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A2 - Elasticity
Economic concept of demand
• An increase in price will cause a decrease in
demand
• This assumes that the only two variables are
price and quantity demanded, nothing else
Normal demand curve
Factors which cause a shift in the
demand curve
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•
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Changes in income level
Increase in price of substitute goods
A reduction in the price of complementary goods
Effective advertising campaign
All of these could operate in reverse too.
Price elasticity of demand
• This is the relationship between price changes
and the size of the resulting change in demand.
Percentage change in quantity demanded
Percentage change in price
There is usually an inverse relationship (a
negative) as an increase in price usually reduces
demand. (you can ignore the – sign)
Value PED
Classification
Explanation
Zero
Perfectly inelastic
demand
The same amount is demanded no
matter what the price
0–1
Inelastic
The % change in demand is less than the
% change in price. It can raise the price
and not lose much demand, increasing
sales revenue
1
Unit elasticity
% change in demand = and opposite to
the % change in price. Any change in
price will be matched by a change in
demand, revenue will remain constant
1 – infinity
Elastic demand
% change in demand is greater than the
% change in price. If price is lowered
demand will increase and increase sales
revenue
Factors that determine PED
• How necessary the product is – the more
necessary the product the less they will react to
price changes. Inelastic.
• How many competing products/brands – if
there are many substitutes consumer will switch
brand if price increases.
• Consumer loyalty – change in price will not lose
customers.
• Price of the product – cheap goods will unlikely
be affected by an increase in price.
Applications of PED
• Accurate sales forecasts
• Assist pricing decisions
Determinants of price
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Cost of production
Competitive conditions in the market
Competitors’ prices
Business and marketing objectives
PED
Whether it is a new or existing product
For each method explain what the
strategy is and advantages/disads.
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Cost-plus or cost-based pricing
Competition pricing
Skimming
Penetration pricing
Loss leaders
Psychological pricing
Promotional elasticity of demand
% change in demand
% change in promotional spending
Greater than 1 = Elastic; responsive to a change in
promotional spending
Less than 1 = Inelastic; little point in increasing
prom0tional spending
Reliability
• Not entirely reliable; changes in demand may be
due to external factors (e.g economy) which
could occur at the same time as a promotion.
• However, if similar elasticity results are obtained
on more than one occasion then this is useful
information.
Income elasticity of demand
• Virtually all businesses will have greater
opportunities for increased sales, profit and
expansion during periods of economic growth.
• The impact of the resulting increase in income
will not necessarily be felt evenly through all
businesses.
• Income elasticity measures the responsiveness
in demand to a change in income.
% change in demand for a product
% change in consumer income
Income elasticity can be classified for
3 classes of goods.
1. Normal goods ( Elasticity of 0 – 1)
When consumer incomes rise, the demand for
these goods may well increase but by a smaller
proportion.
Demand will remain at a similar level no matter
what happens to income.
E.g. Basic foods, pharmaceuticals
2. Luxury goods (Elasticity greater than 1)
When consumer income rises, demand for these
goods rises by an even greater proportion.
E.g. holidays, leisure activities and consumer
durables
3. Inferior goods (Negative income elasticity)
Demand will decline following an increase in
incomes, but rise when incomes reduce.
E.g. second-hand goods, home brand products.
Producers of these products will gain during a
recession.