Do you know your PED from your elbow? Brief explanation of price elasticity of demand.
PRICE ELASTICITY OF DEMAND (PED)
Elasticity of demand measures the sensitivity or responsiveness of the market to a change in price.
The simple calculation is:
% change in quantity demanded
————————————–
% change in price
The result will give us an indication about the effect of the price change on profit.
Price reductions do not always lead to increased profits. Price rises do not always lead to reduced profits either. There are also other factors to consider such as cost of production, economies of scale, distribution costs, cost of substitutes, competition, trends, product lifecycle, customer perception of quality etc.
The table below may help in defining elasticity where price rises are being made:
PED 0 |
This shows perfect inelasticity of demand. A change in price has no effect on demand and people will still buy the same amount. Businesses can increase prices and enjoy increased profits. |
PED 0 – 1 |
Demand is inelastic. However, the percentage change in demand is less than the percentage change in price.This indicates a small sensitivity to the price change. Demand has reduced but not so much that positive growth cannot be made. |
PED 1 |
Demand is unit elastic. The percentage change in price is exactly the same as the percentage change in demand. Profit from the price increase is offset by the loss in demand. |
PED >1 |
Demand is elastic. The price increase will lead to a greater percentage drop in demand. Price rises will lead to reduced profits. |
In considering elasticity, we are looking at the level of the reaction therefore we need not be overly worried about whether the result is a positive or negative number.
PRICE ELASTICITY OF DEMAND (PED) EXAMPLE
Cosy Cottages sells self catering holiday accommodation within the UK. They operate by having contracts with property owners for an agreed number of weeks per year and acting as a holiday letting agent. There are a number of competitors but Cosy Cottages are at the higher end of the market seeking discerning customers who are looking for interesting properties, furnished to a high standard, with that little touch of luxury.
Having been in business for five years, they decided to review their pricing structure last year. The results were as follows.
1. Christmas and New Year had always proved to be very popular with a lot of people hoping to book that special cottage by the sea during the two week holiday period. Cosy Cottages decided to increases prices by 12%. There was no effect at all on demand. Bookings were confirmed as quickly as usual.
Using the PED simple calculation this was:
0 = 0
12
In fact, we didn’t need to do the calculation, it was clear the demand was perfectly inelastic.
2. The peak booking times during the summer are the six week school summer holiday break. All competitors charge a premium for this time. Prices were again increased by 12% but resulted in a 10% drop in demand.
Using the PED simple calculation this was:
-10 = -0.83
12
Although there was a slight drop in bookings, profits were maintained and growth can continue. There is relative inelasticity.
3. For the two week Easter holidays, Cosy Cottages also increased the price by 12% but bookings also fell by 12%.
Using the PED simple calculation this was:
-12 = -1
12
We didn’t need to do the calculation as we already knew that the price increase resulted in a drop in demand of equal amount. Demand at Easter is sensitive to the price change. There is unit elasticity
4. October and November had always proved difficult months to secure bookings and as property owners need to keep their cottages heated to maintain them, they prefer to have them booked to get some revenue. A decision was made to drop prices by 25% but this resulted in a 30% increase in demand.
Using the PED simple calculation this was:
30 = -1.2
-25
There was a sensitivity to the change and there is the opportunity to maintain positive growth at this price level.
EXERCISE – Do this in your own time.
A well known car manufacturer notices a drop in sales of their popular family car. The competitors are offering various inducements such as five years interest free credit and seven year warranties that they are not able to offer. They decide to drop the price of the car from £18,750 to £17,500. They see a 3% increase in sales. What is the price elasticity of demand and what does this tell you?
A well known technology company see a drop in demand for their tablets after the press release information about their upgraded product due to come to market in about three months. As a result the company drop the price of the tablet from £399 to £350 to clear stock. Demand increases by 13%. What is the price elasticity of demand and what does this tell you?