In yesterday’s lesson, we learned that firms should set a price so their marginal revenue is at least as great as their marginal cost. But one practical challenge with applying that maxim is that firms never know for sure how much demand they will have for their product. In a result, a firm that over-produces ends up with unsold inventory and a higher cost than expected, while a firm that under-produces misses out on sales.
One approach to resolving this dilemma is to try and estimate the demand based on the firm’s past experience in selling a product at different price points. This leads to the idea of the price elasticity of demand.
What Does Price Elasticity of Demand Mean?
Price elasticity of demand, often called price elasticity, simply refers to the specifics behind the tradeoff of price and sales. All firms know that when they raise prices, they will lose at least a few customers. For products with loyal customers who have few alternative options, a price increase will likely only mean slightly fewer buyers. For firms facing intense competition, an increased price may mean a substantial portion of the client base defects.
Price elasticity captures this relationship between sales and price in a single number.
Formally, price elasticity is defined as the percentage change in quantity of the product sold, divided by a 1% change in price. So, a price elasticity of -1 would mean that a 1% rise in price leads to a 1% fall in the number of sales. We call a product with a price elasticity of -1, unit elastic.
Products that are unit elastic do not benefit from firms raising or lowering price.
A Price Elasticity: Examples
Firms with a product that has an elasticity of more than -1 (i.e. 0 to -0.99) are referred to as producing an inelastic good. These firms benefit from raising price. A quick example illustrates this.
Let’s pretend a firm has a price elasticity of -0.5. If the firm sells 1,000 units for $10 per unit today, then they have sales of $10,000 ($10 x 1,000). Raising price by 1% means the new price is $10.10, and the unit elasticity of -0.5 means the 1% rise in price will cost the company 0.5% of its customers—in this case, sales of five units.
So, when the firm raises prices by $0.10, the new price is $10.10 and the number of units sold is 995. In this case, total sales for the firm are now $10.10 x 995 units, or $10,049.50. The firm’s revenues have increased by $49.50, and if the firm was able to anticipate lower sales by knowing its price elasticity, then they would have produced five fewer units, which will mean profits increase by even more than $49.50.
Price elasticities of less than -1 (e.g. -1.5, -2, etc.) are referred to as elastic goods. This indicates that a firm is facing enough competition that raising prices is a bad idea. In this case, a price increase will lead to more lost sales than it will generate in additional revenue.
While firms cannot directly observe their price elasticity for a product, they can estimate it by looking at their sales history around any price changes. To do this, they look at the percentage price change the firm put in place and then at the percentage change in the number of units sold (revenue/price = units sold). If the percentage change in units sold is bigger than the percentage change in price, then chances are that the firm makes a product with an elastic price.
Tomorrow, we will move from looking at the economy from individuals and businesses’ perspective to exploring how nations as a whole behave and the economics that drive that behavior.
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