Elasticity of demand, also called price elasticity, pertains to the way people react to price changes. The greater the demand elasticity, the more sensitive people are to price changes. In other words, the quantity of goods or services that consumers demand or want drops as prices rise. Economists actually use a formula for computing price elasticity. Companies can enjoy certain advantages when the elasticity of demand is relatively high.
Setting an Optimum Price
Companies are better able to find the optimum price for products when the elasticity of demand is high. The reason is that consumers greatly react to price changes. Their acceptable price range is much narrower in scope. Therefore, company marketers can test various pricing scenarios, setting prices low, near the competitive average or higher. They can then compute which price point elicits the greatest profit margin. Companies also can use the basic economic formula for price elasticity to derive their optimal price point. They also may conduct marketing research surveys to support their calculations, asking customers their preferred price ranges.
Taxes tend to be lower when the elasticity of demand is higher. The government can charge higher taxes when demand is inelastic because prices are generally higher. Inelasticity occurs when consumers are less senitive to price changes. The government has less leeway to enact tax increases when price elasticity is greater. This would drastically affect the demand for certain commodities or products and would result in reduced revenue, according to Economic Concepts, an online reference site. Companies with lower revenues and profits would simply owe less in taxes.
Business owners may be able to increase sales when the elasticity of demand is high for the types of products or services they sell. The main reason companies can increase sales is that they have a better handle on pricing structures. They know which price points generate the greatest amount of revenue. Still, companies must meet the needs of consumers with quality products and services. It is much more difficult to set prices when demand is ineastic. Acceptable price ranges may be high, but that may not necessarily create more sales. Competition tends to increase more rapidly in growth industries, which is when demand is more inelastic.
There are many factors that affect elasticity of demand and, thus, the benefits derived from that price elasticity. Elasticity of demand is higher with luxury items, for example. People don't necessarily need them so they often wait until the price is acceptable before making a purchase. Elasticity of demand also is greater when products comprise a large portion of the purchaser's budget, according to Quick MBA. People are more cautious in what they spend when there's more at stake.