Price elasticity of demand and operations objectives (July 2004)

Price elasticity of demand and operations objectives

Sam Choon Yin

July 2004

 

Price elasticity of demand measures the responsiveness of the quantity demanded to changes in the price of the product itself. The product is said to be elastic (inelastic) if a percentage change in the price leads to more (less) than a percentage change in the quantity demanded. Understanding the elasticity concept enables managers to properly price the products they offer so that the firms they represent could remain competitive.

 

Managers essentially face a dilemma. As postulated in the Law of Demand, there is a negative relationship between price and quantity demanded. To maximize the firm’s profits, it is in the interest of the managers to reap the highest revenue possible while at least retaining its efficiency. Revenue can be computed by simply multiplying the price per unit of the good and the total number of units sold. Because of the inverse relationship between price and quantity demanded, the strategy to increase the price of the product, with the intention to raise revenue, may backfire if the reduction in the quantity demanded outweighs the increment in the price. This problem could arise if the managers are not well equipped with the concept of elasticity.

 

To resolve the dilemma, it is important for the managers to be aware of the product’s price elasticity of demand. In this respect, economic theory suggests that a relatively lower (higher) price should be offered to the consumers if the product is found to be elastic (inelastic).

 

Consider first the case of inelastic demand. Being inelastic implies that the consumers are less responsive to changes in the price. One reason could be that there are substitutes available in the market for the product understudy which the consumers are able to acquire at lower cost. It is difficult in this case for the firm in study to compete through pricing if it is not able to operate or produce at costs lower than its competitors. Competing through pricing may not be feasible in this respect. Instead, it might make more economic sense for the firm to compete through non-price factors like quality, and offer a premium price for the good that it offers. If the consumers were able to perceive the good to be different, then even a higher price would not lead to a substantial fall in the quantity demanded. Instead, there should be a less than proportionate reduction in the quantity demanded as compared to the increment in the price. Accordingly, the revenue collection will increase.

 

Automobile companies like Jaguar and Mercedes have adopted the above strategy. They have chosen to compete through quality (enhancing the physical appearance and durability of their respective cars) rather than through pricing.

 

However, it does not mean that the firms should not be concerned with costs. The profit equation encompasses both revenue and cost components. To maximize profits, it is equally important for firms to lower the costs of operation through improvement in efficiency. Unfortunately, with greater emphasis on quality, there might be a tendency for the cost of production to increase. If cost controls are lacking, the firm may suffer from lower profits and sales in the medium to long term.

 

In a typical case, improvements in quality could result in higher cost of operation. Inspection of incoming materials and setting up of quality laboratory for example are necessary in manufacturing companies to assure quality before the goods are shipped to the consumers. In services, there is usually a positive relationship between the number of service providers and quality. Essentially, a typical manager must take into consideration the necessary costs incurred in association with higher level of quality. The managers should not perceive cutting of good costs like training and inspection of incoming materials as the first resort to raise firm profits. Instead, there should be continuous attempts by firm managers to reduce unnecessary or ‘bad’ costs resulted from excessive paperwork, bureaucracy and inefficient processes.

 

Now consider the case where the product is price elastic. In this case, a reduction in the price of the product should, in theory, lead to a larger than proportionate increase in the quantity demanded. The net effect should then be an increase in the revenue collection. Basically, firms choose to adopt this strategy because they want to, and are capable of reaping economies of scale. Why is this so? Being elastic, we know that lowering the price of the product could push for greater volume of sales which in turn enables the firm to expand its production (for simplicity, we assume that the firm has the necessary managerial knowledge and capability to expand). The fixed cost incurred like advertising expenses and machines could be spread over a wider base of output thus allowing the firm to lower its average fixed cost. The average cost could also be lowered. This will be realised provided that the variable cost does not increase in a substantial manner in response to the expansion in the scale of production.

 

To enjoy the benefits associated with lower price and higher revenue, it is essential for the firm to have the capability to expand the scale of production. Fast food restaurants like McDonald’s have successfully adopted this strategy. Offers or discounts are given occasionally to customers for the sale of hamburgers at much lower price. What one sees consequently are long queues at the outlets. To maximize profits, McDonald’s has to focus on expanding the volume of sales. This has to be accompanied by efforts to clear the queue as fast as it can so that more customers could be served per day. This has been more or less achieved by standardisation of the menu and procedures, and utilisation of specialised workers.

 

This essay explains the importance of understanding the concept of price elasticity of demand. The direction of change for the price could then be determined. To decide on the absolute change in the price, so as to attain the targeted sales and profits, requires one to estimate the price elasticity of demand. The price elasticity of demand unfortunately is not easy to measure at least in an accurate manner. Measuring it requires knowledge of the change in the price of the good and the subsequent change in its quantity demanded. For new and perhaps most firms, this entails a trial and error method where the firms have to carry out actual changes in the price of the goods offered and then observe how the consumers react to these changes. This could be a costly exercise to carry out. Alternatively, the firms may wish to conduct controlled experiments. Individuals could be selected to participate. Their reactions to arbitrary changes in the variables could be observed in the experiments to assist the managers in introducing the necessary measures to maximize sales. Academics could assist too. Some economists for example have carried out regression analysis to estimate the price elasticity of demand for selected goods. Firm managers could utilize these estimates for their own planning.