Table of Contents
- Two-types of price elasticity
- How price elasticity of demand affects business pricing strategies
- How to calculate own-price elasticity of demand
- Calculates the own-price elasticity of demand from the demand function
- Factors affecting own-price elasticity of demand
Own-price elasticity of demand measures how responsive demand is when the price of goods changes. It is elastic or responsive when a slight change in price causes a more significant change to the quantity demanded. In contrast, when the quantity demanded does not change much, we say demand is inelastic.
Consumers consider the price of buying products. When you purchase food products, what do you think first? Price.
Low prices allow you to shop more. In contrast, when the price of the product you want to buy rises high, you might look for alternatives. When you see an alternative at a more affordable price, you will, of course, buy it.
Two-types of price elasticity
Demand elasticity is a measure of the responsiveness of changes in demand when prices change. The two types of demand elasticity are:
- Own-price elasticity of demand
- Cross-price elasticity of demand
Both concepts are the same, i.e., measuring changes in the quantity of demand when prices change. But, we use different prices to calculate both. Own-price elasticity uses the price of the product itself. For example, how much change the quantity demanded of coffee when its price rises.
Meanwhile, cross-price elasticity uses the price of related products, which can be a substitute or complementary. Let’s say coffee is the substitution for tea. Cross-price elasticity tells us how responsive coffee demand is when the price of tea changes.
The next example is gasoline demand and car prices. Both complement each other. When car prices go up, how significant is the impact on changes in gasoline demand?
How price elasticity of demand affects business pricing strategies
Knowing the elasticity of demand helps companies to set prices. Raising prices does not always increase company revenue. It depends on the elasticity of demand for the product.
Sometimes, a higher price does not translate into higher revenue. Whereas in other cases, price increases reduce revenue. Why? Because the price is not the only determinant of revenue.
Remember, revenue is a function of quantity demanded and price. When the price rises, the effect on income depends on how much it decreases the quantity demanded.
When companies face an elastic demand curve, a slight increase in price reduces the quantity demanded larger. That’s because customers tend to be responsive. So, when companies increase their prices, customers will switch to alternative products. As a result, price increases, reduce total revenue.
In contrast, when demand is inelastic, rising prices will increase total revenue. Consumers are unresponsive to the price increases. Thus, demand will only change small.
Finally, when faced with unitary elastic demand, price increases will not change total revenue. A decrease in quantity demanded will compensate for the rise in price by an equal percentage.
Please remember. The effect of price elasticity on total revenue assumes other factors are unchanged. Also, the effect only applies to necessities. Meanwhile, for luxury goods, price increases will increase demand and company revenues.
How to calculate own-price elasticity of demand
We calculate the own-price elasticity of demand by dividing the percentage change in quantity demanded of an item by the percentage change in price. Here is the mathematical formula:
Own-price elasticity of demand (OED) = % Changes in quantity demanded of goods X /% Changes at the price of goods X
Remember, demand has an inverse relationship with prices. An increase in price decreases the quantity demanded, and in contrast, a reduction in price increases the quantity demanded. Thus, the value of own-price elasticity of demand will be negative.
How to categorize goods based on its elasticity
The absolute value of the price elasticity provides information about the strength of the relationship between the quantity demanded of a product and its price changes. Then, from the absolute value of elasticity, we can categorize demand into five categories:
- Elastic demand, i.e, when the absolute value of elasticity is more than 1. That means the quantity demanded is very responsive to price changes. When prices go up by 10%, the quantity demanded decreases by more than 10%.
- Inelastic demand, the absolute value of elasticity is more than zero but less than one (0 < |OED | < 1). The quantity demanded is unresponsive to price changes. If the price goes up by 10%, then the quantity demanded decreases by less than 10%.
- Perfect elastic demand, when the absolute value is infinite (OED = ∞). At higher prices, the quantity demanded decreases to zero.
- Perfect inelastic demand, when the absolute value is zero(OED = 0) when price changes do not affect the quantity demanded.
- Unitary elastic, when the absolute value is one |OED | = 1. In other words, price changes affect the quantity demanded at an equal percentage. A 10% increase in price will reduce the quantity demanded by 10%.
Calculates the own-price elasticity of demand from the demand function
In a simple linear formula, the demand function is as follows:
Qd = a – b*P
To calculate elasticity, we can use the following formula:
OED = %∆Q /% ∆P = (P0 / Q0) x (∆Q / ∆P) = (P0 / Q0) x b
Note: the value of ∆Q / ∆P is the coefficient of the demand function (b).
For example, the demand function of an item is as follows:
Qd = 100 – 5*P
Let’s calculate the elasticity of demand at the price of Rp4. First, you must determine the quantity demanded (Q0) at that price.
Q0 = 100 – 5 x 4 = 80
Next, you calculate the elasticity of demand as follows:
OED = (P0 / Q0) x (∆Q / ∆P) = (4/80) x -5 = -0.25
Proving the formula
First, you need to recall the concept of the demand curve and the mathematical function of the slope.
In describing demand curves, economics states the Y-axis represents prices while the X-axis represents the quantity demanded. In mathematical terms, price is a function of the quantity demanded. In other words, it is based on an inverse demand function.
If, the demand function is: Q = a + b*P, then the inverse demand function is P = a/b + (1/b) * Q.
Next, the slope formula of a linear curve is:
Change in Y / Change in X
Because Y represents the price (P) and X represents the quantity demanded (Q), then:
The demand curve slope = Change in Y / Change in X = ∆P / ∆Q
Let’s take the two price points P0 and P1 and calculate Q0 and Q1.
∆P = P1 – P0
∆Q = Q1 – Q0
P1 = a/b + (1/b)* Q1
P0 = a/b + (1/b)* Q0
P1 – P0 = a/b + (1/b)* Q1 – [a/b + (1/b)* Q0]
∆P = (1/b)* Q1 – (1/b)* Q0
∆P = (1/b) (Q1 – Q0)
∆P = (1/b) * ∆Q
b = ∆Q/∆P
Next, let’s put in the elasticity formula:
OED = %∆Q /% ∆P = [(Q1-Q0)/Q0] / [(P1-P0)/P0] = (∆Q/Q0) / (∆P/P0) = ∆Q * P0 / ∆P Q0 = (P0/Q0) * (∆Q/∆P) = (P0/Q0) * b
Remember, the formula above only applies to a linear demand function. Too, from the formula above, we know that elasticity is not the same as the slope of the demand curve, except for perfectly elastic or inelastic demand.
Furthermore, the slope depends on the unit of measurement because it is only a relative comparison between price changes and changes in demand. In contrast, elasticity does not rely on the unit of measure because it is based on a percentage change.
Factors affecting own-price elasticity of demand
The elasticity of demand for an item depends on three things:
- Availability of substitute products
- The portion of the income you spend on a product
Availability of substitutes
Substitutes give you similar utility. When a product has many substitutions, it means you have many choices when the price of the product changes.
When there are many suitable substitutes for an item, demand tends to be relatively elastic. When you easily find a substitution close, you will switch to buy it when the price of an item increases.
Conversely, demand tends to be relatively inelastic when there is little or no substitute product available. When depressed, you will still buy sedatives even if the price rises. However, when the price goes down, you will not necessarily buy more.
Portion of income
When consumers spend a large proportion of income on an item, they will be sensitive to price changes. So, demand is elastic.
Conversely, when you spend a little money on an item, you are not sensitive to price changes. For example, when the price of soap goes up, you won’t necessarily reduce demand. Therefore, the smaller the proportion of income you spend on an item, the more inelastic the demand.
Demand will be more elastic when the more extended time has passed since the price change.
Let’s take the labor demand case. In the short term, when wages rise, companies will not necessarily change their production methods and replace workers with machines. Therefore, labor demand is relatively inelastic in the short term.
Conversely, if wages remain high, the company can automate the production process and replace it with machinery. Therefore, labor demand tends to be elastic in the long run.