Wednesday, February 24, 2010

Price Elasticity of Demand

Price Elasticity of Demand (PEd), or the slope of the demand curve, is originally an economics term but has important implications in marketing as well. Simply defined, PEd tells us the responsiveness of demand (customers) to changes in price. Due to the nature of the demand curve, the slope is always negative: a decrease in price (P) will increase demand (D) and vice versa. For example, Figure 1 shows a slope of -1, and Figure 2 shows what would happen if the P fell by -25% (D will increase by 25% as a result). The negative property will be ignored when finding the quotients (D/P) to make things easier. If PEd is 0, then you have a perfectly inelastic demand: where the price does not affect the demand at all (there is a vertical line on the graph). If PEd is between 0 and 1 (.23, .47, etc.), then you have an inelastic demand: where the price and demand change, but demand does so in a smaller proportion. For example, if P changes 25%, then the D’s change will be smaller in comparison to P’s change, say only 20% (20/25= .8). Unitary elasticity occurs when the change in price is proportional to the change in demand, recall 25%/25%= 1 from above (ignoring negative signs). If PEd is between 1-∞, then label as elastic demand (D) where demand is greatly affected by any price (P) change e.g. 50%/25%= 2. On the extreme side, if PEd is ∞ (infinite), then we have a horizontal line where a price change receives no demand at all.

Now that the simple model of economics is over with, let’s move onto some examples. As of this day, a large 3-topping pizza from Pizza Hut costs only $10 ($1 extra for stuffed crust) as a promotional offer (I get coupons in the mail). Let’s assume the demand at this price is 10,000 in Seattle. With this information, we’ll examine changes happened with an inelastic demand curve and with an elastic demand curve.
First the inelastic demand curve. At a price of $10, there are 10,000 customers (10K). If the price increases by only $1 for the same pizza, the demand will fall only change by 1,000. The slope of the curve is P/D x ∆D/∆P= 10/10,000 x 1,000/1= 0.10.

The demand is much more price sensitive with elastic demand. For example, a $1 increase reduced the demand by 6,000 (unlike 1,000 in the previous example). The slope (sensitivity) of the demand is P/D x ∆D/∆P= 10/10,000 x 6,000/1= 6.

As you can see, the price changes can be the same in both situations, but demand varies greatly depending on the sensitivity (elasticity) of the demand. Demand in Figure 3 is not very price sensitive, while demand in Figure 4 is.
Some example of products with PEd of 0 may include necessities such as water and food. For these, everyone would try to get they’re hands on no matter what the price.
Price elasticity of demand has important implication for marketers because with these models and numbers, they can estimate their demand, price and overall profit. For example, imagine that Pizza Hut is in situation Figure 4. It has a demand of 10,000 at a price of $10 per pizza. Bob, an experienced manager at Pizza Hut, proposes that marketers increase the price of pizza to $11 to increase profit (assuming $11 x 10,000= $110,000). Even though you’re fresh out of college, you know that not everyone has the same perceived value at $11. So you sketch a graph to show Bob that with an elasticity of 6, demand will drop to only 4,000, leaving you with a profit of only $44,000 ($11 x 4,000).
With this information marketers can also predict market share at this price (everything else constant—such as pricing of competitors).

Viktor Brynza
MKT 301 Sec. E

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