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Exploring the Relationship Between Price Hikes and Demand

written by: N Nayab•edited by: Ronda Bowen•updated: 8/14/2011

How many times have you decided not to purchase of an item because prices went up? How many times have you still brought the item as you needed it desperately? The concept of price elasticity of demand is a scientific study of such trends, measuring how customers respond to changes in product price.

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    Elasticity pertaining to price and demand is the measure of the how the quantity of demand for a product or service changes relative to changes in its own price. It finds expression as (percentage change in quantity demanded / percentage change in price.)

    Assume the organizers increase the ticket price for a sports event by 10 percent, and as a result, the number of spectators visiting the stadium decreases by 5 percent. Elasticity is 5/10 = 0.5 percent. If the number of spectators decreases by 10 percent, elasticity becomes 10/10 = 1, and if the number of spectators decreases by 20 percent, elasticity becomes 20/10 = 2.

    The concept is different from the demand curve, but has a strong association. The steeper the demand curve, the less the elasticity.

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    Different Types

    Price Elasticity of Demand Price elasticity greater that one (pE > 1) means that demand responds greatly to changes in price. This occurs when the product has many viable substitutes, allowing customers to switch over easily. Usually, most luxuries, or dispensable items have such elastic demand.

    The demand for a product becomes Perfectly Elastic when the quantity supplied or demanded responds wildly to changes in price. Such situations occur rarely, but when they do denotes easily access and availability of high quality products at lesser prices. The graphical illustration of such a state is as a horizontal line in the graph.

    Price elasticity less than 1 (pE <1) denotes inelastic demand, meaning demand does not change significantly in response to changes in price. This occurs when the product or service is essential in nature, there are no competing products available at attractive prices, or when the product is a monopoly. Most necessities in life have inelastic demand, and people tend to purchase the same regardless of the increase in price, unless close substitutes that serve the same purpose exists, in which case demand becomes elastic.

    At times, elasticity becomes zero (pE=0), or the quantity demanded does not change at all regardless of the change in price. This is a case of Perfectly Inelastic demand, illustrated by a vertical line on the graph.

    Unit elasticity is when elasticity is exactly equal to one (pE=1). This means that the demand changes in exact proportion to the fluctuations in price. This is theoretical, and happens in real life more by accident or coincidence.

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    An understanding of the concept of price elasticity of demand helps business owners and analysts predict the changes in demand when price changes, and thereby price products appropriately. For the manufacturer or the seller, total revenue (price per unit x quantity sold) increase when demand is inelastic, total revenue decrease when demand is elastic, and total revenue remains the same when the demand is unit elastic.

    Assume a manufacturer produces 100 units priced at $100 each, and increase the price by 10 percent. If the product has inelastic demand, of say 0.5, it denotes that demand for the product falls only by 5 percent owing to the price rise. Thus, the manufacturer now sells 95 units for $ 110 each. The total revenue for the manufacturer (unit price x quantity) is now 95 x 110 = $10450, an improvement from the earlier revenue of 100 x 100 = $10000. The reduced demand offsets by higher revenues.

    In the same example, assume demand falls by 20 percent. Elasticity now becomes 20/10 = 2, and when unit price increase to 110, demand drops from 100 to 80. The total revenue becomes $8800, and the manufacturer actually looses out by increasing prices.

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    Making Sense

    Price Elasticity of Demand : The Melting Dollar Price elasticity depends on many factors, such as:

    • Availability of substitutes that fulfill the need, and which provide better value for money. For instance, if Ford were to raise its car prices unilaterally, car buyers may opt for similar models offered by Toyota or Honda, making the demand for Ford elastic. Similarly, if a city has efficient public transport system, and the cost of gasoline shoots up drastically, office goers may shift from private cars to public transport or electric rails, reducing the demand for gasoline. The reality however is that most commuters either find public transportation inconvenient or do not have access to the same, and as such commuters would still use their cars regardless of the hike in gasoline prices, making the demand for oil largely inelastic.
    • Information about competing products, and the availability of competing products at the market. For instance, when one manufacturer hikes prices, customers may still be forced to buy the same product, even when cheaper alternatives exists, as the competing product may not have a strong supply or marketing network, or stores may not stock up on such products as it offers them low margins
    • Market conditions. For instance, all manufacturers may form a cartel to increase prices simultaneously, leaving the customer with no option but to pay a higher price regardless of the brand chosen.
    • The perceived need of the product. Monopolists hiking prices of products needed to sustain life, such as a diabetic's insulin or some other life saving drug, or of products that addict such as narcotics will not reduce demand. This is an example of perfectly inelastic demand.
    • The general income levels and how the change in price makes a dent on the income. For instance, a sharp increase in interest rates may reduce the demand for housing loans, as people find repayments unaffordable. In such cases, people may opt to rent the house as a more cost-effective option. Conversely, a high net worth individual would hardly think twice before paying a few cents extra for an ice cream.

    As a rule of thumb, elasticity is greater in the long run compared to the short-term, as people take time to adjust their behavior and make the necessary changes in lifestyle and habit to respond to changes in price. For instance, if price of electricity shoots up, it has no impact on demand in the short run, as people cannot do with electricity for lighting and heating. Over time people would invest in solar heaters, energy-efficient LED lighting and take other measures, and demand would decrease gradually.

    Price elasticity also depends on the definition of the product. For instance, measuring the elasticity of “food" in general would show a highly inelastic demand, for people buy some food or the other, regardless of the price levels. However, when the measure of elasticity becomes “chocolates" the demand may tend to become more elastic. If prices of a brand of chocolate increase, people may opt for another brand, or being a non-essential food item, reduce consumption levels.