When looking to buy a product or service, have you ever been influenced by the price?
If you have, you aren’t on your own.
The Price Elasticity of Demand which is often referred to as PED provides a business with
a measurement of exactly this, how the demand for a business’ goods and services alter
after a change in price.
Let’s have a look into the Price Elasticity of Demand in more detail and calculate some
worked examples.
In business, there are many factors which influence the demand for products and services,
however one of the most influential factors is price.
But how does a business know how influential price is when it comes to the demand of their
products and services.
This is through a concept known as the Price Elasticity of Demand which is used by business
owners and marketing managers to calculate the relationship between the price they charge
for the business’ goods and services and the demand for these goods and services from
the business’ target market.
For example, imagine a product that you purchased on a regular basis was increased by 10% would
this stop you from buying it in the future?
Now imagine the same product was on sale and reduced by 20%, how would this influence your
buyer behaviour and that of the business’ other customers?
This is what the business needs to calculate before making decisions about its selling
prices.
It needs to know whether its products and services are elastic or inelastic and how
a change in price will impact demand.
An elastic product or service means that they are more sensitive to price changes.
In other words, the change in demand is higher than the change in price.
For example, if a business raised the selling price of its product by 10% and the demand
decreased by more than 10%, for this scenario we will use 12%, but it could be any decrease
over the percentage price rise of 10% and this product would then be classified as an
elastic product.
Therefore, the business may decide not to increase the price because total sales revenue
would decrease overall even though the selling price per unit is higher because less people
would buy the product after the change in price.
However, this all changes when a business is looking at decreasing the price of an elastic
product.
If the price of an elastic product was decreased 10% instead, demand would actually increase
by more than 10%.
Again, we will use 12% for the sake of this scenario.
Meaning that total revenue would increase overall even though the revenue per sale would
be reduced as the percentage demand has increased more than the percentage price change, meaning
more customers would be purchasing the business’ product.
So, to summarise, if a product is price elastic, total sales revenue will go down if the selling
price is increased but if the selling price was reduced total sales revenue will go up.
Essentially, changes to the selling price have the opposite impact on total sales revenue.
Examples of products with elastic demand include: Chocolate bars because customers have so much
choice in the market and often little loyalty to a specific chocolate bar.
Therefore, if a brand decided to increase its prices of a particular chocolate bar,
it’s very likely a higher percentage of customers would buy a competitors chocolate
bar instead.
It could be argued that petrol as a commodity is price inelastic, however individual petrol
stations set their own prices which makes the petrol they sell to customers price elastic
as there’s many alternative options and if a competitor is selling petrol for 10%
cheaper locally it’s likely that many customers will switch to this competitor.
Popular supermarket products such as milk, bread, fruit, and veg are also price elastic
as competition is so intense in the industry and customers have lots of choice.
Therefore, if a supermarket such as Tesco raised their prices on these popular items
by 20% it’s likely that demand would decrease dramatically as customers look to their local
competitors for alternative options.
In comparison, an inelastic product means they are less sensitive to price changes.
In other words, the change in demand is lower than the change in price.
Therefore, if a business which sells inelastic products was looking to increase the selling
price by 10%, the change in demand would be less than 10%.
For this scenario we will use 5% but it could be any decrease under the percentage price
rise of 10% and this would be known as an inelastic product.
This is good for business as overall sales revenue would therefore increase because of
the change in selling price as demand wouldn’t be significantly impacted.
However, the option of reducing prices to increase sales would not actually be very
effective.
The business could decrease the selling price of an inelastic product by 10% but demand
is likely increase by less than this.
Let’s again use a 5% increase in demand for this scenario, meaning this would be bad
for business as the total sales revenue would be lower because of the change in selling
price as the change in demand is lower than the percentage price decrease.
So, to summarise, if a product is price inelastic, total sales revenue will go up if the selling
price is increased but if the selling price was reduced total sales revenue will also
go down.
Essentially, changes to the selling price have the same impact on total sales revenue.
Therefore, reducing selling prices isn’t an effective method for inelastic products.
Examples of products with inelastic demand include Train tickets for commuters who rely
on the train to get to work, especially for those who work in London.
If the ticket price were to increase, it is very likely that demand will only fall by
a marginal amount as it is a necessity and alternatives for commuting into London during
peak hours are limited.
Apple products including the iPhone are inelastic as they have several USPs such as Apple’s
operating system which is only available with Apple’s products.
Apple also have very strong levels of brand loyalty from its customers, meaning any increase
in price, unless it was completely unreasonable is unlikely to result in demand decreasing
more than the percentage increase in price.
Tickets for high end sporting events such as Premiership football and Formula One are
inelastic as fans are committed to their respective teams and have high levels of loyalty to the
sport which means any price rise would have to be deemed as completely unreasonable for
demand to reduce to a higher percentage than the price increase.
But how can you tell if a product is elastic or inelastic?
Well, it’s all to do with its elasticity rating which always starts with a minus but
if a whole number follows the minus sign, for example the number 1, 2 or 3 then it means
the product or service is elastic.
Therefore, price increases will not be very effective, but demand is likely to rocket
if the business reduces its prices.
However, if the number which follows the minus sign is below 1 for example as low as 0.1
or as high as 0.9 then the product or service is inelastic.
Meaning that price increases don’t severely impact demand and usually result in an increase
in total sales revenue for the business.
To calculate the elasticity of a product a formula is used.
It is the percentage change in quantity demanded divided by the percentage change in price.
Let’s look at worked example.
Imagine you are the Manager of a local fast food restaurant, and you are considering increasing
the price of a popular burger from £5 to £5.50.
At the current price of £5 the quantity demanded is 1000 units but at the revised price of
£5.50 demand reduces to 925 burgers.
To help you make the decision you need to calculate the price elasticity of demand to
clarify if this would be a good business decision.
You can do this in 3 simple steps.
First, you need to calculate the change in demand as a percentage.
The current demand is 1000 units and the demand at the revised price would be 925 units, leaving
a difference of 75 units.
Divide this difference of 75 units into the current demand of 1000 units, then multiply
the answer by 100 and you have the percentage change in demand, which is in this scenario
is 7.5%.
Step two is to calculate the change in price as a percentage.
The current price is £5, and the proposed change is to increase the selling price to
£5.50 which is a difference of 50p.
Divide this difference of 50p into the current selling price of £5, then multiply the answer
by 100 and you have the percentage change in price, which in this scenario is 10%.
Now we have completed steps one and two having calculated the % change in demand and % change
in price.
We can now move onto the third and final step which is to use the elasticity formula we
learnt previously to calculate the elasticity rating by dividing the percentage change in
quantity by the percentage change in price.
Which in this scenario is 7.5% divided by 10% equalling 0.75, which would be represented
as -0.75?
Therefore, the price is inelastic as the number is below 1 and the percentage change in demand
is less than the percentage change in price.
Meaning it would be a good business decision to increase the selling price of the burger
to £5.50 as total sales revenue is likely to increase even though the business will
lose a small percentage of its customer base for this product.
So that’s it, price elasticity of demand explained, a very useful calculation which
supports a business to make decisions about the selling prices of their products and services
and the potential impact this will have on demand and total sales revenue.
I hope that’s helped and if you want to learn more about business, don’t forget
to subscribe to Two Teachers on YouTube to see our weekly video uploads on key business
topics.
Thank you for listening and all the best.