PRICE ELASTICITY
A business model for working out price/volume relationships
The economist Alfred Marshall in 1890 is credited with defining the elasticity of demand in his book, Principles Of Economics. He referred to elasticity as the responsiveness of a market to the change in demand for a product, given a change in price.
Price elasticity is an important concept in business. It describes the relationship between the price of the products and the demand for those products. Products have high elasticity if a small change in price results in a large change in demand. Think of this small price change as stretching (ie elastic) the market considerably. Products that have a high level of elasticity are foodstuffs, particularly basic food items. These are products people need and so a reduction in their price encourages purchases in greater volume.
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When a change in the price of a product has very little effect on its demand it is inelastic. There is no change, no stretching. Typical products here are those used in industrial applications. People buy nuts and bolts and motors and chemicals to use as components in things they make. If the price of nuts and bolts changes, they cannot consume more because their need is determined by the volume output of whatever they are used in.
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In general if you raise your prices you will sell less and if you lower them you will sell more. That is the theory. Few businesses know the relationship between price and volume.
If you raise your prices by 10% and sales fall by 10% this is regarded as a neutral position and referred to by economists as elasticity of demand of -1.0 (note that the minus indicates the negative relationship and the demand curve slopes to the right – see the diag).
If you raise your prices by 10% and sales fall by only 5% this is referred to as inelastic demand. In this case the price elasticity of demand would be -0.5.
If you were to reduce your prices by 10% and as a result sales increased by 15% the demand would be considered elastic and the elasticity of demand would be -1.5.
A company that does not have a history of data showing the effects of price changes on volume may consider using market research to determine the elasticity of demand. A crude indication of elasticity of demand can be determined by asking a buyer of products the likelihood of making a purchase at a specific price. If the starting price is high and the purchaser says that they would not purchase, they would be asked a series of further questions at lower prices until they finally agree on a price that would trigger the purchase. (See New Product Pricing). This is only an approximate measure as the purchaser is not in a buying situation. Furthermore, the purchaser may hold off on saying that they will pay a certain price knowing that a lower one is forthcoming. This said, with all its faults, the method gives a good indication of elasticity of demand.
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A more sophisticated measure of elasticity of demand is to use conjoint analysis.