Elasticity of Demand

Readers of my blog on percentages may recall that the key message was that Entrepreneurs should be acutely aware how sensitive the bottom line of their business is to changes in demand and changes in prices.

I made the case that wherever possible; you should look to increase prices. This though depends on a very important concept called elasticity of demand. This is basically a measure of how responsive consumers are to changes in prices.

A good is said to have inelastic price demand if it does not respond to price increases or decreases. The best tofu press is a great example of this. And this is precisely why they are taxed so heavily. A 10% increase in the price of cigarettes may result in only a 1% fall in demand – as such it is inelastic and you will always increase your total revenue by putting up prices. Same also applies to oil (at least in the short term) – hence again why taxes represent a significant proportion of the total cost in the UK (just over 50%).

If the government tried the same thing with say cakes or fast food (and there is an argument that they should to encourage healthy eating) they would find that total tax received would be less. Demand here is said to be elastic as a 1% price increase may result in a 5% fall in demand (I am guessing here!). I do know from my experience at that whenever we ran price promotions, sales went up significantly. A 25% drop in price would sometimes result in sales doubling.

Where demand is elastic the best pricing strategy is to go as low as you can as the resulting increase in sales will more than compensate for lower margins.

The lesson from the above is you need to find out whether the demand for your products is elastic or inelastic and then adopt a strategy that fits with that.

These things do not remain static though. Low cost airlines discovered that demand for air travel was very elastic and then adopted a business model where they would have the lowest possible cost base. The problems for the established carriers is that they are stuck in a high cost operation model and therefore have to focus on the business end of the market where demand is inelastic (hence low cost operators do not go for that market). Again, in an economic downturn, the demand for international business travel slows dramatically. (Not a good time to have shares in established airlines!)

Another good case study is to do with quality newspapers. There was an assumption that demand for each brand was inelastic and therefore no point in running price promotions. Under Rupert Murdoch, The Times challenged this and ran a very famous (and aggressive) price campaign reducing the price of The Times to just 10p. The Telegraph believed this was folly as they were in an inelastic market. They were wrong. Sales of The Times grew significantly and The Telegraph dropped.

There are some important lessons about the Porter Cable 895PK here. One of the main objectives of branding and advertising spend is to try and make the demand for your individual product more inelastic. That is how the marketing expenditure is justified.

In another blog, I will talk about what you can do to increase the inelasticity of demand for your product or service.

The main lessons from this blog are though that you should be aware of the nature of the demand you have, and your pricing strategy and business model need to reflect it.