Explain why price elasticity of demand is important for firms to consider when setting the prices to ensure that they maximize their profits.(maximum 150 words)
Answers
Answer:
important for firms to consider when setting the prices to ensure that they maximize their profits.(maximum 150 words)
Answer:
Price Elasticity of Demand: Definition + How to Calculate
Written by Vivian Guo | August 21, 2012
At the core of marketing is predicting how consumers will respond to different forms of stimulus. How much will getting Ryan Gosling (or Patrick's hero Hal Varian) to endorse the product raise sales? How would consumers feel about a teddy bear in the marketing email or on the package? Although businesses can never be 100% sure of the way a consumer will react, the purpose of every marketing and product team is to increase conversion, usage, and positive brand outlook.
priceelasticity resized 600
Pricing, and more specifically your company's pricing strategy, is the one area applicable to marketing and product that still contains a considerable amount of guesswork. Phenomenal marketing and product development can lead to an increase in your prices while maintaining the same level of conversion. The two areas of your business can also tank your conversion if done incorrectly. Yet, setting a price and communicating value shouldn’t be a blind man’s game. Similarly, price optimization and changes shouldn’t be a shot in the dark.
Fortunately, there is a way to guide that process. One of the cornerstones of pricing strategy, microeconomics, and a great marketing/product foundation is the theory of price elasticity of demand, also known more simply as price elasticity. Let's lay out the basics of price elasticity and how you can increase demand by making your product offering more inelastic through marketing and product development.
What is Price Elasticity of Demand?
Price elasticity of demand (PED) is an economic measurement of how quantity demanded of a good will be affected by changes in its price. In other words, it’s a way to figure out the responsiveness of consumers to fluctuations in price (as opposed to price elasticity of supply, which determines the responsiveness of supply to price).. I know equations are negative amounts of fun, but this one is super simple.
How to Calculate Price Elasticity of Demand
Price Elasticity of Demand = (% Change in Quantity Demanded)/(% Change in Price)
Since quantity demanded usually decreases with price, the price elasticity coefficient is almost always negative. Economists, being a lazy bunch, usually express the coefficient as a positive number even when its meaning is the opposite. We're a pretty difficult people. It’s important to note, however, a decrease in quantity demanded does not automatically mean that revenue decreases. The additional profit margin could make up for the slight decrease in purchases.
When the price elasticity of a good is less than 1, it’s considered inelastic. That means a one unit increase in price resulted in a less than one unit decrease in demand. On the other hand, if the coefficient (the absolute value) is more than 1, the good is elastic. That means a unit increase in price will cause an even greater drop in demand. Theoretically, revenue will be maximized when the price elasticity of a good equals 1, or in other words, when demand is unit elastic.
what-is-price-elasticity-inline.png
Let's break it down with some price elasticity of demand examples
I just threw out a lot of words like "unit", "elastic", "coefficient", "lazy", etc. Yea, economists like to use fancy words to alienate those political science or communication folks (kidding, of course), so let's break this down a bit with some examples.
Price and demand typically head in the opposite direction, but the demand curve varies greatly based on product (and, in particular, on how necessary the product is). When you're looking at something like a tank of gas, does a $0.50 increase per gallon affect whether you'll fill up or not? Typically, other than aggravating you, the answer is no, because many commuters rely on gasoline to get them to or from their jobs. In this manner, gasoline is considered inelastic, where it would take a drastic price increase to truly drive down demand. Boston's MBTA saw this recently with their price increase, when the price went up, but ridership wasn't really affected.
Conversely, if a slice of pizza you purchased every day for lunch went up $0.50 would it affect your purchase? As long as you weren't super attached to the pizza and had other options (more on this below), you probably would move to another lunch establishment. The pizza, and food in general, tends to be elastic, where even slightly higher prices may cause a change in demand.