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One of the topics you learned about economics in this first module is price elasticity of demand. This is an important topic to you as a new entrepreneur because it will help you to price your products appropriately. This is because a change in price affects the demand of the product. Some companies assign a lower cost to a new product for a short period of time and then bump up the price when the introductory period is over, which impacts demand for the product.
In a 2- to 3-page paper, explain the economic concept of elasticity of demand. In addition, answer the following four questions as they pertain to your business venture.
My business venture is the McDonalds Franchise.
What will happen to demand for the new product when the price is raised by 5%?
Is there an impact on the demand for your product if the introductory period is too short?
How large a reduction in price of a product is required to increase sales by 25 percent?
Besides elasticity of demand, what other economic and noneconomic forces might occur over time in the global market’s reception to your new product?
Price Elasticity of Demand
Elasticity of demand explains buyer behavior in response to price changes. This is a concern that you will run into often in business. Brand managers want to know how much less consumers will buy if they hike the price of a product by 5%. Production managers want to know how price changes will affect their labor and materials requirements on the assembly line. Marketers want to know how effective a price reduction will be at attracting new buyers. All of these concerns can be addressed by analyzing the sensitivity of demand for a product in the face of a price change.
Knowing the price elasticity of demand also helps in making decisions about pricing policy. It should be clear that if demand is elastic, revenue will increase by reducing the price, but if demand is inelastic, revenue will be gained by raising price. Firms attempt to reduce the consumer’s perception of elasticity through advertising and other promotional activities.
Products with Elastic and Inelastic Demand
It is helpful to know the factors that can affect price elasticity for a given product:
Substitutes. If there are substitutes for the product, a consumer may just switch products in response to a price change. The more the available substitutes, the greater the elasticity. When thinking about substitutes, it is good to think broadly. For example, if the price of steak goes up, consumers may not only switch to hamburger, but they may switch away from beef altogether and eat more chicken—or macaroni and cheese. Advertising is often geared toward creating an image of “uniqueness” of a product and reducing the number of perceived substitutes.
Luxury. If a good or service is seen as a “splurge” item, it tends to be more elastic. Again, the goal of advertising is to create a feeling that the consumer “must have” the product. Note, however, that this can depend on the income level of the consumer. For the very wealthy, luxury items may be viewed as necessities. Since they have the income to pay higher prices, these luxury items can be relatively inelastic.
Habit. Habitually demanded products are less elastic. Think of how cigarette smokers continue to smoke in spite of rising prices.
Proportion of income. The less expensive the item, the lower the elasticity. A 25 cent rise in the cost of a fast food hamburger is likely to have much less of an effect on consumption than a $2,500 rise in the price of a car.
Brand loyalty. To some degree, high loyalty to a specific brand reduces elasticity. Frequent flyer and other loyalty programs are designed to increase brand loyalty and reduce switching brands due to price.
Life cycle. When a product is new to a market, there may be few substitutes and elasticity is low. As the product “ages” and competitors bring similar products to the market, there is greater choice and it is common to see sales, discounts, and rebates to stimulate consumption.
Absolute price. When a product is very expensive, even a small percentage change in price will make it prohibitively expensive to more buyers. If the price of a product is a tiny percentage of the buyer’s overall spending power, then a change in price will have less impact.
Importance of use. In our previous example, we examined the elasticity of demand for cookies. A buyer may enjoy a cookie, but it doesn’t fulfill a critical need the way a snow shovel after a blizzard or a life-saving drug does. In general, the more important the product’s use, the more inelastic the demand will be.
Competitive dynamics. Goods that are produced by a monopoly generally have inelastic demand, while products that exist in a competitive marketplace have elastic demand. This is because a competitive marketplace will create more options for the buyer.