Introduction
The law of demand tells us that there is an inverse relationship between price and quantity demanded. That means if a producer reduces the price the demand for the product will increase and vice versa. But just knowing the inverse relationship is not enough for a business firm. It is more important to know the extent to which the demand changes with the change in price. Thus price elasticity of demand is an important tool to decide upon the appropriate pricing strategy. In this paper we are going to present the concept of price elasticity of demand, how it is computed and discuss how the elasticity varies with the nature of the good and also market structures.
Definition of Price Elasticity
Price elasticity of demand is the degree of responsiveness of demand to the change in price of the product. That is it expresses the extent to which the quantity demanded of a product changes as the price of the product changes. Alternatively we can say that it is the percentage change in the quantity demanded due to one percent change in the price. We present the following expression for computing the price elasticity of demand :
ep=percentage change in quantity demandedpercentage change in price
or, ep=∆qq∆pp
or, ep=∆q∆p ×pq
or, ep=∂q∂p×pq
When the elasticity is greater than one, we say that the demand is price elastic. A one percent change in the price causes a more than 1% change in demand. If the elasticity is less than 1 we say that it has an inelastic demand. One percent increase in price will lead to fall in quantity demanded by less than one percent. In case of unitary elastic demand the quantity demanded changes by the same proportion as the change in price.
Now let us consider some examples in which we compute the price elasticity of demand for products:
As the price of laptop increases by 20% the quantity demanded falls by 40%. Therefore the elasticity of demand will be:
ep = 40/20 = 2
The elasticity is greater than 1. Thus the demand for laptop is elastic.
The price of a pack of cigarettes increase by 10% resulting in a 5% fall in the quantity demanded. The price elasticity of demand will be:
ep = 5/10 = 0.5.
The elasticity in this case is less than 1. Thus the demand is price inelastic for cigarettes.
We can see that the demand for laptop is price elastic while the demand for cigarettes is price inelastic. The differences in the price elasticity of different goods arise from the nature of the good and human habit. In our example we see that Laptops have elastic demand. Since laptops are not essential commodities not even necessities a rise in price of a laptop will lead to a proportionately higher fall in the quantity demanded as people would prefer not purchase laptops at a high price. The consumption can be foregone or postponed. A fall in price, on the other hand, will induce consumers to possess laptops and so demand will increase significantly.
Cigarettes give rise to addiction. A person addicted to it cannot do without the consumption of cigarettes. So the demand is price inelastic. A rise in price will not reduce the demand to any great extent as a person habituated to it cannot cut back on consumption of cigarettes. A fall in price will not make people not addicted to it to start consuming it. So a price fall will not be accompanied by a significant rise in demand.
Importance of the concept of elasticity in business
A business firm should have the knowledge of the elasticity of demand for its products to take appropriate pricing decisions. For an inelastic good a cut in price will not lead to a significant rise in demand. As a result the firm will face revenue loss. If the firm increases the price the demand will fall only by a small amount. Thus the revenue earnings of the firm will increase. So, for an inelastic good keeping a higher price is the appropriate strategy.
For an elastic good a fall in price will lead to a considerable increase in demand . Thus the firm will enjoy higher revenue. If the firm reduces the price the demand will fall drastically leading to a considerable fall in revenue. Thus, for an elastic good the firm would keep the price low to earn higher revenue. We can discuss this issue in the light of some real life example of commodities with varying elasticities.
Bridge Toll: If the bridge is in an area with large traffic movements then using the bridge will be essential for all traffic commuting from one side of the bridge to the other. Thus the demand for availing the bridge will be price inelastic. A higher bridge toll will yield higher revenue as people will have no other option other than using the bridge and paying the toll.
Beachfront properties: Beachfront properties are luxury commodities. These properties are holiday destinations and not everyday necessities. The demand will be highly elastic. If the price is too high there will be fewer buyers. On the other hand a fall in price will create a rush to buy such property.
Gourmet coffee: Gourmet coffee is a comfort food. It cannot be treated as a necessity as regular coffee. Thus the demand will be somewhat elastic. If the price is too high people will prefer to have more of regular coffee than gourmet coffee. If the price is low the demand will increase considerably.
Gasoline: It a necessity in everyday life. The demand will be price inelastic. We can see that the gasoline prices are falling now. But the demand has not increased to a very high extent. The reduced expenditure on gasoline due to the fall in price has in fact increased the demand for other commodities.
Cell phones: These are necessities in today’s world and thus have an inelastic demand. Reduced price will not increase the demand to any significant extent.
Demand for Flowers
Flowers are high in demand during the time of festivities and in the wedding season. In the festival period the demand is quite inelastic because people have to get flowers no matter how high the price is. So the price during the festival and wedding seasons should be kept high. For the rest of the year the demand is low and the price should be kept at a moderate level as the demand will be price elastic.
References
Han, S. (2012). Principles of Microeconomics. Texas: Department of Economics, Texss A&M.
Henderson, J. M., & Quandt, R. E. (2003). Microeconomic Theory: A Mathematical Approach. McGraw Hill Education.
Koutsoyiannis, A. (2008). Microeconomics. Macmillan Press Ltd.
Pindyck, R., & Rubinfield, D. (2009). Microeconomics (7th ed.). Prentice Hall.
Varian, H. R. (2010). Intermediate Microeconomics A Modern Approach (8th ed.). New York: W. W. Norton & Company.
