Chapter 21 - Marketing Analysis Learning Objective: To understand the different factors impacting elasticity of demand
I hope you remember the concept of price elasticity of demand...
It is the measure of responsiveness of demand for a product following a change in its price. In other words it measures how price influences demand.
The demand for different products react differently following a change in price:
Having such information is of key importance for marketing decisions such as pricing:
Even though the price of both products increased by the same amount the sales revenue of one of them increased whereas for the other it decreased. In most cases, however, there is an inverse relationship between price and demand (higher price = lower demand, and vice-versa).
Using the information on the graphs above, calculate the PED for both products. What do your results mean?
There are a number of factors that will determine the price elasticity of demand of a product:
Another important factor impacting PED is the price of the product as a proportion of consumers' income.
As mentioned, PED is important information for pricing decisions. It is also important for businesses on making wages decisions:
Businesses with low PED for their products can carry on price increases when pressured to increase wages and still keep their profit margins untouched.
Activity 21.2
Price, however, is not the only factor influencing the demand for a product:
Consumer income (income elasticity of demand);
Promotional spending (promotional elasticity of demand);
The price of related goods (cross elasticity of demand).
Let's look at each of those measures individually.
The Income Elasticity of Demand measures the change in demand for a product following a change in consumer incomes.
Not every type of product responds the same way to a change in average income:
On the other hand...
The inferior goods demand will raise if income falls;
Luxury goods demand goes down as income decreases;
Necessity goods demand stays the same regardless of income changes.
How does income elasticity of demand connect to business decisions?
Businesses focus on increasing output and launching products with high income elasticity of demand during times of economic growth;
Recessions make it so businesses focus on more basic version of their products aiming affordability. Companies producing inferior goods will have to increase output to cope with increasing demand for their products.
The Promotional Elasticity of Demand measures the change in demand for a product following a change in the amount spent on promoting it:
As a rule of thumb:
Results greater than 1 would mean that the demand is considered responsive to a change in spending on promotion.
Results lower than 1, on the other hand, mean that the demand is inelastic to promotion.
AED is good measure to decide what products to invest in promotion and which ones the investment is not necessary.
AED is not an entirely reliable measure: decrease in demand for a product at the time of promotion may have been caused by other factors (e.g. a competitor's better promotional activity);
AED depends on the effectiveness of the promotional activity - can make it an unreliable measure;
AED needs to be recalculated frequently (e.g. following a price change);
When commenting on an elasticity calculation, you should never assume that the result will be accurate and relevant for future changes in price, income or promotion spending. It would be unwise to base major marketing decisions on elasticity results alone.
Activity 21.4
Business in Action 21.1
Finally, Cross Elasticity of Demand measures the change in demand for a product following a change in the price of another product:
A result below 0 would mean that the two goods compared complementary to each other and are often purchased together (e.g. buying a laptop automatically means buying Microsoft OS);
An above 0 (positive) result represents that the two goods compared are substitutes and therefore compete for the same spending (e.g. when the price for SONY TVs rises the demand for TOSHIBA TVs will increase).
Final considerations about the different measures of elasticity:
All of the different measures should be used with caution and with consideration of the various factors simultaneously taken place;
Such measures assume that nothing else is changing but the variable in question;
They may need to be recalculated frequently as they become outdated;
It is not always easy to calculate such measures as it usually requires past data to be available;
It would be unwise to base major marketing decisions on elasticity alone.
Chapter 21 - Marketing Analysis
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