Elasticity of Demand - Research Paper Example

?ELASTI OF DEMAND The sales of a product depend upon the demand for the product. There are several factors which influence the demand for the products. Price being the primary determinant, other factors includes disposable income level of the buyers for the particular product, prices of the substitute products and future trends in prices and changes in tastes and preferences of the consumers. The supply side constraints may push up the prices. Similarly elasticity of demand for the product acts as a limiting factor to sales. However, in real life situations, the elasticity of demand is governed by diverse factors such as branding, cross selling, value addition, creating new uses for the products, multi-level marketing, direct marketing, discount sales and online marketing. Most of the strategies are designed to overcome the ‘elasticity’ factor. Availability of credit being the important element in the scheme, the seller’s ability to arrange finance for the consumers to buy their product plays an important role with the highly developed financial services sector to-day. Exchange rates and interest rates are the important considerations while buying on credit. The supply side constraints on account of events such as monsoon failure, industrial unrest and natural disasters and the regulation of supply through collusion under monopolistic conditions vitiate the market conditions. The pharmaceutical companies taking advantage of the protection given under patents fix the prices at exorbitant levels for their products, the demand for which are inelastic in nature. This paper seeks to analyze elasticity of demand from a comprehensive perspective. Key words: Elasticity, Demand, Price, Branding & Marketing. ELASTICITY OF DEMAND Price Elasticity of Demand Law of demand states that other things being equal, the quantity demanded extends with a fall in price and contracts with a rise in price. (Mandal, 2007, p. 73) Under the dynamic market conditions, there are several factors which may influence the demand irrespective of change in price. Apart from the accepted exceptions such as prestige goods consumed by rich people which forms the basis for conspicuous consumption and speculative goods like shares where the demand will be more when the prices rise and demand for hoarding purposes due to scarcity or hyper inflation, technically the law of demand does not apply to necessaries of life where the demand is said to be inelastic. Robert Giffen discovery could be the real exception in this case. He found that poor people will demand more of inferior goods if their prices rise. They reduce their expenditure on superior goods to conserve their little income to spend more on inferior goods. The quantum of change is explained by elasticity of demand or rate of change. The ratio of a relative change in quantity to a relative change in price is called as elasticity. Mankiw states that economists compute the price elasticity of demand as the percentage change in the quantity demanded divided by the percentage change in price. That is, Percentage change in quantity demanded Price elasticity of demand = ----------------------------------------------------- Percentage change in price (2012, p.91) The concept of price elasticity of demand is the primary force behind the innovations that we have witnessed during the last few decades. For instance, rising cost of fuel has forced the car companies to manufacture fuel efficient cars. The rise in fuel cost has been compensated by the increased mileage provided by the cars. (Annexure I) Hughes, Knittel, & Sperling concluded in their study that “results suggest that technologies and policies for improving vehicle fuel economy may be increasingly important in reducing U.S. gasoline consumption." (2006)The same concept leads the car manufacturers to concentrate their attention on electric cars. The depleting natural resources and their increasing cost make the industrialists to concentrate on alternative renewable energy sources. The price elasticity of demand comes into play in all facets of human life and business, as we cannot sustain economic growth with ever increasing inflation. Factors influencing Price Elasticity of Demand The demand for necessaries is inelastic and for comforts it is elastic. When demand is inelastic, can the seller make huge profits by selling at the higher price?  Market segmentation comes into play, which target different categories of consumers at different prices. Actually, overall quantity of basic commodity demanded by the buyers may not differ significantly. But, their shift to the next lower category of a brand will affect the sales differently depending upon the income level of the buyers. Variants of soap or washing powder brands at various prices from the house of Unilever are good examples of this case. Price elasticity of a commodity will not be the same if the same is sold under brand name. This could be observed in marketing of the agricultural produces under different brand names. This is due to the image of the brand, brand loyalty and the implied assurance about the quality. The financial service sector’s growth and sophisticated methods of financing and the debt culture ingrained in the society has considerably altered the ‘elasticity’ factor, since the ability of the seller to make arrangements with the financier for and on behalf of the buyer is an important factor to be reckoned with. For instance, sale of cars or houses is mostly done on hire purchase basis to be settled by the buyer on EMIs. In fact, subprime crisis is the product of reckless financing. Price elasticity of demand in such cases would be very difficult to workout. Also, Brand extensions undertaken with variations in quality, composition of the ingredients, size of the pack to attract different classes of customers are not susceptible to price elasticity of demand. For instance, shampoos with various properties for various types of hair or their sale in sachets for one time use, health drinks made available separately for mothers and children along with the regular variant, diet coke in the case of beverages and food items separately marketed for heart or sugar patients fall in this category. Consumer preferences and brand loyalty are effectively used by the companies for marketing purposes. Value addition plays an important role. The different formulas adopted for adding value results into an array of final products, especially in the case of food products with various permutations and combinations of several ingredients as in the case of KFC or McDonald’s. Here, unique taste is the platform for sale. Taste and certain other features are the basis for customer loyalty. Price elasticity of demand is very difficult to determine in such cases. Patent protection enables the international pharmaceutical companies to fix their prices exorbitantly. As there is demand for their products from the patients afflicted by various diseases like Aids and Cancer, these companies are in a position to fix high prices and regulate the supplies. It is in no way better than the regulation of supply through collusion under monopolistic conditions. Price elasticity of demand does not exist under this setup, and their profitability is simply maintained by increasing the prices. Creating demand for the existing product is a strategy to make the demand inelastic. Ice cream is a good example in this respect. The manufacturers have promoted the production for consumption even in winter season stating that “Ice cream is a healthy food product for all seasons.” This promotion drive has been considerably successful in creating continuous demand for the ice cream throughout the year. Even the common salt which is used to be an example in text books for inelastic demand is marketed under different brand names with small variation in the basic properties - for example ‘iodized salt’. Rise in food prices to-day is partly attributed to the decreased area under cultivation of food crops. The lands previously used to cultivate food crops are now being used for cultivating Jatropha for producing bio-diesel. Similarly blending of ethanol with gasoline has encouraged the farmers to cultivate sugar cane instead of food crops. The inelastic nature of the demand for food suggests that the prices are expected to rise up to a point where cultivating food crops become profitable compared to sugar cane. Roberts & Schlenker state, “The current US ethanol mandate requires that about 5 percent of world caloric production from corn, wheat, rice, and soybeans be used for ethanol generation. As a result, world food prices are predicted to increase by about 30 percent and global consumer surplus from food consumption is predicted to decrease by 155 billion dollars annually.” (2010) On the other hand, technological innovations in the field of agriculture, say new hybrid varieties, could increase the supply of food grains, pulses, vegetables and fruits. Mankiw states, “Regardless of whether the price starts off too high or too low, the activities of the many buyers and sellers automatically push the market price toward the equilibrium price”. (2012, p. 78) Various strategies such as multi-level marketing, direct marketing, discount sales and online marketing followed by the sellers try to overcome the issue of price elasticity of demand in the business. For instance, the business model of Amway is a combination of multi-level and direct marketing. Harvard Business School’s ‘Leadership’ writes about the Amway strategy: "...accomplished their success through the use of an elaborate pyramid-like distribution system in which independent distributors of Amway products received a percentage of the merchandise they sold and also a percentage of the merchandise sold by recruited distributors." Prices of Related Goods and Demand The prices of two commodities could be positively or negatively correlated. Rise in demand for coffee may lead to rise in demand for tea. In this case, they are substitutes for each other. Increase in demand for cars may result into increase in demand for tires. The demand for tire is complementary in nature. Increase in sale of cars and motor cycles caused the increase in demand for gasoline and diesel. This is also called as cross elasticity of demand. Practical importance of Price Elasticity of Demand The change in price is going to affect the volume due to change in demand patterns. Analysis of consumption pattern will enable the seller to determine the price for his product. He is in a position to work out the volumes he could sell at different prices. The seller decides upon the brand variants for the product at different prices with changes in the smell, color, package or other attributes to suit the tastes and purses of the different classes of buyers. The concept of elasticity of demand makes marginal cost analysis useful and realistic. The concept of elasticity of demand plays an important role in international trade in price fixation. The taxation and economic policies of the government takes into account the elasticity of demand for any commodity to forecast the impact of its policies. Andreyeva et al. mentioned in their research report that (2010, p.220) “The effects of cigarette taxes on smoking prevalence demonstrate the signi?cant potential of tax policies to modify purchasing behavior”. In the cases of subsidies given by the government to various sectors such as agriculture and energy or the policies of the government in the case of defense procurement, the effect of price on demand can’t be worked out meaningfully. Relationship between Price and Revenue Elasticity of Demand Bergtold et al. state “Economic analyses of issues relating to firm or industry competitiveness and the impact of public policy upon the performance of the food system depend critically upon the existence of reliable and disaggregate elasticity of demand estimates.” (2004, p.276) Marginal revenue at any level of output is the revenue which would be earned by selling additional unit of a product. We can establish a relationship between revenue and price elasticity of demand. This concept would be useful in formulation of price-output strategies by the companies. If the market is not perfect, as is the case usually, due to several factors at interaction, the rate of fall in marginal revenue will not be in tune with elasticity of demand. If the company can reasonably predict the elasticity of demand, it can calculate marginal revenue at different prices. Income Elasticity of Demand Income level of the buyer is closely related to demand. The consumers buy different quantities of commodities or services at different levels of income. Obviously, the buyer would try to postpone buying of consumer durable goods when their income level declines. The propensity to consume i.e., Total expenditure/Total income will vary with marginal propensity to consume i.e., Additional expenditure/Additional income, and it is easier to increase the consumption at the time prosperity than reducing the standard of living at the time of recession. Consumption will be at higher proportion of the income during recession. Income elasticity of demand can be stated as a formula, Proportion of change in quantity demanded Income elasticity of demand: = ---------------------------------------------------- Proportionate change in income When the income elasticity of demand will be less than ‘1’ it signifies that the consumer spends less than the increase in income. This is mainly because the expenditure on necessaries may not increase with the same proportion. Business decisions are based on income elasticity of demand. For instance, if the income elasticity is more than ‘1’ the sales will increase faster than the general economic growth. When economic growth is negative, the sale will be slower. But, it could be less or more slow than recession depending upon the income elasticity of demand. Advertising and Demand The companies depend more and more on advertisements in media to promote their products. Caglar et al. state, “When the economic outlook is sluggish, effective promotions are critical, especially in the fiercely competitive and spending-constrained lower- to middle-income market. These frugal consumers are highly sensitive to pricing and frequently use coupons.” (2012). Advertisement has become the major expenditure item in the financial statements of the companies. This is due to the basic relationship between the advertisements and sales. Other things such as price, brand value and quality remaining the same, there is a direct relationship between advertisement and the volume. Increase in spending on advertisements leads to increase in sale. However, the effectiveness of the advertisements beyond certain point is less than proportionate increase in sales. The formula for advertising elasticity of demand is given below: Proportionate change in sales Advertising elasticity of demand = ------------------------------------------------------------- Proportionate change in advertisement expenditure The advertisement elasticity of demand would be affected by a number of factors which include the stage of the market development, reactions to the competitors’ advertisements, quality of the advertisement, the media used for advertisement and its usage cost and the strengths and weaknesses observed in the other determinants of demand. References Andreyeva, T., Long M. W. & Brownell, K. D. (2010). The Impact of Food Prices on Consumption: A Systematic Review of Research on the Price Elasticity of Demand for Food. American Journal of Public Health. February 2010, Vol 100, No. 2. Retrieved from http://www.yaleruddcenter.org/resources/upload/docs/what/economics/FoodPricesElasticity_AJPH_2.10.pdf Bergtold, J., Akobundu, E. & Peterson, E. B. (2004). The FAST Method: Estimating Unconditional Demand Elasticities for Processed Foods in the Presence of Fixed Effects, Journal of Agricultural and Resource Economics 29(2):276-295. Retrieved from http://ageconsearch.umn.edu/bitstream/31108/1/29020276.pdf Caglar, D., Hodson, N., Martin, K. & Tau, M. (2012). Retail: Become Better Curators. Strategy+Business, Feb, 17, 2012 Spring 2012 / Issue 66, Retrieved from http://www.strategy-business.com/article/12104j Leadership. Harvard Business School. Amway Corporation. Retrieved from http://www.hbs.edu/leadership/database/leaders/richard_m_devos.html Hughes, J. E., Knittel, C. R. & Sperling, D. (2006). EVIDENCE OF A SHIFT IN THE SHORT-RUN PRICE ELASTICITY OF GASOLINE DEMAND. Working Paper 12530. NATIONAL BUREAU OF ECONOMIC RESEARCH. Retrieved from http://www.nber.org/papers/w12530 Mandal, R. K. (2007). Microeconomic Theory. Atlantic, New Delhi. Mankiw, N. G. (2012) Principles of Economics, Sixth edition. South-Western Cengage Learning, Mason, USA. ISBN13:978-0-538-45305-2. Roberts, M. J. & Schlenker, W. (2010) IDENTIFYING SUPPLY AND DEMAND ELASTICITIES OF AGRICULTURAL COMMODITIES: IMPLICATIONS FOR THE US ETHANOL MANDATE. Working Paper 15921, NATIONAL BUREAU OF ECONOMIC RESEARCH. Retrieved from http://www.nber.org/papers/w15921 Annexure I Mileage Rate History July 1, 1980 through 2012 (O.S. 74 §500.4) July 1, 1980. . . . . . . . . . . . . . . . . . . . . . . . . . 22.04 per mile July 1, 1985. . . . . . . . . . . . . . . . . . . . . . . . . . 20.54 per mile November 1, 1989. . . . . . . . . . . . . . . . . . . . . 24.04 per mile November 1, 1995. . . . . . . . . . . . . . . . . . . . . 28.04 per mile July 1, 1997. . . . . . . . . . . . . . . . . . . . . . . . . . 31.54 per mile January1, 1998.. . . . . . . . . . . . . . . . . . . . . . . 32.54 per mile April 1, 1999. . . . . . . . . . . . . . . . . . . . . . . . . . 31.04 per mile January 1, 2000. . . . . . . . . . . . . . . . . . . . . . . 32.54 per mile January 1, 2001. . . . . . . . . . . . . . . . . . . . . . . 34.54 per mile January 1, 2002. . . . . . . . . . . . . . . . . . . . . . . 36.54 per mile January 1, 2003. . . . . . . . . . . . . . . . . . . . . . . 36.04 per mile January 1, 2004. . . . . . . . . . . . . . . . . . . . . . . 37.54 per mile January 1, 2005. . . . . . . . . . . . . . . . . . . . . . . 40.54 per mile September 1, 2005.. . . . . . . . . . . . . . . . . . . . 48.54 per mile January 1, 2006. . . . . . . . . . . . . . . . . . . . . . . 44.54 per mile January 1, 2007. . . . . . . . . . . . . . . . . . . . . . . 48.54 per mile January 1, 2008. . . . . . . . . . . . . . . . . . . . . . . 50.54 per mile July 1, 2008. . . . . . . . . . . . . . . . . . . . . . . . . . 58.54 per mile January 1, 2009. . . . . . . . . . . . . . . . . . . . . . . 55.04 per mile January 1, 2010. . . . . . . . . . . . . . . . . . . . . . . 50.04 per mile January 1, 2011. . . . . . . . . . . . . . . . . . . . . . . 51.04 per mile July 1, 2011. . . . . . . . . . . . . . . . . . . . . . . . . . 55.54 per mile January 1, 2012. . . . . . . . . . . . . . . . . . . . . . . 55.54 per mile http://www.owcc.state.ok.us/PDF/Mileage%20Rate%20History%20Chart.pdf Read More