Elasticity of Demand

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Elasticity of Demand

• A2 Business Studies
• Unit 4 - Marketing

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Objectives
3
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

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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

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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

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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

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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

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Price Elasticity of Demand (4)
-20 10

• This demonstrates that for every 1 price
  increase, demand will fall by 2

-2

• Some product are more price sensitive than others
• Example 1
• Example 2

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Using price elasticity information

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

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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 its price elasticity?

Can the higher demand levels be met?
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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 firms own information about
  costs, to forecast the effect of price change on
  profit

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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?

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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

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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

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Pricing Strategy Example (4)

• A 15 fall in demand on current sales equates to
  a fall of 9 cars per year

60 100
9 cars per year
15

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 (51x2,000) 138,000
• New Profit 153,000 138,000 15,000

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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