Price elasticity basically tells people whether the population is willing to buy your product even when you change the prices.
A much formal definition is as follows:
It is defined as responsiveness of a good/service to a change in its price and is calculated by
Elasticity= % Change in Quantity Demand(Sales) / % Change in Price
So suppose price elasticity of your product is high(Greater than 1), it means that even with a small change in price, the change in sales will be high. For Eg: Let’s say an ice-cream manufacturer decides to increase the price by 5% and after some time checks the sales of the ice-cream. He finds that sales of his product had gone down by 40% . Thus elasticity is equal to 8 (40% / 5%) . And his product is highly elastic. People either switch over to some other product or maybe stop using that commodity all together.
If the price elasticity is low( less than 1), it simply tells that even if you increase the prices, the sales won’t go down that much because your product has the required demand. This happens in cases whenever there are less substitutes. Thus this commodity is price inelastic. A product can be inelastic may be due to two reasons:
- Either that product is a necessity or there aren’t any other substitutes available in the market. For eg- Gasoline. You need to use it. Even if the price is high. So companies can easily increase the prices without bothering about the sales.
- Or the consumers are brand loyal and that brand pull is very high. An example which acc. to me fits in this situation is of Apple. It’s customers are brand loyal and even if prices of I-phones are way higher than that of other smartphones, the consumers don’t stop buying that. Thus their products can be said to be price inelastic.
When the elasticity=0, the product is said to be perfectly inelastic and the quantity demanded just doesn’t depend on the prices.
It is generally seen that sales go down with an increase in prices. Thus normally price elasticity comes out to be negative. Economists, being a lazy bunch, usually express the coefficient as a positive number even when its meaning is the opposite. However, a decrease in sales doesn’t mean a loss in revenues. It can happen that the increase in prices can make up for the lost sales. Actually this is what happens. Otherwise there ain’t any use of changing the prices.
Sometimes it happens that price elasticity actually comes out to be positive. Meaning even if you increase the prices, the sales go on increasing. An example of such a good was potato during the Irish potato Famine. At the time potatoes were severely desired due to the large amount of starch/calories it had and the vast number of food items that could be made with them . When prices of potatoes went up in the famine, people bought even more than they did the last time because consumers thought prices will keep on increasing. Thus, increasing the demand and further increasing the prices.
Companies try to make their product as much inelastic as they can, so that they can continue to reap profits even after increasing their prices without loss in sales.
Price Elasticity depends on :
- Necessity v/s Luxury: It is observed that necessities tend to be inelastic(Gasoline, electricity, water) whereas luxury items are elastic(Entertainment, Hospitality Industry, Food items like-chocolate, juices, etc). You won’t leave to drink water even if it’s price go up by 20 Rs. (%change in price- 100%, initial price- 20 Rs.) but you would definitely refrain eating that choco-bar if it’s price increases by 20 Rs. (% Change in price- 100%, initial price- 20Rs.)
- Competition: If there are a lot of competitors in your product segment that it is highly possible that your product is highly price elastic. Even a small change in price can lead people to changing their products.
- Proportion of Income required: When the absolute price of products is high, the product is generally seen to be more elastic than others. Consider this example. Let’s say the price of toffee is increased to 2 Rs having initial price of 1 Rs. The change in sales would probably be not that much as compared to change in prices( 100%) . Whereas if you increase the price of let’s say an automobile by 100%, sales would automatically go down more than 100%.
- Permanent/Temporary Price Change: A one-day discount will have a different effect on sales than a permanent change in price. You probably wouldn’t have bought the product if it weren’t for the discount.
Knowing PED (Price elasticity demand) helps the firm decide whether to raise or lower price, or whether to price discriminate. Price discrimination is a policy of charging consumers different prices for the same product. If demand is elastic, revenue is gained by reducing price, but if demand is inelastic, revenue is gained by raising price.
The basic formula of price elasticity mentioned above is useful only when change in sales and price are small. But when these changes become larger, the formula becomes inaccurate. This is due to the fact that price elasticity varies at different points along demand curve and because percentage change is not symmetric.
Price elasticity can be of two types:
- Arc Price Elasticity
- Point Price Elasticity
Arc Price Elasticity– Usually what happens is suppose you change the price of your product today, then this change would affect the sales after some days. The change in sales may get reflected for say about 2 months after you changed the prices. This maybe due to the fact, that there is still some old priced product left in the market.
Normally the effect due to change in prices is seen gradually over a period of time and thus point price elasticity won’t give accurate results.
Q1 is initial sales or quantity demanded
Q2 is final sales after price change
P1 is the initial price of product
P2 is the final price of product
Point Price Elasticity– When you wish to calculate price elasticity at a particular point of time or the time interval is very less so that it can be compared.
In the formula above, dQ/dP is the partial derivative of quantity with respect to price, and P and Q are price and quantity, respectively, at a given point on the demand curve.
The point elasticity can be approximated by calculating the arc elasticity for a very short arc, for example, a 0.01% change in price.
Probably in the coming posts, I’ll explain about the difference between Price Elasticity of Demand, Price Elasticity of Supply and Cross Price Elasticity.
You can read more about this topic at : Price Elasticity