Relationship between Elasticity of Demand and Revenue

16/04/2020 1 By indiafreenotes

It’s human nature. If the price of a product goes up, consumers buy less of it. If the price goes down, consumers buy more. In economic terms, that’s called price elasticity. But what if the price of gasoline goes up, the gas tank in your SUV is on empty, and you have to be at work in 20 minutes? Will you refuse to buy gasoline because the price is high? Of course not. You don’t have any alternative, so you pay the higher price, buy the needed quantity of gasoline and go to your job. That’s called price inelasticity.

Price Elasticity

Price elasticity measures the changes in demand for a product in reaction to changes in the price for that product. It’s a ratio of percentages, and the formula is as follows:

Price elasticity of demand = Percentage change in demand ÷ Percentage change in price

When this ratio is greater than one, the price is considered to be elastic, and demand declines as the price increases. When the ratio is less than one, the demand for a product does not change substantially with changes in price. In this case, a company could increase its prices and not suffer a significant decline in sales volume.

Example of Price Elasticity

Let’s suppose that a 10-count box of Quaker Instant Oatmeal sells for $2.18. When the price goes up to $2.59, the demand drops from 500 boxes per week to 350 boxes per week. The elasticity is calculated as follows:

Price elasticity = ((500 – 350)/500) ÷ (($2.18-$2.59)/$2.18)

= (150/500) ÷ ($0.41/$2.18)

= 30 percent ÷ 19 percent

= 1.6

Since the result, 1.6, is greater than one, the price elasticity for an increase in the price of Quaker Oatmeal is high. The price for oatmeal goes up, and consumers buy less of the product. They may start buying other cereal products, or they might switch to the grocery store’s generic brand of oatmeal.

Factors That Affect Elasticity

The factors that affect the price elasticity of any product include:

(i) Substitutes

As in the case of rising prices for oatmeal, consumers can shift their purchases to similar products if they are readily available. Coca-Cola and Pepsi are products that can be easily substituted for each other when prices change. This is an example of elastic demand. If the alternatives are limited, the demand is less elastic.

(ii) Necessities versus luxuries

Necessities are products that people must have regardless of the price. Everyone has to drink water, so if the water company raises prices, people continue to consume and pay for it. Luxuries are optional; they aren’t necessary to live. Large-screen HDTVs are nice to have, but if the prices go up, consumers can put off buying them.

(iii) Share of the consumer’s income

Products that consume a high proportion of a family’s income are sensitive to price increases. A car is a good example. Increases in car prices can cause a family to delay purchasing a new car. They keep their old car longer and make the necessary repairs. However, if a grocery store increases the price of toothpicks, consumers still buy them because the price isn’t a big piece of their income.

(iv) Short-term versus long-term timing

Gasoline is an excellent example of a product that prices inelastic in the short term but elastic in the long term. When gas prices go up, the consumer still has to buy gas to get to work. However, if gas prices stay high for the long term, consumers make changes. They may buy more fuel-efficient cars, set up a carpool with other workers, or start taking a train or bus to work.

Why Elasticity Is Important?

Marketers must have some knowledge about the elasticity of their products to set pricing strategies. If marketers know that the demand for their products is inelastic, then they can raise prices without fear of losing sales. On the other hand, if demand for their products is highly elastic, then raising prices could be a dangerous game.

The relationship between price elasticity and total revenue is an important metric for marketers to understand. Understanding whether the price of a product is elastic or inelastic is essential for a company to develop an effective marketing campaign and survive in the marketplace. Price elasticity is a tool that marketers can use against their competitors to increase their share of a market.