Price Elasticity of Demand and the Factors That Influence Price

A bakery in Abuja cuts the price of its loaf from ₦500 to ₦450 and sells 15% more loaves. A pharmacy raises the price of a prescription drug by 15% and loses only a few customers. The same price move can raise revenue in one business and lower it in another. The difference is price elasticity of demand, which measures how strongly buyers react to a change in price.

A manager who knows it can tell whether a price cut will pay for itself, whether a rise will be accepted, and how far the market will bear. This topic explains how to calculate elasticity, what elastic, inelastic and unit elastic demand mean for revenue and contribution, what makes demand more or less elastic, how elasticity connects to cost-plus pricing, and the other factors that influence a price.

It builds on the earlier topic on slack and shadow prices, where the value of a scarce resource set a ceiling on what to pay. The next topic covers demand and cost functions and the profit-maximising price.

Price elasticity of demand

The measure

PED = % change in quantity demanded ÷ % change in price. Each percentage change is the change divided by the original figure, unless the question tells you to use the average. The result is negative because demand and price move in opposite directions, and in practice the minus sign is dropped and the figure is called the elasticity of 1.5, 0.4 and so on.

• Elastic demand (above 1). The percentage change in quantity is greater than the percentage change in price. A price cut raises revenue; a price rise lowers it.
• Inelastic demand (below 1). Quantity changes by a smaller percentage than price. A price cut lowers revenue; a price rise raises it.
• Unit elastic demand (exactly 1). The percentage changes are equal and revenue stays the same.
• Perfectly inelastic (zero) means quantity does not respond at all; perfectly elastic (infinite) means that buyers leave completely for any rise above the market price.

What makes demand more elastic

• Substitutes. The more close substitutes, the more elastic. Rival brands of the same soft drink make each brand’s demand elastic.
• Necessity or luxury. Necessities such as basic food and medicine are inelastic; luxuries are elastic.
• Share of income. A large item, such as a car, draws more reaction to a price change than a small one such as salt.
• Time. Demand is more elastic in the long run, because buyers find alternatives.
• Definition of the market. The demand for “food” is inelastic; the demand for one brand of biscuits is elastic.
• Loyalty and switching costs. A strong brand or the cost of changing supplier makes demand less elastic.

Cross and income elasticity

Cross elasticity measures how demand for one product responds to a change in the price of another: positive for substitutes (a higher price of one brand raises demand for another), negative for complements. Income elasticity measures the response of demand to a change in income: positive for normal goods, above 1 for luxuries, negative for inferior goods.

Using elasticity in pricing, and other factors that influence price

Revenue is not profit

Elasticity tells you the effect on revenue. The effect on contribution also depends on the variable cost. If demand is elastic and the company cuts its price, revenue rises, but the contribution on each unit falls. If the volume gain is not large enough to offset the lower unit contribution, total contribution falls.

A price cut should therefore be tested on contribution: new contribution per unit × new volume against the old figure. A price rise with inelastic demand usually raises contribution twice: more revenue and, because volume falls, lower variable cost.

Elasticity and cost-plus pricing

A company that adds a standard mark-up to cost ignores elasticity. If demand for a product is elastic, a high mark-up loses volume and a lower one may earn more; if demand is inelastic, a higher mark-up is likely to be accepted.

When a change in costing method, such as a move to activity based costing, changes product costs, a cost-plus price changes too, and elasticity shows what happens to sales. A product whose cost, and so price, rises with elastic demand loses volume; a product whose price falls with elastic demand gains it; and a product with inelastic demand keeps its volume whichever way the price moves.

Other factors that influence price

• Costs. A price must cover full cost in the long run, and variable cost in the short run. Cost sets a floor, not the price.
• Demand and elasticity. What customers will pay and how they react.
• Competition. The number of rivals, their prices and the chance of retaliation.
• Objectives. Profit maximisation, market share, survival, return on investment or image.
• Product life cycle. Skimming at launch, falling prices in growth, steady in maturity.
• Market and customer. Segments that value the product differently allow different prices.
• Product range. Complements and substitutes in the company’s own range.
• Legal and economic setting. Price controls, regulation, inflation and exchange rates.

Price makers, supply and demand, and the wider influences on the price level

A company’s freedom to choose a price depends on its size relative to its market. A firm that dominates its market is a price maker: it can set the price, though it faces a downward-sloping demand curve and loses sales if it raises it, and it may price low to defend its share.

A firm that does not dominate is a price taker: it must sell at about the market price, because a lower price makes a loss and a higher one sends customers to rivals. In the short term any firm may use temporary price cuts or a low price for a special contract to win a new customer.

For a market as a whole, demand is the quantity wanted at each price (higher price, lower demand) and supply is the quantity suppliers will offer (higher price, more supply). The equilibrium price is where they meet. When demand suddenly outruns capacity, as with oil, prices and margins can rise sharply until capacity catches up.

In a highly competitive market firms price against their rivals and use short-term tactics such as discounts, volume rebates and longer credit.

• Cost. In the long run the price must exceed average cost. Cost is moved by suppliers’ prices, inflation, exchange rates, wage rates and quality; a firm that cuts cost can cut price and compete harder.
• Income of customers. Rising incomes raise demand and tend to raise prices; a recession lowers demand and may lower prices.
• Product life cycle. At introduction a new product can be priced by skimming or penetration. In growth, competitors enter and prices fall, though margins stay fairly high, and niches or differentiation can protect them. In maturity the product may become a commodity and firms compete on price for share. In decline firms leave, prices stay low, unless the product gains rarity value.
• Quality. Quality can be real (better materials, reliability) or perceived (a brand), and customers will pay more for either.
• Substitutes and complements. A high price pushes buyers to substitutes; complements can be priced together. Fashion, advertising and public relations can also raise demand and allow a higher price.

Two further points on elasticity. The same product can be elastic at one price and inelastic at another. And if one company cuts its price when demand is elastic, rivals may follow and start a price war, after which all sellers are usually worse off; so firms try to make demand less elastic by non-price means such as better quality and service, advertising and promotion.

Calculating elasticity and its effects

1. % change in price. (New price − old price) ÷ old price × 100.
2. % change in quantity. (New quantity − old quantity) ÷ old quantity × 100.
3. PED. % change in quantity ÷ % change in price; ignore the sign for the size, and state elastic, inelastic or unit.
4. Revenue. Price × quantity, before and after.
5. Contribution. (Price − variable cost) × quantity, before and after.

Money is in naira and each answer is rounded once, at the end.

Worked examples

1. Price change.
   (450 − 500) ÷ 500 = −10%.
   Quantity change. (23,000 − 20,000) ÷ 20,000 = +15%.
2. PED.
   15 ÷ 10 = 1.50: elastic.
3. Revenue.
   Before 500 × 20,000 = ₦10,000,000.
   After 450 × 23,000 = ₦10,350,000, up ₦350,000.
4. Contribution.
   Before (500 − 300) × 20,000 = ₦4,000,000.
   After (450 − 300) × 23,000 = ₦3,450,000, a fall of ₦550,000.
5. Comment. Demand is elastic and revenue rises, but contribution falls, because each loaf now contributes ₦50 less. The price cut raises sales and lowers profit. It would pay only if there are other benefits, such as spare capacity that is otherwise idle or customers who will buy other products.

1. Price change. +15%.
   Quantity change. (47,000 − 50,000) ÷ 50,000 = −6%.
2. PED.
   6 ÷ 15 = 0.40: inelastic.
3. Revenue.
   Before 200 × 50,000 = ₦10,000,000.
   After 230 × 47,000 = ₦10,810,000.
4. Contribution.
   Before (200 − 120) × 50,000 = ₦4,000,000.
   After (230 − 120) × 47,000 = ₦5,170,000, up ₦1,170,000.
5. Comment. With inelastic demand the rise is clearly profitable. The pharmacy should consider whether regulation, public reaction or a rival entering the market limits how far it can go.

Expect variants: a question that gives the elasticity and asks for the new volume, midpoint elasticity, or elasticity used with cost-plus prices for several products.

Common mistakes

• Dividing the wrong way round. Quantity change goes on top.
• Using the new figure as the base. Use the original, unless told otherwise.
• Stopping at revenue. Check contribution, because variable cost matters.
• Saying a rise always lowers revenue. With inelastic demand it raises it.
• Ignoring the time dimension. Demand is more elastic in the long run.
• Listing factors without applying them to the product in the question.

Quick revision

• PED = % change in quantity ÷ % change in price. Above 1 elastic; below 1 inelastic; 1 unit.
• Elastic: price cut raises revenue. Inelastic: price rise raises revenue.
• More elastic with substitutes, luxuries, large share of income, longer time, narrow market.
• Check contribution as well as revenue. Cost-plus pricing ignores elasticity.
• Other factors: costs, competition, objectives, life cycle, customers, law.

How the marks are earned

• Calculate: both percentage changes, the elasticity and its description.
• Evaluate: revenue and contribution before and after, with a recommendation.
• Discuss: the factors, each with a reason and an example.

Practice questions

These are original questions, written in the style of the Skills examination. Work each one before you open the answer.

Recall check: multiple choice

Section B style: written questions

Model answers

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