A common economic measure, known as elasticity of demand, is something that every small business owner should understand. It is such a fundamental economic concept that failure to be aware of it may cause a small business to quickly fold.
What Is Elasticity of Demand?
Price elasticity of demand, also called demand elasticity, is a measure that shows the change in the demand of a product or service in response to a change in its price. Typically, it measures the change in demand for a 1% change in the price of the product or service. Understanding demand elasticity helps businesses make decisions that lead to more optimal and competitive behavior, and also increases the accuracy of budgeting and production.
How Elasticity Is Calculated
The formula for demand elasticity is very straightforward:
Demand elasticity = The absolute value of (% change in quantity demanded / % change in price)
As an example, assume a good was priced at $9 and is now priced at $10. The old quantity demanded was 150 units, and the new quantity demanded is 110 units. The demand elasticity is:
% change in price = ($10 – $9) / $9 = 11.11%% change in quantity demanded = (110 – 150) / 150 = -26.67%Demand elasticity = absolute value of (-26.67% / 11.11%) = 2.4
Interpretation of Elasticity
The interpretation of elasticity is as follows:
If demand elasticity is less than 1.0, then demand is price inelastic, meaning it is not sensitive to price changes.If demand elasticity equals 1.0, then demand is unit elastic, which means changes in quantity and price are perfectly proportional.If demand elasticity is greater than 1.0, then demand is price elastic, which means it is sensitive to price changes.
Examples of Elastic and Inelastic Industries
Below are examples of elastic goods and services, and inelastic goods and services. In real life, there are no examples of unit elastic goods.
*Examples of elastic goods: coffee, airline tickets, stocks, name brand products, and high-end restaurants*Examples of inelastic goods: gasoline, electricity, water, telephone service, and generic foods
How Elasticity Affects Business
As a small business owner, it is important to understand what causes elasticity. Once these factors are known, operational and development decisions can help make the business and its products more competitive and more in demand. The following are things that determine elasticity:
*Availability of substitutes – more substitutes equals higher elasticity; make your product stand out.*Income – lower incomes lead to more elasticity; perhaps drive product prices down.*Necessity – a lower necessity equates to higher elasticity; make your product a necessary part of life.*Brand loyalty – strong brand loyalty tends to override elasticity; Apple is a perfect example.*Who pays for the product – when the end user is not the person actually spending money, demand usually becomes inelastic. For example, when a business pays for a product for an employee, price is less of a decision point.