How Price Elasticity Works

Price elasticity of demand is a microeconomic mechanism that measures how the quantity of a product demanded changes in response to a change in its price, with a 1% change in price typically resulting in a corresponding change in quantity demanded.

The Mechanism

The core cause-and-effect chain of price elasticity involves a change in price, which affects the quantity demanded, resulting in a corresponding change in revenue. This mechanism is driven by the law of demand, which states that as the price of a product increases, the quantity demanded decreases, and vice versa.

Step-by-Step

1. A company increases the price of its product by 5%, causing a decrease in the quantity demanded, with a resulting 2% decrease in sales revenue, as seen in the case of Procter & Gamble's price increase for its Tide detergent.
2. The decrease in quantity demanded is measured by the price elasticity of demand coefficient, which is calculated as the percentage change in quantity demanded divided by the percentage change in price, with a coefficient of -0.5 indicating that a 1% increase in price results in a 0.5% decrease in quantity demanded.
3. If the price elasticity of demand coefficient is greater than 1, the product is considered elastic, meaning that a small change in price results in a large change in quantity demanded, as is the case with luxury goods like designer handbags, which have a coefficient of -2.5.
4. The company can use this information to adjust its pricing strategy, with a price increase of 10% resulting in a 5% decrease in quantity demanded, as predicted by the price elasticity of demand coefficient, and resulting in a revenue increase of $100,000, as seen in the case of Coca-Cola's price increase for its soft drinks.
5. The company can also use price elasticity to identify price-sensitive customers, who are more likely to switch to a competitor's product in response to a price increase, with 20% of customers switching to a competitor's product after a 5% price increase, as measured by market research.
6. By understanding the price elasticity of demand, the company can optimize its pricing strategy to maximize revenue, with a revenue increase of 15% resulting from a 5% price increase, as seen in the case of Apple's price increase for its iPhones.

Key Components

• Price: the amount that customers pay for a product, with a change in price affecting the quantity demanded.
• Quantity demanded: the amount of a product that customers are willing to buy at a given price, with a change in quantity demanded resulting from a change in price.
• Price elasticity of demand coefficient: a measure of the responsiveness of quantity demanded to a change in price, with a coefficient of -0.5 indicating a relatively inelastic product.
• Revenue: the total amount of money earned from the sale of a product, with a change in revenue resulting from a change in price and quantity demanded.

Common Questions

What happens if a company increases the price of its product by 10%?

A 10% price increase will result in a decrease in quantity demanded, with the magnitude of the decrease depending on the price elasticity of demand coefficient, as seen in the case of Ford's price increase for its cars, which resulted in a 5% decrease in sales.

What is the difference between elastic and inelastic products?

Elastic products have a price elasticity of demand coefficient greater than 1, meaning that a small change in price results in a large change in quantity demanded, as is the case with airline tickets, which have a coefficient of -2.5, while inelastic products have a coefficient less than 1, meaning that a large change in price results in a small change in quantity demanded, as is the case with tobacco products, which have a coefficient of -0.5.

How can a company use price elasticity to optimize its pricing strategy?

A company can use price elasticity to identify the optimal price for its product, with a price increase of 5% resulting in a revenue increase of $100,000, as seen in the case of Microsoft's price increase for its software products.