Elasticity of Demand A2 Business Studies Unit 4 - Marketing

Objectives

Introduction The demand for goods and services is determined by a wide variety of factors The demand for the new Fiat Punto will be influenced by: – The price – The price of similar cars – The amount spent on advertising – Seasonality – And many other factors

Introduction (2) Elasticity measures how the demand for a product changes in response to a variable such as price or income. Each variable that affects demand has its own relative elasticity – A price rise is likely to reduce demand – An increase in advertising is likely to increase demand The elasticties most commonly used business are Price & Income

Price Elasticity of Demand In the short term, the most important factor affecting demand is PRICE If Coca-Cola increased the price of Coke, sales would almost certainly fall – Some consumers would switch to a different brand – Some would buy Coke less frequently If Coca-cola increased their price by 10%, and demand only fell 1%, they would benefit hugely from the price hike

Price Elasticity of Demand (2) How much will demand fall when price increases? This can be answered by calculating the price elasticity of demand for Coca-cola PEoD is not about whether the demand changes with price, but the degree to which it changes

Price Elasticity of Demand (3) Price elasticity can be calculated using the following formula: Price elasticity = % Change in quantity demanded % Change in price If a 10% price increase led to a 20% fall in demand, the price elasticity would be: -20% 10% = -2

Price Elasticity of Demand (4) This demonstrates that for every 1% price increase, demand will fall by 2% -20% 10% = -2 Some product are more price sensitive than others Example 1 Example 2

Using price elasticity information There are two main purposes for price elasticity: – Sales forecasting – Pricing strategy

Forecasting sales A firm considering a price rise will want to know the effect the price change is likely to have on demand The Sun newspaper cut its price by 20% (from 25p to 20p, and sale rose by 16% (which was up to 4million copies per day – What was it ’ s price elasticity? 16% -20% = -0.8 Can the higher demand levels be met?

Pricing strategy There are many factors that determine the demand and profitability of a product that are beyond control However, the price a firm charges is within its control Price elasticity information can be used in conjunction with the firm ’ s own information about costs, to forecast the effect of price change on profit

Pricing Strategy Example A second hand car dealer sells 60 cars each year. Each car costs around £ 2,000 to buy Annual overheads are £ 18,000 He charges customers £ 2,500 per car How much profit does he make per year?

Pricing Strategy Example 2 Total revenue = £ 2,500 x 60 = £ 150,000 Total Cost = £ 18,000 + (2,000 x 60) = £ 138,000 Total Profit = £ 150,000 - £ 138,000 = £ 12,000

Pricing Strategy Example (3) From past experience, the salesman believes the price elasticity of his cars is approximately – 0.75 He is thinking about increasing his prices to £ 3,000 per car, and increase of 20% How would this impact profit? % Change in demand = 20% x – 0.75 = -15%

Pricing Strategy Example (4) A 15% fall in demand on current sales equates to a fall of 9 cars per year: = 9 cars per year15 x On the basis of these new figures, the new annual profit would be: Total revenue = £ 3,000 x 51 = £ 153,000 Total cost= £ 18,000 + (51x £ 2,000) = £ 138,000 New Profit = £ 153,000 – £ 138,000 = £ 15,000

Pricing Strategy Example (5) This equates to an increase in profit of 175% £33,000 - £12,000 £12,000 = 175% 100x These calculations are all based on two assumptions: – The price elasticity of – 0.75 was correct – Other factors that could affect demand remain unchanged