2.2.1 Price elasticity of demand

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    Elasticity – a measure of how responsive demand is to a change in price or income

    Price elasticity can calculate by how much demand will fall/rise when prices change.

    Price elastic products are very responsive to price changes. This means when there is a small change in price there will be a large change in demand. An example of this would be that if one supermarket raised the price of bread above the levels of other supermarkets, sales would fall. This is due to the many substitutes in this competitive market.

    On the other hand, there are price inelastic products which are not very responsive to price changes. This means when there is a large change in price there will be a small change in demand. An example of this would be an increase in the price of designer clothing such as Gucci, sales would fall but not by as much as the price rose. This is because the product is highly branded  so people are often willing to pay the high prices.

     

    HOW IS PRICE ELASTICTY IS USEFUL TO FIRMS?

    Pricing decisions à a business needs to know what will happen to demand if they change the prices of products (due to changes in costs or competitors prices)

    Branding decisions à if a business uses branding for a product it will become more inelastic which means prices can be raised without losing too many sales.

    Mass markets à Goods in these markets are more likely to have substitutes or be standardised so prices changes will have a larger effect on demand.

    Niche markets à these tend to rely on having a less competitive price as niche market products tend to be more specialised with fewer substitutes.

    FACTORS AFFECTING ELASTICITY

    • Necessity – prices will not affect demand for products that are needed such as petrol or electricity (inelastic). Luxury goods such as holidays will see are elastic so if prices of flights increase then sales will fall dramatically.
    • Habit/dependency – products such as cigarettes are habit-forming so people are willing to pay any price for them due to addiction and demand is mostly consistent even at higher prices.
    • Substitutes – if a product has a lot of substitutes then it is more elastic as there are cheaper options whereas with less/no substitutes the product is more inelastic
    • Brand loyalty – the more brand loyalty a product has, the more inelastic it is as consumers are attached to the brand
    • Durability of good – long-lasting products such as washing machines have more elastic demand as when prices rise consumers prefer to repair old ones etc. rather than buy new
    • Proportion of income spent – if a good takes up a small amount of income such as a magazine, a rise in price will be relatively price inelastic as consumers do not mind paying a small amount more. On the other hand, purchases such as cars take up a significant portion of income so will be more price elastic.
    • Peak/off-peak demand – during peak times, such as at 9am and 5pm, demand for train tickets is inelastic as more people need to travel at these times so tickets are more expensive as demand will not change much.

    The elasticity formula can be rearranged to find the % change in demand or price. This can be done by rearranging the triangle on the right.

    PROBLEMS WITH ELASTICITY

    • Consumer reaction to changes in price takes time to monitor and changes frequently
    • Other factors can affect demand, not just price e.g. taste, competitors, state of the economy etc.

    Difficult to measure and predict accurately (only a rough approximation of sales revenue).

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