Price Elasticity: From Theory to Reality

The price elasticity theory used to be the domain of classical economists, but it had only a few applications in real life. Uber and other companies, using their massive data sets and surge algorithms, can now triangulate prices in real-time to manipulate demand.

This article will introduce the basics of the price elasticity theory of demand before taking us into the real world, where the idea will meet with both big data and consumer psychology in order to create new opportunities.

Economics 101: Understanding Demand

demand, at its most basic level, is the amount of a good that a customer is willing to buy along a price continuum. The demand curvature is used by both theoretical economists as well as businesspeople to represent and measure the demand.

The demand curve (as shown in Figure 1) is typically drawn as a function (the curve), with quantity and price plotted on the horizontal axis (x). This represents a downward slope or a negative relationship, which migrates left to right.

This is the outer bound of a customer’s willingness to pay. This is the limit of a customer’s willingness to pay. The point where the demand curve crosses over the x-axis represents the maximum amount a customer will pay at any price. The maximum number of products a firm can sell if it assumes its product is priced at zero.

The slope of the demand curve represents the likely purchase quantities for various prices. It can be calculated using the formula below:

After understanding the concept of demand, it is important to understand the main law and the factors that govern this.

The Law of Demand

The law of demand states that the quantity demanded for a good is inversely related to its price. In other words, higher prices will lead to lower doses, while lower prices will lead to greater amounts. Five other factors are used to determine demand elasticity. These are:

Price for related goods. Related products are either compliments (i.e., goods that have a positive Cross-elasticity Demand) and so typically consumed together (think of cars and petrol), substitutes (i.e., goods with negative cross-elasticity demand, and which can be easily substituted for the other, such as bottled water vs. regular tap water). A rise in price for a complement will typically lead to an increase in the cost of the entire bundle, which in turn leads to a decrease in demand. With substitutes, however, the opposite occurs.

Incomes of buyers. As the incomes of individuals or aggregates increase, so do individual and aggregate demand. This is in accordance with marginal utility functions. In this case, marginal utility is defined as an additional unit of satisfaction that a consumer receives from purchasing one other team of a good. This utility typically decreases with time or each other unit consumed.

Consumer tastes and preferences. A positive change in consumer tastes or preferences in favor of the good (or brand in a particular good category) increases demand. This is why billions of dollars a year are spent on advertising, marketing, and branding in order to manipulate or shift tastes, preferences, as well as the stickiness (or loyalty) of customers in favor of one firm’s brand.

Expectations of Consumers. Two other cornerstone principles are intrinsic to this variable. First, there are future values, and second, discounting present value. Simply put, when consumers believe that the price of a product will increase in the future, they will be more willing to pay in the present for the product, which will lead to greater demand. This concept is at the intersection of when even basic consumer goods can be considered as investments on the basis solely of perception, consumer behavior, and fashions/trends.

Numbers of buyers on the market. Stated that while income per capita remains constant, an increase in the number of consumers who are able to purchase the product due to changes in demographics or improved relevance of the product will lead to greater demand. The greater the number of people who can afford and use a product, the more need there will be.

The Demand Curve Revisited – A Shift Along…

In this context, it’s worth noting that there are two ways to express changes in demand in economics. A shift in the curve of order is one example, while a movement on the angle of charge is another. The only way to induce a shift in the demand curve is by changing one of the non-price determinants, as described above and illustrated in Figure 2.

A change in the curve/function of demand is only triggered by price changes. This results in a difference in the quantity demanded, but still within the limits of the function/curve. The price elasticity of demand is the measure of how sensitive the change in amount to the price change is.

Price Elasticity and Demand

The Price Elasticity of Demand (PED) measures the change in percentage in quantity demanded as a result of a change in rate in price. The PED ratio is used to calculate the price elasticity by dividing the percentage change in amount by the price change.

Due to the inverse relation between price and quantity demanded (the law demand), the elasticity coefficient, i.e., the output from the formula for price elasticity, is almost always negative. The negative sign is usually ignored in the analysis since the focus is on the magnitude.

Interpreting Elasticities

Demand is elastic if a relatively small price change is accompanied by a disproportionately large change in quantity demanded. It is non-elastic if a fairly big price change is accompanied by a disproportionately lower change in the amount required. Unit-elasticity is any situation where an exact/proportional increase in the amount necessary accompanies a price change.

Mathematically speaking, the demand for a product is considered to be relatively elastic if its coefficient of elasticity is greater than one and relatively inelastic if it is lower than 1. The PED coefficient of exactly one is the final indicator that demand is unit elastic.

Thomas Steenburgh, Jill Avery, and other senior lecturers from the Darden School of Business at Harvard Business School believe that there are five main zones of elasticity.

How do companies use price elasticity of demand?

In a different direction, I’d like to look at how companies utilize the price elasticity of the demand. In order to answer this question effectively, we need to go back and define/clarify what a company does.

The most basic function of a business is to create or at least perceive value for customers and (2) capture that value for stakeholders. Companies create or at least perceive value in the goods/services they choose to produce and distribute. Capture this value as profits in the choices made about how to price their products and cost structures. It is, therefore, possible to assume that a firm’s primary goal is to maximize profits.

After settling this, we must now understand the role played by the marketer. Most of us can agree that the part of the marketer, along with other managers in a company, is to help achieve their firm’s goal, which we have defined as maximizing profit. Since costs are not under the purview of the marketer, they can only maximize revenue. A marketer can do this by optimizing the Four Ps, which are the four aspects of business theory: product, price, place, and promotion. The effect describes the nature of the good/service and its relative differentiation. Price is the amount that a service is sold at. Place is where the good/service is located and is easily accessible. Promotion is the marketing method used to inform and persuade a target audience about the good’s merits.

It is the job of the marketer to determine demand, estimate the impact of different price combinations (price elasticity), and then use this data to inform the management of the pricing strategies that are most appropriate for the company and its products.

In the real world, ceteris parebus cannot hold. To put it another way, variables in competitive markets can never remain constant. In reality, firms are operating in complex and dynamic environments. These environments contain intangible forces of competition that can be difficult to quantify or predict. By definition, the real world is fluid, imperfect, and unreliable without accounting for consumers.

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