Table of Contents
- What Is Elastic Demand?
- What Is Inelastic Demand?
- Factors That Impact Elasticity of Demand
- Examples of Products With High Elasticity of Demand
- Examples of Products With Low Elasticity of Demand
- Elasticity of Demand Formula
- Example Calculation
- Using Elasticity as a Strategic Business Leader
- Keep Adding Tools to Your Toolbox
During the first quarter of 2023, as prices for used electric vehicles fell, sales soared by 32%, demonstrating a perfect example of a product with high elasticity of demand, or in other words, a product that has a change in demand when there is a change in price. While many people feel it’s intuitive that sales rise as prices fall, this principle isn’t as simple as you might think.
In fact, not all products experience a change in demand after a price change, like toilet paper and pharmaceuticals. Other products experience a much more significant change than you’d expect. That’s why it’s critical for business leaders to understand elasticity and use it strategically to maximize revenue.
In this article, learn how to calculate elasticity of demand, what it means, and how to use it to gain a strategic advantage.
- Elastic demand describes a situation where consumers are likely to change their behavior as prices rise and fall.
- Elasticity of demand is impacted by the presence of substitute products, whether a product is a “need” or a “want,” and the proportion of consumer budgets the product represents.
- Business leaders who understand elasticity use it while making pricing decisions, analyzing their competition, learning about their customers, and preparing for economic fluctuations.
What Is Elastic Demand?
Elastic demand is a term used in economics to describe a situation where the quantity demanded of a good or service is highly responsive to changes in its price. In other words, when a product’s demand is elastic, if the product’s price increases, consumers will reduce the quantity demanded. If the price decreases, consumers will increase the quantity demanded. This can also be referred to as having high elasticity of demand or high price elasticity.
Imagine you own a local bike shop and typically sell 25 bikes per month. You believe you can increase revenue by increasing the price of the bikes. However, when you raise prices, sales decrease significantly. Revenue dropped instead of rising as you expected. This is because your customers are price-sensitive, and demand for your product is highly elastic.
What Is Inelastic Demand?
Inelastic demand is the opposite of elastic demand. While consumers of products with elastic demand are sensitive to price changes, when a product has inelastic demand, or low elasticity of demand, consumers don’t change their purchasing behavior, even as the product’s price rises and falls.
In 2022, the price of electricity in the U.S. rose 14.3%. However, consumers did not decrease usage simply because the price rose. In fact, Americans’ electricity consumption in 2022 was very similar to 2021, with a small 2.6% increase.
Factors That Impact Elasticity of Demand
A few key factors influence whether a product’s demand will be elastic or inelastic. When predicting whether a product will have elastic vs. inelastic demand, ask these questions:
- Can consumers find sufficient substitutes for the product?: If consumers can find alternative products, when the price of the original product changes, they are more likely to switch to a substitute product. This means products with many substitutes have high elasticity of demand.
- Is this product a “need” or a “want”?: As the price of unnecessary products rises, consumers are likely to cut them out of their budget. But if the product is a necessity, regardless of price, consumers keep purchasing the product, meaning the product has low elasticity of demand.
- Is this product a significant portion of consumer budgets?: When a product represents a small portion of a consumer’s budget, a price change won’t impact the overall budget very much. This means that low-cost items are more likely to have low elasticity of demand, while high-cost items are more likely to have high elasticity.
Products sold in areas with high incomes can have a different level of elasticity than the same products sold in areas with low incomes. For example, a high-end clothing store might lose customers due to price increases if it’s located in a middle-class neighborhood because the clothing represents a large portion of middle-class consumer budgets.
However, a high-end clothing store in a high-income neighborhood might not see a change in consumer behavior after a price change because the product represents a smaller portion of high-income consumer budgets.
Examples of Products With High Elasticity of Demand
- Bottled water: If the price of a consumer’s favorite brand of bottled water rises, they can easily switch to another brand, drink filtered tap water, or another beverage. Because tap water is so readily available, bottled water is generally considered a “want.”
- Restaurants: Going out to eat is usually considered a “want,” and consumers have numerous options. When restaurants raise their prices, consumers have multiple choices for alternative restaurants or making food at home. A 2022 study found restaurant-goers avoid eating at establishments after significant price increases. Scott Foxworth, Director of Consulting Services at RMS, explains, “When price increases went beyond 10% to 13%, traffic started to severely decline, negating some or all of the net sales benefits.”
Television streaming services: A 2022 study found that 50% of users across all streaming platforms would cancel their subscriptions if prices rose by up to 30%. This is likely due to the high availability of alternative products and the fact that these services are not necessities. In 2021, Flixed reported over 200 TV streaming services were available in the United States. In addition to the 200+ streaming platform options, consumers can substitute other entertainment options if they don’t like their television options.
- Major home renovations: A home remodel is typically a large portion of a consumer’s budget. If the remodel is primarily for updating the home’s aesthetic, it’s likely not a necessity, making this product’s elasticity of demand quite high.
- Vacation packages: Vacations are also a major expense for many consumers, and they are not considered a necessity. This makes vacationers highly price sensitive.
Examples of Products With Low Elasticity of Demand
- Life-saving medications: Demand for important medications rarely shifts due to price changes because there are few substitutes for consumers to choose from, and these products are a necessity.
- Gasoline: Though the price of gasoline frequently shifts, demand rarely changes because many consumers rely on gas-powered cars to get to their jobs, and many homes are heated with gas. In regions where public transportation is a good substitute for commuting by car, demand for this product may be elastic. However, in areas where there are no good substitutes, demand for gasoline is inelastic.
- Baby formula: A 2022 baby formula shortage caused prices for this product to skyrocket in the U.S. Despite rising prices, though, families that relied on formula had no option but to continue buying this product. While some families used substitute products like watered-down formula, cow’s milk, and soy milk, these products aren’t good substitutes because they are unhealthy for infants. The shortage showed that demand for formula is very inelastic.
- Toilet paper: Toilet paper has few good substitutes and is often considered a necessity. It also represents a small portion of many consumer budgets, making it highly inelastic.
Elasticity of Demand Formula
Elasticity of demand can be calculated with the following formula:
Percentage Change in Quantity Demanded / Percentage Change in Price
((New Quantity Demanded – Initial Quantity) / Initial Quantity Demanded) x 100
((New Price – Initial Price) / Initial Price) x 100
To calculate, follow these steps:
- Find the initial quantity demanded and the initial price.
- Find the new quantity demanded and the new price.
- Calculate the percentage change in quantity demanded using this formula:
((New Quantity Demanded – Initial Quantity) / Initial Quantity Demanded) x 100
4. Calculate the percentage change in price using this formula:
((New Price – Initial Price) / Initial Price) x 100
5. Now that you have the percentage change in quantity demanded and the percentage change in price, divide the percentage change in quantity by the percentage change in price to get your final answer:
Change in Quantity Demanded / Change in Price = Elasticity of Demand
INTERPRETING ELASTICITY OF DEMAND
After calculating elasticity of demand, if the formula gives you an absolute value greater than or equal to 1, your product has elastic demand. In other words, customers will be sensitive to price changes.
The greater the number, the more price-sensitive consumers will be. If the formula gives you an answer with an absolute value less than 1, you have inelastic demand.
Imagine you have a bookstore that sells 100 books each week for $10 each. You change the price of books to $12 each, and now you are selling 95 per week.
Here’s how to calculate the elasticity of demand:
- Initial quantity demanded = 100 books
- Initial price = $10
- New quantity demanded = 70 books
- New price = $12
Step 1: Calculate the Percentage Change in Quantity Demanded
((70 – 100) / 100) x 100 = -30%
Step 2: Calculate Percentage Change in Price
((12 – 10) / 10) x 100 = 20%
Step 3: Divide the Percentage Change in Quantity Demanded by the Percentage Change in Price
-30% / 20% = -1.5
Elasticity of demand = -1.5
Because the formula gave us an absolute value greater than 1, this situation is an example of high elasticity of demand.
Using Elasticity as a Strategic Business Leader
Once you understand the elasticity of your product, you can use it as a key piece of your decision-making process. Here are a few examples of how to incorporate elasticity into your business strategy:
- Determine the right price for maximizing revenue: Once you know whether your product’s demand is elastic or inelastic, you can determine whether raising or lowering prices will increase revenue. The level of elasticity can also help you determine how much you can raise prices before you lose business.
- Understand your competition: High elasticity of demand can create intense competition among businesses, as consumers have many options and are likely to switch to a competitor if prices are too high. While this means you’ll have to watch your competition carefully, you also may be able to win new customers by pricing your products lower than your competitors.
- Get to know your customer characteristics: Business leaders who understand elasticity know it’s critical to understand who is buying their products. A product with a high-income customer base will have lower elasticity of demand, meaning your business may be able to support price increases.
- Prepare for economic fluctuations: If you sell a product with high elasticity, it’s likely more of a “want” than a necessity. This means you should prepare for demand to drop during economic downturns. You’ll need to price your product appropriately to hold onto customers when times are tough.
Keep Adding Tools to Your Toolbox
Elasticity of demand is a great tool for supporting business leaders in their decision-making. But great leaders should continue adding analytical tools to allow them to gain the upper hand, provide good service, and carry their company forward.
Founder and CEO of Reforge Brian Balfour explains why it’s important to continue learning, saying, “As you gain fresh insight from your data, it opens the door to new questions. . . Saying the process is ‘done’ is saying you understand everything there is to know about your users, product, and channels.”
Once you’ve mastered the concept of elasticity, add these decision-making tools to your toolbox:
- SWOT Analysis: A strategic planning framework used to evaluate the internal strengths and weaknesses of a business, as well as the external opportunities and threats it faces. The acronym “SWOT” stands for Strengths, Weaknesses, Opportunities, and Threats.
- Porter’s Five Forces: A framework designed to analyze the competitive dynamics of an industry by considering five key forces: competitive rivalry, supplier power, buyer power, threat of new entrants, and the threat of substitute products. It helps identify industry attractiveness and competitive advantages.
- Product Performance Metrics: Key performance metrics like market share, ROI, customer acquisition, and retention rates can provide valuable insights for decision-making. Leaders can use these metrics to identify underperforming products, allocate resources effectively, or make decisions regarding product improvements or divestment.
To further improve your knowledge as a business leader, check out these articles:
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