Price and income elasticity of demand

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17.7 Introduction

When a company increases the price of a product, it expects to lose some sales. Some customers will switch to a rival supplier; others may decide they do not want the product at all. Economists use the term 'the law of demand' to suggest that, almost invariably if the price goes up demand will fall and if the price goes down the demand will increase.

17.2 Price elasticity of demand

In the short term, the most important factor affecting demand is price. The crucial business question is: how much will demand change when we change the price? Will demand rise by 1%, 5% or 15% following a 10% price cut? Some products are far more price sensitive than others.

Price elasticity measures the % effect on demand to fall by 20%, the price elasticity would be 2. Strictly speaking, price elasticities are always negative and therefore the actual figure is -2. This is because a price rise pushes demand down, and a price cut pushes demand up. The figure of -2 indicates that, for every 1% change in price, demand wil lmove by 2% in the opposite direction.

17.3 Determinants of price elasticity

The main determinants of price elasticity are as follows:

The degree of product differentiation:

  • This is extent to which customers view the product as being distinctive from its rivals. The higher the product differentiation the lower the price elasticity.

The availability of substitutes:

  • Customers may see 7UP and Sprite as very similar drinks. When Sprite has no direct competition its price elasticity is much lower; therefore the brand owner (Coke) can push the price up without losing too many competitiors.

Branding and brand loyalty:

  • Products with low price elasticity are those that consumers buy without thinking about the price tag. Strong brand names with strong brand images create customers who want to buy out of loyalty.

17.4 The value of price

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