Elasticity of Demand | Sample Business Plan

Elasticity of Demand


What is Elasticity of Demand?

Elasticity of Demand is a topic reviewed in good ole’ economics. In short, elasticity of demand refers to how sensitive or responsive consumers are to price changes of a product. If consumers buy more or less of a product due to a change in that products pricing, then the product is considered to have elastic demand. However, if price does not have an effect on consumer demand, then that product is considered to have inelastic demand.

 

Elasticity of Demand Formula

The formula to determine elasticity of demand is as follows:

 

(E) Elasticity =

 

Percent change in quantity demand for product x
   ---------------------------------------------------------------
         Percent change in price for product x

 

If E is less than 1, demand is considered inelastic

If E is greater than 1, demand is considered elastic

If E equals 1, demand is considered unitary.

 

It should be noted that unitary elasticity occurs when an increase in sales is offset by the decrease in price, resulting in a situation where revenue remains the same.

 

As a quick rule of thumb, the following apply when determine elasticity of demand:

 

If price and revenue increase, then demand is inelastic

If price and revenue decrease, then demand is inelastic

If price increases and revenue decreases, then demand is elastic

If price decreases and revenue increases, then demand is elastic

If price increases or decreases and revenues stay the same, then elasticity is unitary

 

Sample Elasticity of Demand Problem

Company ElastiPad produces tablets competing with the iPad. Their demand curve has shown that their product is extremely elastic. Six months into the release of their new product, elastoPad, they reduced the price from $200 to $100 to test the market and their theory that they could improve revenues by making the change. It was a huge success! At $200 demand for their elastoPad was 20,000 units, but with the reduced price of $100 demand topped 60,000 units! At $200 revenue was $4 million, whereas at $100 revenue reached $6 million. Using the above formula, to solve for E, the problem looks like the following:

 

E = [(60,000 – 20,000) / [(60,000 + 20,000)/2]] / [($200 - $100)/[($200 + $100)/2]]

E = (40,000/40,000) / (100/150)

E = 1 / .67

E = 1.49: This product is considered elastic because E > 1

 

Elements that Affect Elasticity

There are a number of elements that affect the elasticity of demand. The areas to consider are as follows:

 

Substitutes: When there are many substitutes the consumer can make a purchasing decision to buy a competitor’s product, creating elastic demand.

 

Purchasing Power: If a consumer’s personal budget is so large and the low price of a product seems to bear no consequence to their budget, then this will create inelastic demand.

 

Product Durability: Durable products are those products that can be repaired rather than replaced, prolonging their useful life. Consumers are sensitive to price increases with these products, creating elastic demand.

 

Product Uses: The more uses a product has, the greater the elasticity of demand. For example, copper has many uses and as price drops, demand increases due to the increase in practical uses at this “lower” price. However, as price increases, substitutes will be used as they are more practical (such as polyethylene pipe products).

 

Inflation: When inflation occurs, it has been shown that people become more sensitive to pricing, increasing demand elasticity.