Elasticity

Philip Kotler "Marketing basics"

Price Elasticity of Demand

Marketers also need to understand the concept of price elasticity, how responsive demand wills be to a change in price. Consider the two demand curves in Figure 12-4. In Figure 12-4A a price increase from Pl to P2 leads to a small drop in demand from Q1 to Q2. In Figure 12-4B, however, the same price increase leads to a large drop in demand from Q1, to Q2. If demand hardly varies with a small change in price, we say that the demand is inelastic. If demand changes greatly, we say the demand is elastic.

Suppose that demand falls by 10 percent when a seller raises its price by 2 percent. Price elasticity of demand is therefore -5 (the minus sign confirms the inverse relation between price and demand) and demand is elastic. If demand falls by 2 percent with a 2 percent increase in price, elasticity is 1. In this case the seller's total revenue stays the same: the seller sells fewer items but at a higher price that preserves the same total revenue. If demand falls by 1 percent when the price is increased by 2 percent, elasticity is 1-2 and demand is inelastic. The less elastic the demand, the more it pays for the seller to raise price.

What determines the price elasticity of demand? Buyers are less price sensitive when the product is unique or when it is high in quality, prestige, or exclusiveness. Chains try to differentiate their brand to create a perception of uniqueness. Consumers are also less price sensitive when substitute products are hard to find. After the closure of the Neil House in downtown Columbus, Ohio, Stouffer's Hotel became one of the few places in the central business district to hold a major banquet function. With supply down, they could charge more for their banquets. They maintained this advantage until new hotels were built and the market became competitive.

 

If demand is elastic rather than inelastic, sellers will generally consider lowering their prices. A lower price will produce more total revenue. This practice makes sense when the extra costs of producing and selling more products do not exceed the extra revenue.

Wikipedia, the free encyclopedia

A set of graphs shows the relationship between demand and total revenue. As price decreases in the elastic range, revenue increases, but in the inelastic range, revenue decreases.

A firm considering a price change must know what effect the change in price will have on total revenue. Generally any change in price will have two effects:[21]

  • the price effect: an increase in unit price will tend to increase revenue, while a decrease in price will tend to decrease revenue.
  • the quantity effect: an increase in unit price will tend to lead to fewer units sold, while a decrease in unit price will tend to lead to more units sold.

Because of the inverse nature of the price-demand relationship the two effects offset each other; in determining whether to increase or decrease prices a firm needs to know what the net effect will be. Elasticity provides the answer. In short, the percentage change in revenue is equal to the change in quantity demanded plus the percentage change in price.[22]

In this way, the relationship between PED and revenue can be described for any particular good:[23][24]

  • When the price elasticity of demand for a good is perfectly inelastic (Ed = 0), changes in the price do not affect the quantity demanded for the good; raising prices will cause revenue to increase.
  • When the price elasticity of demand for a good is inelastic (|Ed| < 1), the percentage change in quantity demanded is smaller than that in price. Hence, when the price is raised, the total revenue of producers rises, and vice versa.
  • When the price elasticity of demand for a good is unit elastic (or unitary elastic) (|Ed| = 1), the percentage change in quantity is equal to that in price and a change in price will not affect revenue.
  • When the price elasticity of demand for a good is elastic (|Ed| > 1), the percentage change in quantity demanded is greater than that in price. Hence, when the price is raised, the total revenue of producers falls, and vice versa.
  • When the price elasticity of demand for a good is perfectly elastic (Ed is infinite i.e. undefined), any increase in the price, no matter how small, will cause demand for the good to drop to zero. Hence, when the price is raised, the total revenue of producers falls to zero.

Hence, to maximise revenue, a firm ought to operate close to its unit-elasticity price.[24]

 

Objections


The most common argument for the theory of elasticity based on general considerations. Example of such – «without drugs (bread, salt, etc.) people can not live, hence, the demand for these products are inelastic ». Why, however, the sellers of goods with inelastic demand not increase the price of these goods (if this price is not regulated by the state)? In addition, we can show that after reaching a unit elasticity of sellers profitable to raise the price.

Although revenues under such price growth declining, but the profit grows until it reaches a maximum. The price the "extremely necessary" products will increase, until demand becomes elastic.
Consequently, the elasticity coefficient is always (in an established system where the goal of business - profit) is greater than unity.

The experimental work, which found that demand for some products is inelastic, must provide justification for this paradox (the goal of business - not profit, government regulation of prices, or other reasons). One could assume that the deviation from the price for maximum profit due to the fact that sellers can not correctly identify the optimal price. However, practice shows that after the sharp fluctuations in variable costs (such as races exchange rate) is a rapid transition to a new price level. Consequently, the markets can easily find the optimal price. In such a market the existence of goods with inelastic demand is impossible.

In any case, arguments about the elasticity and the inelastic demand for some goods, it makes no sense. They no have any influence on the pricing.

Some economists argue that even if the comparison with a unit elasticity is not significant, the elasticity is an important element for decision making. It supposedly allows you to:

  • Determine to what goods the seller may raise the price
  • Correct prices in the commodity category
  • Make a prediction of possible shift in demand from brand to brand, etc

Let us check this assertion.

The figure shows graphs of marginal income, calculated from the curve in demand for motor oil (Kotler, "Marketing Essentials"). For the first of these graphs sum of variable costs equal to 30, for the second - 50. It is evident that if the price of 53 is required to raise the price in the first case, and is required  to lower in the second case. But they are based on the same demand functions!
Thus, the concept of flexibility in its traditional form (i.e., excluding the cost) does not allow to take a sensible decision.
The optimal price can be found taking into account the variable costs and assuming a linear dependence of demand on prices. However, this assumption is valid only if a certain way the price is close to the point of measurement of elasticity.

If someone tries to convince you that you need to change the price of goods on the basis of the elastic - it is either honestly mistaken, or trying to confuse you.

Pricing.

 

 


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