Elasticity of Demand

Elasticity of Demand A2 Business Studies Unit 4 - Marketing

Objectives

Introduction • The demand for goods and services is determined by a wide variety of factors • The demand for the new Fiat Punto will be influenced by: • The price • The price of similar cars • The amount spent on advertising • Seasonality • And many other factors

Introduction (2) • Elasticity measures how the demand for a product changes in response to a variable such as price or income. • Each variable that affects demand has its own relative elasticity • A price rise is likely to reduce demand • An increase in advertising is likely to increase demand • The elasticties most commonly used business are Price & Income

Price Elasticity of Demand • In the short term, the most important factor affecting demand is PRICE • If Coca-Cola increased the price of Coke, sales would almost certainly fall • Some consumers would switch to a different brand • Some would buy Coke less frequently • If Coca-cola increased their price by 10%, and demand only fell 1%, they would benefit hugely from the price hike

Price Elasticity of Demand (2) • How much will demand fall when price increases? • This can be answered by calculating the price elasticity of demand for Coca-cola • PEoD is not about whether the demand changes with price, but the degree to which it changes

Price Elasticity of Demand (3) • Price elasticity can be calculated using the following formula: % Change in quantity demanded Price elasticity = % Change in price • If a 10% price increase led to a 20% fall in demand, the price elasticity would be: -20% 10% -2 =

Price Elasticity of Demand (4) • This demonstrates that for every 1% price increase, demand will fall by 2% -20% 10% -2 = • Some product are more price sensitive than others • Example 1 • Example 2

Using price elasticity information • There are two main purposes for price elasticity: • Sales forecasting • Pricing strategy

16% -20% -0.8 = Forecasting sales • A firm considering a price rise will want to know the effect the price change is likely to have on demand • The Sun newspaper cut its price by 20% (from 25p to 20p, and sale rose by 16% (which was up to 4million copies per day • What was it’s price elasticity? Can the higher demand levels be met?

Pricing strategy • There are many factors that determine the demand and profitability of a product that are beyond control • However, the price a firm charges is within its control • Price elasticity information can be used in conjunction with the firm’s own information about costs, to forecast the effect of price change on profit

Pricing Strategy Example • A second hand car dealer sells 60 cars each year. • Each car costs around £2,000 to buy • Annual overheads are £18,000 • He charges customers £2,500 per car • How much profit does he make per year?

Pricing Strategy Example 2 • Total revenue = £2,500 x 60 = £150,000 • Total Cost = £18,000 + (2,000 x 60) = £138,000 • Total Profit = £150,000 - £138,000 = £12,000

Pricing Strategy Example (3) • From past experience, the salesman believes the price elasticity of his cars is approximately –0.75 • He is thinking about increasing his prices to £3,000 per car, and increase of 20% • How would this impact profit? • % Change in demand = 20% x –0.75 = -15%

Pricing Strategy Example (4) • A 15% fall in demand on current sales equates to a fall of 9 cars per year: 60 100 15 9 cars per year x = • On the basis of these new figures, the new annual profit would be: • Total revenue = £3,000 x 51 = £153,000 • Total cost = £18,000 + (51x£2,000) = £138,000 • New Profit = £153,000 –£138,000 = £15,000

£33,000 - £12,000 £12,000 175% x 100 = Pricing Strategy Example (5) • This equates to an increase in profit of 175% • These calculations are all based on two assumptions: • The price elasticity of –0.75 was correct • Other factors that could affect demand remain unchanged

Elasticity of Demand