Price and Income Elasticity of Demand
Elasticity measures the responsiveness of demand to a change in a relevant variable—such as price or income.
Price elasticity of demand—measures the extent to which the quantity of a product demanded is affected by a change in price.
Price Elasticity of demand (PED) is calculated using:
% change in quantity demanded / % change in price
Price elastic=> PED is greater than 1 => Change in demand is more than the change in price
Price inelastic => PED is less than 1 => Change in demand is less than the change in price
Unitary price elasticity => PED is exactly 1 => Change in demand = change in price.
If PED greater than 1, a change in price will cause a larger change in demand, so overall revenues would increase with a price cut, but drop with a price increase.
# Factors influencing PED
- Price of complementary goods
- Brand strength
- Habit
- Availability of substitutes
- Time
Income elasticity of demand-measures the extent to which the quantity of a product demanded is altered by a change in income.
Calculating income elasticity of demand (YED) is done using the formula:
% change in Quantity Demanded / % change in income
Typically:
- a rise in income will result in a rise in demand
- a fall in income will result in a fall in demand To the extent:
- this depends on the type of product (necessity vs luxury)
For inferior goods, demand falls as income rises, but increases as income declines.
PED: A(-1.5), B(-0.2) IED: A(0.5), B(-1.9) Negatives can be ignored here
PED: A is elastic, B is inelastic Y/IED: B is luxury(elastic), A is necessary (inelastic)
Limitations of calculating and using elasticities
- Can be difficult to get reliable data
- Other factors affect demand
- Many markets subject to rapid technological change
- Competitors will react
Key evaluation points
- Elasticities provide useful insights for management in decision-making
- Firms tend to like to have products with inelastic demand
- Building strong brans and product USPs is a good strategy for making demand more price inelastic
Elastic products are more vulnerable to a decrease in demand if they increase their price. A price inelastic product will not notice much impact on demand if they increase prices.
Petrol’s elasticity depends on factors such as the number of nearby petrol stations, the need of customers to get petrol and various other factors. This means that petrol in a city would be fairly elastic, but fairly inelastic in the middle of nowhere.
Price elasticity = % change in demand / % change in price
Example of a product raising prices by 20%:
- Server costs
- May prompt to look for another provider
- Current provider has several USPs, meaning that migration would likely be too much of a hassle
Price elasticity of demand measures the responsiveness of demand to a change in the price. We normally assume that a rise in price results in a fall in demand. The level of elasticity depends upon several factors including: the number of substitutes in the market which make it possible for customers to switch, whether the good is a necessity or a luxury and brand loyalty.