Pricing and Price elasticity of demand
Pricing, is the act of setting a price for a product you buy or a service that you avail. The money charged for a product or service is the price. The cost is the amount spent by a business for making the product. Businesses take into account the cost of production when setting the price to ensure that it is making profit. The price a business charges for its product or service is one of the most important decisions the upper management has to take.
The business organizations take into account the price elasticity of demand while fixing the price of their products/services. Price Elasticity of Demand (PED) is the responsiveness of quantity demanded to a change in price. The demand for a product can be elastic or inelastic, depending on the rate of change in the demand with respect to the change in the price. A change in the price of a product could affect a change in the quantity demanded based on the co-efficient of price elasticity.
I have explained below the price elasticity of demand taking commodities as an example.
Elasticity is the responsiveness. It works on cause and effect. Elasticity is affected if there is a change in the cause. If there is a 1% change in the cause, elasticity will tell how large is the effect to the 1%change in cause.
Price is the cause and demand is the effect. As per the law of demand, when the price goes up the demand for the quantity goes down. For e.g. let us assume that the price elasticity of demand for electricity is -3. This means that the % change in the demand for electricity goes down by -3% for an increase in the price by 1%. In this example, there is an inverse relationship between price and demand for electricity which means that a decrease in the price would cause an increase in the consumption of electricity.
Price elasticity of demand is always negative or Zero, based on the records for the past several years. Most often the negative sign is dropped only for price elasticity of demand. Sometimes people buy less when the demand goes up for certain products. For certain others, they do not respond at all. If the price elasticity is zero then it is perfectly inelastic or unresponsive.
For e.g. If the Price Elasticity of salt = 0, which means that if the price goes up by 1%, then change in the quantity demanded is Zero (i.e.) there is no change in demand. It is also true with some of the essential medicines that people use. They do not buy less or more because of the variation in price.
Why are some products elastic or inelastic?
Some products are inelastic because they might be very inexpensive. Increase in the price of the product does not bother the consumer. They might not notice the increase in price. Price elasticity of demand depends on how large a share of your budget that product takes. Example for price elasticity of salt illustrates this.
Even for some of the essential daily medicine for patients, the elasticity might be zero if there are no other equivalent substitutes for it. You will still consume the same quantity irrespective of the price change unless the price change is very high that you cannot afford it.
For perfectly Inelastic products E = 0. As can be seen in the figure below, irrespective of the price change the demand remains a constant.
Some goods can be very inelastic for e.g. elasticity of green chilies could be 0.1. Either they might not occupy a huge portion of your budget or you might not want to substitute it with a red chilies or chilly powder. The figure below is an example of a very inelastic product.
If the change in effect is equal to the change in the cause it is unitary elastic.
Sometimes in the long run a product becomes more elastic. For e.g. if electricity becomes more costly, in the short run the elasticity could be low, but in the long run elasticity could be high. People might switch to substitutes like solar power. Similarly, the elasticity of demand for cigarettes could be low in short run and could become high in the long run. The government increased the GST on cigarettes for regulating its consumption and also for increasing the tax revenue.
Recently the cost of airline travel had increased. This is an example of increase in price elasticity. It occupies a huge portion of your budget. So, you might cut down on foreign travels and also use substitutes like going to places nearby.
Similarly, the recent increase in the price of gold and hence gold jewelry is extremely price elastic.
The following figure shows extreme price elasticity
Theoretically elasticity can be infinite, for a tiny change in price. For an extremely small change in price there could be 100% cut in the purchase of a product. If you have 2 products that are perfect substitutes for each other the elasticity could be infinite. For. E.g. A packet of bread from two different brands of the same quality. If the price of the brand from one brand is slightly increased, it could result in 100% loss.
