Price elasticity of demand is an economic measurement that shows how product demand correlates with the changes in some factors, in this case, price. Demand is considered elastic if the demand for a product changes significantly in response to the change in price. Goods with elastic demand include soft drinks, clothing, luxury items, cars, etc.
In this article, you'll get to know why economists and marketers monitor the price elasticity of demand, uncover the factors affecting it, and learn how to calculate the measurement, so stay tuned.
Why is the price elasticity of demand important?
Price elasticity of demand is of high priority for economists and marketers since this concept lets them forecast the success of their business. They are set on developing a product with inelastic demand so that consumers buy it regardless of whether the price changes.
Monopolistis and owners of products with almost no substitutes on the market consider the elasticity of demand when setting a price for their products. In the case of inelastic demand, they can fix high prices, while elastic demand makes them set lower prices to stand out from the competition.
If you want to start an international trade business, you need to analyze the elasticity of demand for the necessary products in the country you intend to export to. If the demand for products with inelastic demand in your country turns out to be elastic in the importing country, you'll have to set lower prices, which may bring you losses. Besides, the taxation system may require you to pay higher taxes for goods with inelastic demand.
Farmers, paradoxically, suffer from heavy crops. Rich harvest causes high competition among farmers which results in inelastic demand for some products. So, a big supply doesn't let farmers increase their income.
Now that you know how the elasticity of demand works and why it is so important, let's consider the factors influencing it.
Factors Affecting Price Elasticity of Demand
We'll uncover the 5 most important factors impacting the elasticity of demand.
- Nature of the product. Conventionally we can classify all items into those which are necessary for our living, comfort goods, and luxury goods. Necessities include gas, electricity, higher education, and life-saving drugs, for example, insulin. These products and services are difficult to refuse and can't be replaced by any substitutes, so their elasticity of demand is very low, or they are inelastic. People can live for some time without comfort goods, such as refrigerators, which makes their elasticity higher. Finally, the elasticity of luxury goods, such as cars and jewelry, is high.
- Availability of substitutes. The more substitutes a premium product has, the more price sensitive it becomes, as consumers look for a cheaper product. As a result, the demand for a premium product will decrease and the owner will have to lower prices.
- Income level. It's vital to study not only the market and economic situation in the county but the income level of your consumers as well. People with higher incomes aren't as sensitive to price changes as people with low incomes. So, the elasticity of demand for those who earn more will be very low, whereas low-income groups will experience high elasticity of demand.
- Part of the income spent on a product. The price elasticity of demand is generally low if consumers spend a small portion of their income on this product. For example, such goods as salt, soap, and matchboxes don't make a significant share of total consumers' expenditures, so the change in price for these products won't increase the elasticity of demand. On the other hand, more expensive goods, such as laptops, will have a higher elasticity of demand, since the cost of these goods is more tangible in the income of customers.
- Time period. People don't like to change their buying habits and switch brands, that's why in short term the demand tends to be inelastic, however, in long term, clients will look for substitutes if the price continues to increase. This does not work with seasonal price fluctuations that consumers have long been accustomed to.
Now it’s time to find out how to calculate the price elasticity of demand for your business.
How to calculate the price elasticity of demand
The price elasticity allows us to find out how the price change affects the demand for a certain product. This measurement is shown as a percentage change in the volume of demand for some goods.
To calculate this measurement, follow the formula below.
The demand for the product is considered to be elastic if the price elasticity is higher than one. For, example if the price of your product increases by 2%, and sales decrease by 2.5%, the price elasticity of demand is 2.5%/2% = 1.25%.
If the product price elasticity of demand lowers, the less responsive the volume of demand is to the price change. If the demand is not sensitive to the price change, the demand is perfectly inelastic. As a result, a company can fix higher prices and get more income since people do not respond to the price change.
Congrats, now you know why price elasticity of demand is important and how to measure it, so you can forecast sales and make informed decisions.
Last Updated: 06.10.2022