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Price elasticity of demand (PED) is a crucial concept in economics that measures the responsiveness of the quantity demanded of a good to a change in its price. Understanding PED helps businesses make informed pricing decisions and plan effectively.
Here, we will thoroughly explain the concept of price elasticity of demand and how it works, as well as why it is so important for businesses (producers) to understand.
Understanding Price Elasticity of Demand
Price elasticity of demand is calculated using the following formula:
Price Elasticity of Demand (PED)=
% Change in Price/ % Change in Quantity Demanded
PED can be categorised into three main types:
- Elastic Demand (PED > 1). When the percentage change in quantity demanded is greater than the percentage change in price. In this case, demand is sensitive to price changes.
- Inelastic Demand (PED < 1). When the percentage change in quantity demanded is less than the percentage change in price. Here, demand is relatively insensitive to price changes.
- Unitary Elastic Demand (PED = 1). When the percentage change in quantity demanded is exactly equal to the percentage change in price.
Influences on Price Elasticity of Demand
We know that a lot of the time, supply and demand can be impacted by a number of different things, and a lot of these are linked closely to price elasticity of demand. For instance, if there is a product that may suddenly be in huge demand (or suddenly not).
- Substitutability: Products with readily available substitutes tend to have higher elasticity because consumers can easily switch to alternatives if the price rises. For instance, if one brand of cereal became overly expensive, there are plenty more.
- Necessity vs. Luxury: Necessities often have inelastic demand because consumers need them regardless of price changes. Luxuries have more elastic demand.
- Proportion of Income: Expensive items that take up a significant portion of a consumer's income typically have more elastic demand. If the economy takes a downward turn, more people will abandon these types of products.
- Time Period: Demand is usually more elastic in the long run as consumers have more time to adjust their behaviour and find substitutes.
- Brand Loyalty: Strong brand loyalty can make demand more inelastic, as loyal customers may be less sensitive to price changes.
Price Elasticity and Pricing Decisions
Knowing the price elasticity of demand helps managers make strategic pricing decisions. For instance, products may sell a lot more when the cost is lower, and even at a lower profit per piece, this could mean a bigger profit overall if the company can keep up with this demand.
Elastic Demand
When demand is elastic, consumers are highly responsive to price changes. If a business lowers its prices, the percentage increase in quantity demanded will be greater than the percentage decrease in price. This leads to an overall increase in total revenue. For example:
Example: A company sells a product for $10 each. If the price is reduced to $8 and the quantity demanded increases from 100 to 150 units:
Original Revenue: $10 x 100 = $1,000
New Revenue: $8 x 150 = $1,200
In this scenario, reducing the price increases total revenue because the increase in quantity demanded offsets the lower price.
Inelastic Demand
When demand is inelastic, consumers are less responsive to price changes. If a business raises its prices, the percentage decrease in quantity demanded will be smaller than the percentage increase in price, leading to an increase in total revenue. For example:
Scenario: A company sells a product for $10 each. If the price is increased to $12 and the quantity demanded decreases from 100 to 90 units.
Original Revenue: $10 x 100 = $1,000
New Revenue: $12 x 90 = $1,080
In this scenario, increasing the price leads to higher total revenue because the drop in quantity demanded is smaller than the price increase.
Strategy and Price Elasticity
The elasticity of prices can play a big part in businesses and their decision-making. Certain industries are known for their changes in prices, or huge sales that occur when they haven’t sold through all of their stock.
Price elasticity plays a part in promotions, as well as other aspects of how a producer works.
Managers can adjust prices based on elasticity to maximise total revenue. For elastic products, lowering prices can boost revenue, while for inelastic products, raising prices can achieve the same goal.
Knowledge of demand elasticity helps in planning inventory levels. For products with elastic demand, lower prices leading to higher sales require larger inventories. Conversely, higher prices for inelastic products mean lower inventory needs which can make a difference to production levels. On top of this, anticipating changes in demand allows businesses to manage staffing effectively. Increased demand from price cuts might necessitate more staff, while decreased demand from price hikes might reduce staffing needs.
Price elasticity of demand also provides critical insights for various business decisions beyond pricing. Elastic products might benefit from promotional discounts to drive sales volumes, while inelastic products can leverage value-based marketing to justify higher prices.
Understanding elasticity can guide product development. For instance, enhancing features of an inelastic product can justify a higher price, while improving cost efficiency for an elastic product can maintain competitiveness.
Price elasticity of demand is a powerful metric for businesses, influencing a wide range of strategic decisions. By understanding whether demand for their products is elastic or inelastic, managers can make informed pricing decisions that optimise revenue.
Review Questions
A company decreases the price of its product from £10 to £8. As a result, the quantity demanded increases from 100 units to 150 units. What is the price elasticity of demand (PED)?
Please select a response.
Initial price (P1) = £10
New price (P2) = £8
Initial quantity demanded (Q1) = 100 units
New quantity demanded (Q2) = 150 units
So, the price elasticity of demand (PED) is 2.5.
If the price elasticity of demand for a product is 2, what does this indicate about the product?
Please select a response.
If the price elasticity of demand (PED) for a product is 2, this indicates that the product has elastic demand. Elastic demand means that a small change in price leads to a proportionately larger change in quantity demanded.
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