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HL MARKETING THEORY ELASTICITY IB BUSINESS & MANAGEMENT – A COURSE COMPANION: p214-218 ELASTICITY Price Elasticity of Demand (PED) • PED measures how sensitive the quantity demanded is to changes in the price. • You would expect the demand for most goods to fall as the price increases, but PED measures how much of a fall is likely. • It is important to distinguish between elastic and inelastic demand. Elastic Demand • A relatively small change in price, leads to a disproportionally large change in demand. • For example, the price of a bottle of wine is increased by 10% and there is a 30% decline in demand for the product. • With calculations, an elastic good or service will have a number greater than 1. Inelastic Demand • A relatively large change in price results in a disproportionally small change in demand. • For example, the price of gasoline in the United States increases by 15%, but there is only a 3% change in demand for gasoline. • With calculations, an inelastic good or service, will have a number less than 1. What determines whether a good or service is elastic or inelastic? The number of substitutes • When there are many substitutes, a product or service will generally be characterized by elastic demand. • When there are few or no substitutes, a product or service will generally be characterized by inelastic demand. Essential Goods/Service & Non Essential Goods/Services • Goods & Services which are essential for all consumers will generally be characterized by inelastic demand. • Good & Services which are not essentials or luxury items will generally by characterized by elastic demand. Seasons / Time of the Year • The season or time of the year can have a great impact on the elasticity of the good/service. ELASTICITY Price Elasticity of Demand (PED) Formula for PED: % change in quantity demanded % change in price How do we calculate the % change??? Change in Quantity Original Quantity ________________ (divided by) Change in Price Original Price PED Example • The price of a popular chocolate bar increases from $3 to $4 per bar. • The quantity demanded per week falls from 10000 bars to 9000 bars. • Calculate the PED. Change in Quantity = 1000 Original Quantity 10000 = .1 .1__ .333 = .3 What does this number Change in Price = 1 = .3333 mean ? – the product is Original Price 3 inelastic. ELASTICITY Price Elasticity of Demand (PED) Unitary Elasticity • If PED is exactly 1, this is know as unitary elasticity, which means that a change in price will lead to an identical change in quantity demanded. ELASTICITY Price Elasticity of Demand (PED) The Importance of PED for Business • It is useful for business to look at PED when deciding whether or not to change the price. • Revenue (price x quantity) will be affected by any change in price, but how it is affected depends on whether a product is elastic or inelastic. ELASTICITY Price Elasticity of Demand (PED) PED is Inelastic (less than 1) = Business Can Increase Revenue by Increasing Price • They will lose some revenue from quantity demanded, but will gain more revenue from the higher prices, as demand changes less than proportionally to the change in price. ELASTICITY Price Elasticity of Demand (PED) PED is Elastic (Greater than 1) = Businesses Can Increase Revenue by Lowering Prices They will lose some revenue from the lower prices, but will gain more revenue from the higher quantity demanded, as demand changes more than proportionally to the change in price This means that businesses must be careful to interpret their sales data correctly before making decisions on price changes. PED EXERCISES (1) American Airlines (AA) decides to increase its airfares on the Caracas to Miami route from $400 one way to $700 one way during December and January. Weekly demands for the seats at this price level falls from 10000 per week to 9500 per week. • Calculate the Price Elasticity of Demand (PED) • Explain what the number means – are airfares on this route at this time elastic or inelastic?? • From a revenue perspective was this a wise and smart decision for AA. PED EXERCISE (2) APPLE decides to decrease the selling price of its basic IPAD from $499 to $399. Weekly demand in a specific market increases from 10,000 units to 11,000 units. • Calculate the Price Elasticity of Demand • Explain what this number means • From a revenue perspective, was this a wise/ smart decision for APPLE. ELASTICITY Income Elasticity of Demand (YED) • YED measures the change in demand for a product if there is a change in consumers income. ELASTICITY Income Elasticity of Demand (YED) Formula: % Change in Quantity Demanded % Change in Income How do we calculate the % change??? Change in Quantity Original Quantity ________________ (divided by) Change in Income Original Income ELASTICITY Income Elasticity of Demand (YED) Elastic Income Demand • If demand is more than proportionally affected by a change in income it is elastic. • If incomes rises by 5% and demand increases by 20% it clearly is elastic. • Income elastic goods are known as luxury goods. • Expense jewelry is a good example – demand will be significantly affected by changes in income. ELASTICITY Income Elasticity of Demand (YED) • You would expect most goods to have a positive relationship to income with demand rising as income rises. • After all, if you have more money you will spend more. However, we need to distinguish between two different types of goods: Normal Goods Inferior Goods ELASTICITY Income Elasticity of Demand (YED) Normal Goods • Normal goods which will have a positive YED, because more is demanded as income rises – both the top and bottom of the calculation will have the same size. Inferior Goods • Demand actually falls as income rises. • The best examples are the low cost value ranges stocked by most supermarkets. • As income rises, instead of customers buying more of these products, they may choose to swap to a higher quality or brand alternative. ELASTICITY Income Elasticity of Demand (YED) Inferior Goods • These products are extremely popular in times of recession and when incomes are falling, but are quickly abandoned once incomes and employment start to rise. • The success of low cost chains across Europe such as Lidl and Aldi will increase as the global economy tips into a recession. • As demand falls when income rises, the top and bottom of the equation will have different signs and therefore have a negative YED. Income Elasticity of Demand (YED) Exercise The average middle income salary increases from $50,000 to $70,000. The amount spent by these consumers on restaurant meals (fine dining) increases from $80 per week to $150. • Calculate the YED. • Explain the meaning of the number. • Are restaurant meals a normal or an inferior good? Why? ELASTICITY Cross Elasticity of Demand (XED) • XED is a measure of responsiveness of change in the demand of one product to the change in the price of another (a complement or a substitute). ELASTICITY Cross Elasticity of Demand (XED) The formula is: % Change in Quantity Demanded of Product A % Change in the Price of Product B How do we calculate the % change??? Change in Quantity A Original Quantity A ________________ (divided by) Change in Price of Product B Original Price of Product B ELASTICITY Cross Elasticity of Demand (XED) Substitutes • Products that can replace each other (substitutes) will have a positive XED – the price of butter goes up, demand for margarine will increase as some people choose to swap to the option that has become relatively cheaper. ELASTICITY Cross Elasticity of Demand (XED) Complements • Products that are linked (complements) have a negative XED – as the price of airfares increases, the demand for hotels in resort locations may go down. ELASTICITY Cross Elasticity of Demand (XED) No Relationship Between Goods • Goods with no relationship will have an XED of zero – for example if the price of cars increases, demand for cheese will remain unchanged. ELASTICITY Cross Elasticity of Demand (XED) What does the number mean? • The higher the number calculated, the stronger relationship between the products, whether a complement or a substitute. Examples • Coke and Pepsi are likely to have a very high, positive XED as they are very close substitutes. • Coke and Spirit will still have a positive XED, but it is likely to be lower, as Spirit is alternative soft drink, but not quite as close a match as another Cola. Cross Elasticity of Demand (XED) Exercise The number of subscribers to Super Cable increases from 10,000 per month in September to 11,000 per month in October. During October Direct TV decided to increase the cost of platinum TV package (all channels) from $60 per month to $80 per month. • Calculate XED • Explain the meaning of the number. ELASTICITY Advertising Elasticity of Demand (AED) • Advertising elasticity of demand measures how sensitive the quantity demanded is to changes in an organization’s advertising expenditure. ELASTICITY Advertising Elasticity of Demand (AED AED formula: % Change in Quantity Demanded % Change in Advertising Expenditure Change in Quantity Original Quantity ________________ (divided by) Change in Advertising Expenditure Original Advertising Expenditure ELASTICITY Advertising Elasticity of Demand (AED) Advertising Elastic • If the AED is more than 1, it is known as advertising elastic. • The change in demand is more than proportional to the change in advertising expenditure. Inelastic Demand • An advertising elasticity of less than 1 is referred to as advertising inelastic ELASTICITY Advertising Elasticity of Demand (AED) Expectations with AED: Retail Goods • You would expect most products to have a positive AED as increases in spending should, all other things being equal, lead to more demand for a product. • AED will be useful to businesses when deciding how to promote a product. • Retail goods (products sold to the general public) tend to have a higher AED – changes in advertising expenditure are likely to have a significant effect on sales. ELASTICITY Advertising Elasticity of Demand (AED) Expectations with AED – Industrial Matters • The level of demand in industrial markets (transactions between two businesses) is likely to be less influenced by advertising as businesses will be focused on the characteristics of the product itself. Advertising Elasticity of Demand: AED Exercise • The Atlantis Hotel & Resort complex in the Bahamas decides to increase their yearly spending on advertising from $10 million to $20 million. • The number of hotels rooms demanded increases from 100,000 per year to 110,000 per year. • Calculate the AED • Is the product elastic or inelastic in regard to advertising? • Was does this mean? • Was it a wise or a smart decision for the Atlantis Hotel & Resort to implement this additional expenditure?