Demand Elasticity

Abstract

Demand elasticity refers to the economic phenomenon that intersects demand for a service or product and its price. A product's elasticity is directly linked to the response of consumers to price changes. If a price rises too much for consumer acceptance, and they are not desperate to have it, buyers will look for similar products at a more comfortable price. In this case, it is said that the demand is elastic. Elasticity is measured in percentages, gauging how close in percentages the demand change is to the percentage the price has changed.

Overview

Demand elasticity, also known as price elasticity of demand, is a concept used in business and economics to measure the response sensibility of a product as it changes its price. It is defined as the percentage change in the demand amount, divided by the percentage change in price. It is usually represented in a graph through a simplification of the demand curves. Both buyers and sellers respond to a price change for a good or service, and how they respond to a price change dictates its range of elasticity. The elasticity of a product or service is also determined by market variables such as the number of close substitutes available, its relative or comparative cost, and the period of time that has passed since the price change.

The concept of Demand Elasticity was first posited in 1850 by Antoine Augustin Cournot (1801–1877), a French mathematician. Cournot argued that the demand for a good is a function of its price; therefore, the lower the price, the higher the demand, as long as all other things remain constant. In 1890, Alfred Marshall (1842–1924) further developed the concept in his Principles of Economics. Marshall sought to measure the market's sensitivity to price. He explained that a price is determined not only by demand but also by supply. In other words, both the amount of demand and the amount of supply—or availability of a good—are interdependent and intersecting. Thus, the lesser the supply or availability of a good, the higher the price.

This inverse relationship between price and amount generates a negative coefficient, and mathematically, the value of elasticity is generally an absolute value. Demand elasticity depends on the capacity of response to price changes. The steeper the demand curve in a chart, the more inelastic the demand; the contrary is also true, the flatter the demand curve in a chart, the more elastic it is. In general, as expressed numerically, the demand of a good is relatively inelastic when the elasticity coefficient is less than one in absolute value. What this means is that the variations in price have a relatively small impact on the amount of the demand.

For example, a product that is medically necessary, such as insulin or nitroglycerine, both of which are medical staples for diabetics and patients of heart disease. Changes in their price have little to no impact on demand. In other words, it is inelastic, because despite its price, people need it and will find a way to buy it. Also, due to reasons of public good, governments will exert pressure to keep the prices within a range of availability, a phenomenon that also applies to other goods that cover basic needs, such as utilities.

On the other hand, product with much competition or alternatives, is elastic. A decrease in the price of a food staple such as beef does impact the amount of demand, particularly because there are close substitutes such as chicken or pork, which may be had at competitive and even lower prices. On the other hand, if the price of beef decreases and beef becomes cheaper, people may purchase more beef.

Experts list several components to demand, the most important of which are the price of the good or service; prices of complimentary or substitute goods or services; buyers' income; consumer tastes and preferences; and buyers' expectations. Many variables impact a good or service's price, to different extents. The need for a product is very influential. If the product is an essential staple, the demand will be relatively inelastic. Price changes will have a practically null effect on its demand, because people need to buy that product. On the other hand, if it is a luxury good—say, high grade diamonds—the demand will be much more elastic, given that the steep price prevents it from being a mass consumption product. Moreover, the availability of desirable substitutes, such as cubic zirconia—will contribute to price elasticity, as there will always be a segment of the market who will be content with an approximation of the luxury good. This applies to lower priced staples, as well, such as butter and margarine, but the percentage elasticity is lesser at lower price points.

Another important variable is time. Even among products that show a relatively inelastic price, elasticity will loosen up or increase given time. Competitors will come up with less expensive versions or acceptable substitutes, and buyers will have time to get used to the new price and adjust their consuming behavior accordingly. Moreover, determining the future elasticity of demand also involves complex factors of human psychology and unexpected contingencies, so that it is not an exact system.

Demand elasticity is a useful planning tool. The main advantage of calculating demand elasticity is that it allows organizations—from public as well as private sector—to anticipate market behavior. For instance, if a rise in the price of energy or fuel is expected, both government and the private sector know this will impact the cost and prices of goods that depend, to different extents, on fuel and energy. This calculation allows organizations to take steps to ameliorate the impact a fuel price hike may have upon firms and society at large.

For instance, based on a demand elasticity assessment, a tourism-based firm can anticipate a fuel price hike and prepare for the impact by preventively lowering their prices so that the increase will not impact prices excessively or at all. The tourism industry depends on a high season to profit the most; therefore, it can also take other preventive measures, such as increase their prices when demand is still high, spend less on advertising, and so on. Public institutions also use demand elasticity calculations for future policies. When a government foresees that in the coming years prices will rise in a specific sector, it may lower taxes to help ameliorate a price rise and stimulate consumers to continue spending at the same rate.

Further Insights

Across a wide range of sectors, it is important to calculate, as accurately as possible, how a price change will impact the amount of demand. Thus, if demand is elastic, a price decrease may increase profit and dividends as sales increase given the lower price. For instance, one of the reasons to tax fossil fuels and products such as cigarettes, is the demand inelasticity that such products have long term. That is, industry needs to consume fuels across all production levels, and people who smoke will usually continue to smoke the same amount, regardless of the price. Both will adjust other aspects of their daily lives in order to continue to consume the products required at any given price, one due to an industrial dependency and the other, a psychological one. The same could be said, as well, for people who depend on specific medications for their daily maintenance, such as diabetics. These are the classic views on demand elasticity.

Nevertheless, contemporary experts explain that price inelasticity is not as inflexible as initially believed. Conventional theory stated that consumers have time to adjust their behavior and adapt by finding and consuming substitute goods. For instance, in the face of a price increase in oil, consumers usually respond in the short term by decreasing their consumption. However, with time they adapt to the new price and gradually increase their consumption. Moreover, contemporary studies show there is a growing segment of the market—which includes users and governments—that have found a solution in behavior modification, that is, changing their lifestyle and long-term consumption choices so that they consume the least amount of fossil fuels possible and leave a smaller ecological footprint. These phenomena show that the elasticity of demand is more complex and less rigid than it was believed decades ago, and culture and changing values also have a strong influence, as do government interventions and other phenomena.

Understanding the concept of demand elasticity, then, allows individuals and organizations to have a more accurate idea about the amount of elasticity or inelasticity for a specific good or service and the margin they have available to modify prices. In general, primary staple goods show a high degree of inelasticity, because even as prices increase, demand remains relatively stable. Meanwhile, high end or luxury goods have a more elastic demand, because an increase in the prices of these goods will lead many consumers not to buy these products and either refrain from consuming them or seek for a good enough substitute. There are great advantages to being able to calculate demand elasticity; not understanding this phenomenon has led many a firm to bankruptcy.

Issues

The perceived value of a good by the consumer is a strong determinant on how high a price may go. This includes the knowledge or determinations made by consumers about all the elements that go into the cost of the product or service, that is, the factors of labor, materials, time, equipment, and so on. Sellers determine prices based not only on costs, but also on hoped-for profit. However, an important element in pricing is the psychology of consumers and of different market demographics or segments. In the first case, these are known as psychological strategies of product pricing and in the second, price differentials strategies.

These pricing strategies are based on elasticity demand. However, there are other important factors that drive pricing, among the most important of which is competition. Managers must make pricing decisions taking into account competition and include it in their marketing strategies. Even though a strong reference point for pricing is competition, costs continue to determine the minimum price at which a product can be sold. Prices also vary according to the position of the product in the market, that is, whether it is a market leader or a more generic product. In fact, price can also be used as a positioning strategy, as when sellers lower the price to sell more and make the product appear as a "leader," or when sellers increase the price in order to make the product appear of a higher end quality than it would generally be perceived to be.

In general, however, companies determine a price based on what is average for similar products in that particular market sector, unless it has a specific edge or advantage relative to the others or, to the contrary, a disadvantage. Advantages and disadvantages can be of many kinds, based on factors such as branding, distribution, quality, complementary services, and value added, all of which play a role in the determination of a price.

Not all prices are determined for retail or for a mass market. There are more specific market scenarios in which pricing plays a very important roll, such as by bidding and by tender offer, systems most often used in some industries, such as construction and the stock market, among others. In the case of bidding, a contest is opened for all firms that want to sell or offer their best services, products, and prices to the organization that opened the bid. The contract for the purchase of the services or products will be given to the company who at the lowest price, offers the best deal, as long as the firm complies with all stipulations or conditions established by the buyer. Therefore, those firms that offer the lowest prices have a higher chance to win the contract, but will also reap less profit from the transaction.

The potential problem for a firm in this case, is that once it wins the contract, it may not change its prices later if market circumstances change. Therefore, it has a narrower margin of profit and a higher risk of loss if market conditions change in ways unfavorable to the firm. Companies who participate in many bidding contests, usually use a formula or rule of thumb to determine how much to bid. This formula includes calculating expected returns and a formula that takes into consideration the probabilities of winning the bid and other possible future contingencies, both positive and negative.

A typical case in point is that of the shale gas industry. Shale gas has become an important alternative fuel in the United States, United Kingdom, and other countries, leading to a rapid expansion of its extractive industry, known as fracking. Most of the fracking companies operate by bidding for contracts from local governments and land owners. Fracking has long been a hot button issue, because opponents argue that studies show the industry's impact is detrimental to the environment and that not enough is known about the structural damages caused by its activities. The problem became more visible when companies who had invested much into gas extraction realized that the process was costlier than initially considered, which, in turn, significantly decreased its profitability and forced some extractive companies to go into debt to be able to comply with their obligations to contractors and investors. The fracking industry is concerned that, should the situation not improve, the future of fracking may not be as beneficial as its supporters initially projected. This is an issue that relates to competition as well. Whereas smaller, independent firms find it more difficult to weather these contingencies, large corporations such as British Petroleum (BP), ExxonMobil, and others, are better equipped financially and structurally to withstand them in the long term. If smaller companies eventually disappear from the fracking industry sphere, it is expected that decreased competition would also affect gas prices.

Terms & Concepts

Bidding: A contest opened by a client to all firms interested in obtaining a contract to perform a service or sell goods. The contract for the purchase of the services or products will be given to the company who offers to do the best job for the lowest cost.

Cost: In business and economics, cost is the monetary value of a product or service that will include a set of factors such as time, risk, effort, resources, and opportunities lost or forgone.

Demographics: Statistical factors of human societies, such as their numbers, where they live, their age, gender, and ethnic divisions, and so on.

Market leader: It refers to a company that dominates and has a higher share of the market, or a product that sells significantly more than its competition.

Price point: Although it is often used interchangeably with the term "price," price point is often used in relation to its position in the demand curve. In that sense, it refers to a point in the scale of all possible prices at which it may be sold in the market.

Staple: In business, a basic product constantly used and needed by large groups of people, such as wheat, salt, and rice.

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Suggested Reading

Bodea, T., & Ferguson, M. (2014). Segmentation, revenue management and pricing analytics. London, UK: Routledge.

Burke, P. J., & Abayasekara, A. (2018). The price elasticity of electricity demand in the United States: A three-dimensional analysis. Energy Journal, 39(2), 123–145. Retrieved January 1, 2018 from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=128030845&site=ehost-live

Guo, J., Zhang, Y., & Zhang, K. (2018). The key sectors for energy conservation and carbon emissions reduction in China: Evidence from the input-output method. Journal of Cleaner Production, 179, 180–190. Retrieved January 1, 2018 from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=127843583&site=ehost-live

Karlan, D., & Zinman, J. (2018). Price and control elasticities of demand for savings. Journal of Development Economics, 130, 145–159. Retrieved January 1, 2018 from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=126514616&site=ehost-live