The first law of economics states that there is an inverse relationship between the demand for a product and its price. However, this is too general a statement. It is equally important for economists to measure the degree of consumer reaction to a changing price, because in different markets, with the same change in the value of the goods, the amount that the consumer wants to purchase varies differently.
The concept of price elasticity
To measure the sensitivity of demand or the reaction of changes in the magnitude of demand for changes in the value of the goods, an indicator called “price elasticity” is used. In other words, elasticity is the ratio of the percent change in demand to the percent change in the value of the goods.
The quantitative measure is called the "coefficient of elasticity", which makes it clear how many percent the demand will change after the price of the goods changes by one percent. Due to the presence of an inverse relationship between the value of a product and the value of demand for it, the coefficient of elasticity always assumes a value less than zero. However, for comparison purposes, economists neglect the minus using the absolute value of the coefficient.
Interpretation of the coefficient of elasticity
The value that price elasticity acquires in each individual case allows economists to judge the degree of elasticity of demand for the product in question. Depending on this, the following product groups are distinguished:
- Goods for which demand is elastic. Their elasticity coefficient takes on a value greater than unity. In this case, there is a sensitive reaction of buyers to changes in the value of the goods, as a result of which demand changes to a greater extent than value. In this situation, a change in the value of the goods entails a change in the total revenue from its sale in the opposite direction.
- Inelastic goods . The price elasticity calculated for them takes a value of less than one. In the case of a decrease in the price of goods with inelastic demand, an increase in demand is not enough to compensate for the fallen revenue, as a result, following the price, sales revenue falls.
- Goods whose price elasticity is equal to one. In this case, the price and magnitude of demand change the same way, as a result, neither a decrease nor an increase in value changes the sales proceeds.
Elasticity Calculation Methods
The elasticity coefficient can be calculated in two ways:
- When calculating the arc elasticity, two points are taken into account, between which the elasticity value is measured.
- The point price elasticity of demand represents a change in demand with an infinitely small change in price. The fact is that the demand graph is convex. All this leads to the fact that price elasticity at each point in the chart takes different values.
Determining price elasticity sometimes causes difficulties in understanding, but not a single company can do without it. In the process of making decisions about pricing policies, organizations should be guided by the elasticity of demand for goods, so that a change in revenue following a change in value is not unexpected.