes in prices on revenues and expenses. While a decrease in the price of a product may bring an increase in the volume of purchases, it may also result in a decrease in total revenues if the increase in volume is not enough to offset the lower price. This depends on the slope of the demand curve.
3. Customer Preferences
It’s not just prices that influence customer buying decisions; it could also be the effect of fads and trends. Business managers must remain up-to-date with surveys on what the buyer currently likes and expects from a product.
4. Shifts in Population
Changes in the location and composition of the population in a geographic region will affect the demand for products. Baby boomers who once purchased goods for their immediate families may now be looking for products for their grandchildren. They will also need more medical services tailored for an older population.
5. Product Changes
Another effect is the change in the profit structure of the product. A lower price combined with a constant cost of production will result in a lower gross profit contribution to overhead and a lower net profit. Business managers have to make all of these calculations before changing prices.
To the Total
Determining the elasticity of demand for a product involves more than just a consideration of changes in prices. A business manager must absorb all of these economic factors.
Then, he or she can develop strategies for prices and the volume of products that the company will manufacture.
The images are from depositphotos.com.