What Is Price Elasticity? Price Elasticity In A Nutshell

Price elasticity measures the responsiveness of the quantity demanded or supplied of a good to a change in its price. It can be described as elastic, where consumers are responsive to price changes, or inelastic, where consumers are less responsive to price changes. Price elasticity, therefore, is a measure of how consumers react to the price of products and services.

Understanding price elasticity

Consumers are sensitive to the price of a product or service when deciding whether to make a purchase decision. While most consumers are more likely to purchase a cheap product and less likely to purchase an expensive product, the role of price in the decision-making process is more nuanced.

Gasoline is one example of a product with inelastic demand. Consumer demand for the product is less responsive to price changes because it is considered a vital commodity. Common products with elastic demand include soft drink, cereal, clothing, electronics, and vehicles. Consumers are more responsive to changes in price because these products are not considered necessities and there are readily available substitutes.

Price elasticity data is valuable to a marketing team. The data enables them to determine how the market will react to price changes to existing products and whether such a reaction will impact the company’s bottom line.

The four types of price elasticity

There are four types of price elasticity, with each used to explain the relationship between two economic variables:

Price elasticity of demand (PED)

A measure of the change in consumption of a good or service in relation to a change in its price.

Price elasticity of supply (PES)

A measure of the change in the supply of a good or service in response to a change in its price.

Cross elasticity of demand (XED)

This is a measure of the change in demand for one good in response to a change in demand for another good.

Income elasticity of demand (YED)

A measure of the change in demand for a good in response to a change in the buyer’s income.

Factors that affect elastic and inelastic demand

In the introduction, we touched on some of the factors affecting elastic and inelastic demand. Let’s take a more detailed look at these below.

Factors affecting elastic demand

Available substitutes

When there are many products of a similar type available, those with a lower price are more attractive than those that are more expensive. Chocolate bars are one example. 

Homogenous products

Similarly, the presence of homogenous products gives consumers more choice and freedom. Demand for insurance is not affected by price increases because there is always a provider offering cheaper premiums.

Lower switching costs

If there are no costs associated with switching products, then demand is less likely to be impacted by price. For example, there is no cost to the consumer in switching to Mercedes if they consider BMW sedans to be too expensive.

Factors affecting inelastic demand

Purchase frequency

Consumers tend to spend more money on one-off purchases such as a new car or smartphone.

Lack of substitutes

If there are no suitable alternatives, then demand tends to be elastic. For example, demand for milk does not change if prices rise by 10% because for most people, there is no substitute.

Geographical location

Some goods and services are inelastic because a company has geographical dominance. In most sports stadiums, food and beverage retailers can raise prices without affecting demand because fans have no choice but to purchase from them.

Basic necessities

Some products are necessary to survival, including medication, electricity, water, and some food items. Demand for these goods and services is unresponsive to price changes.

Key takeaways:

  • Price elasticity is a measure of how consumers react to the price of products and services. It can be described as elastic, where consumers are responsive to price changes, or inelastic, where consumers are less responsive to price changes.
  • Price elasticity data is valuable to a marketing team. This data enables them to determine how the market will react to price changes to existing products and whether such a reaction will impact the company’s bottom line.
  • Factors affecting elastic demand include available substitutes, homogenous products, and lower switching costs. Factors affecting inelastic demand, on the other hand, include infrequent purchasing, a lack of substitutes, geographical location, and whether the product is a basic necessity. 

Main Free Guides:

Connected Business Concepts

Economies of Scale

In Economics, Economies of Scale is a theory for which, as companies grow, they gain cost advantages. More precisely, companies manage to benefit from these cost advantages as they grow, due to increased efficiency in production. Thus, as companies scale and increase production, a subsequent decrease in the costs associated with it will help the organization scale further.

Diseconomies of Scale

In Economics, a Diseconomy of Scale happens when a company has grown so large that its costs per unit will start to increase. Thus, losing the benefits of scale. That can happen due to several factors arising as a company scales. From coordination issues to management inefficiencies and lack of proper communication flows.

Network Effects

A network effect is a phenomenon in which as more people or users join a platform, the more the value of the service offered by the platform improves for those joining afterward.

Negative Network Effects

In a negative network effect as the network grows in usage or scale, the value of the platform might shrink. In platform business models network effects help the platform become more valuable for the next user joining. In negative network effects (congestion or pollution) reduce the value of the platform for the next user joining. 

Creative Destruction

Creative destruction was first described by Austrian economist Joseph Schumpeter in 1942, who suggested that capital was never stationary and constantly evolving. To describe this process, Schumpeter defined creative destruction as the “process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.” Therefore, creative destruction is the replacing of long-standing practices or procedures with more innovative, disruptive practices in capitalist markets.

Happiness Economics

Happiness economics seeks to relate economic decisions to wider measures of individual welfare than traditional measures which focus on income and wealth. Happiness economics, therefore, is the formal study of the relationship between individual satisfaction, employment, and wealth.

Command Economy

In a command economy, the government controls the economy through various commands, laws, and national goals which are used to coordinate complex social and economic systems. In other words, a social or political hierarchy determines what is produced, how it is produced, and how it is distributed. Therefore, the command economy is one in which the government controls all major aspects of the economy and economic production.

Animal Spirits

The term “animal spirits” is derived from the Latin spiritus animalis, loosely translated as “the breath that awakens the human mind”. As far back as 300 B.C., animal spirits were used to explain psychological phenomena such as hysterias and manias. Animal spirits also appeared in literature where they exemplified qualities such as exuberance, gaiety, and courage.  Thus, the term “animal spirits” is used to describe how people arrive at financial decisions during periods of economic stress or uncertainty.

State Capitalism

State capitalism is an economic system where business and commercial activity is controlled by the state through state-owned enterprises. In a state capitalist environment, the government is the principal actor. It takes an active role in the formation, regulation, and subsidization of businesses to divert capital to state-appointed bureaucrats. In effect, the government uses capital to further its political ambitions or strengthen its leverage on the international stage.

Boom And Bust Cycle

The boom and bust cycle describes the alternating periods of economic growth and decline common in many capitalist economies. The boom and bust cycle is a phrase used to describe the fluctuations in an economy in which there is persistent expansion and contraction. Expansion is associated with prosperity, while the contraction is associated with either a recession or a depression.
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