A2 - Elasticity

Economic concept of demand An increase in price will cause a decrease in demand This assumes that the only two variables are price and quantity demanded, nothing else Normal demand curve

Factors which cause a shift in the demand curve Changes in income level Increase in price of substitute goods A reduction in the price of complementary goods Effective advertising campaign All of these could operate in reverse too.

Price elasticity of demand This is the relationship between price changes and the size of the resulting change in demand. Percentage change in quantity demanded Percentage change in price There is usually an inverse relationship (a negative) as an increase in price usually reduces demand. (you can ignore the – sign)

Value PEDClassificationExplanation ZeroPerfectly inelastic demand The same amount is demanded no matter what the price 0 – 1InelasticThe % change in demand is less than the % change in price. It can raise the price and not lose much demand, increasing sales revenue 1Unit elasticity% change in demand = and opposite to the % change in price. Any change in price will be matched by a change in demand, revenue will remain constant 1 – infinityElastic demand% change in demand is greater than the % change in price. If price is lowered demand will increase and increase sales revenue

Factors that determine PED How necessary the product is – the more necessary the product the less they will react to price changes. Inelastic. How many competing products/brands – if there are many substitutes consumer will switch brand if price increases. Consumer loyalty – change in price will not lose customers. Price of the product – cheap goods will unlikely be affected by an increase in price.

Applications of PED Accurate sales forecasts Assist pricing decisions

Determinants of price Cost of production Competitive conditions in the market Competitors’ prices Business and marketing objectives PED Whether it is a new or existing product

For each method explain what the strategy is and advantages/disads. Cost-plus or cost-based pricing Competition pricing Skimming Penetration pricing Loss leaders Psychological pricing

Promotional elasticity of demand % change in demand % change in promotional spending Greater than 1 = Elastic; responsive to a change in promotional spending Less than 1 = Inelastic; little point in increasing prom0tional spending

Reliability Not entirely reliable; changes in demand may be due to external factors (e.g economy) which could occur at the same time as a promotion. However, if similar elasticity results are obtained on more than one occasion then this is useful information.

Income elasticity of demand Virtually all businesses will have greater opportunities for increased sales, profit and expansion during periods of economic growth. The impact of the resulting increase in income will not necessarily be felt evenly through all businesses. Income elasticity measures the responsiveness in demand to a change in income.

% change in demand for a product % change in consumer income

Income elasticity can be classified for 3 classes of goods. 1.Normal goods ( Elasticity of 0 – 1) When consumer incomes rise, the demand for these goods may well increase but by a smaller proportion. Demand will remain at a similar level no matter what happens to income. E.g. Basic foods, pharmaceuticals

2.Luxury goods (Elasticity greater than 1) When consumer income rises, demand for these goods rises by an even greater proportion. E.g. holidays, leisure activities and consumer durables

3.Inferior goods (Negative income elasticity) Demand will decline following an increase in incomes, but rise when incomes reduce. E.g. second-hand goods, home brand products. Producers of these products will gain during a recession.