The way things are priced
Elasticity determines how flexible prices are. If a product is highly elastic, a company will find it difficult to increase the price because customers can go elsewhere, either to competitors or to purchasing entirely different goods. If it is inelastic, sales are less dependent on price – perhaps there are few suppliers and the product is essential.
Can you charge more for a product? Price elasticity answers that simple question, indicating the price you can set, which markets to enter and the levels of justifiable investment.
• If your product is highly sensitive to price changes, focus on reducing costs or achieving market dominance by creating a stronger brand. Aim to create artificial scarcity or desirability to lower the price elasticity for your product. Alternatively, focus on reducing costs to raise profit margins.
• If your product is less sensitive to price, you can increase profit through higher prices because people have fewer options. With cost reductions, price inelasticity is a recipe for supra-normal profits. Theoretically – brand issues and company longevity aside – the ultimate goal in a free market is monopolistic profits. Here, high price inelasticity is ideal – enter quickly, scoop profits and switch lanes when others enter the market.
Because free markets are free, companies can never be certain about how secure their positions are. Companies that once enjoyed price inelasticity and now rest on their laurels may often find themselves on the wrong side of enterprising, innovative, disruptive start-ups with new technologies and better products. Also, when price inelasticity becomes too high for an essential product provided through few companies (an oligopoly), governments often step in and regulate prices.
Veblen goods
Usually, when prices rise, demand falls. However, with ‘Veblen goods’ (goods with snob value), demand rises when price increases. Here, perception is everything: customers value products because they are expensive.
Price elasticity in detail
Elasticity is calculated as the percentage change in demand divided by the percentage change in price. The negative or positive sign in the answer only indicates the relationship between demand and price. Except in the case of Veblen goods, the sign is usually negative because price rises reduce demand, so the negative sign is usually ignored. It is the extent of the change that indicates price elasticity:
• If the percentage change in demand is less than the change in price, demand is relatively inelastic. (See graph 1; the answer is less than one.)
• If the percentage change in demand is greater than the change in price, demand is relatively elastic. (See graph 2; the answer is greater than one.)
The area of the rectangle under each price/quantity combination reveals the impact of price levels on revenue.