While price elasticities are typically negative, there are some notable exceptions which decision makers need to be aware of. For example, when you increase price and experience an increase in demand - and vice versa. Executives and entrepreneurs need to understand these paradoxes to capitalize on.
- While price elasticities are typically negative, there are some notable exceptions which decision makers need to be aware of. Normally when you increase price, you decrease demand. And when you decrease price, you increase demand. The exception is that a positive elasticity when you increase the price and experience an increase in demand, and vice verse. I would like to illustrate such a paradox, using an experiment I was running at my business school in Switzerland. Over the last four years I have presented the following scenario to 413 participants.
You are in the process of planning your 25th wedding anniversary party. You have already selected the menu. Now you need to decide on the red wine. Which one do you choose, given that you need about 12 bottles? I presented them four different wines from different regions with a different price tag. 7% would choose a Cabernet for less than seven euros. 36% would choose the Chateauneuf-du-Pape for 20 euros. 42% would buy a Chianti for 24 euros.
And 15% would pick the Shiraz for 36% euros. So far, so good. (laughs) Except that some of my participants spent less than seven euros for a wine at their 25th wedding anniversary. Good luck with that. Then I present a slightly different scenario to a different group. I ask them the very same question, however, I change the price of the Cabernet with the price of the Chianti. If we now compare the results of the two groups, we see that the demand for the Chianti drops significantly when we reduce its price.
By calculating the elasticity, we see that the demand goes down by 79% when the price goes down by 73%, which results in a positive elasticity of 1.08. On the other side, the demand for the Cabernet increases by 214% if the price increases by 264%. In this case, the elasticity is 0.81.
When I was raised as a kid in my father's restaurant, he would never talk about price elasticity, but he stated the elasticity paradox when he said, "If you have a very good wine in the cellar "that guests don't buy, "double the price and see what happens." But here comes the reality check. It is impossible for a wine seller to assume that all wines have positive elasticity all the time. If this was the case, they would sell each bottle for a billion dollars and would sell trillions of bottles.
What this example illustrates is that a wine can be perceived as too cheap for a certain occasion. A similar paradox can occur in any luxury market. If you lower the price of an expensive watch, say a Rolex, customers may be confused about its brand value and buy less. As you can see, price elasticity is very different, depending on the context. And if you are facing a pricing paradox in your business, you need to understand why it exists so that you can capture the higher price while increasing your sales volume.
- What are customers buying? (demand theory)
- What should we produce? (production theory)
- Which costs do I need to worry about now? (cost theory)
- What market am I in? (competition theory)
- What should we charge for it? (pricing theory)
To understand what managerial economics looks like in practice, Stefan explains how Google's auction-based advertising system employs the principles of game theory and how understanding this can help decision makers to outmaneuver their competitors.
- Using economics to solve business problems
- Understanding price elasticity
- Demand curve shifts
- Economics of scale vs. scope
- Break-even and what-if analysis
- Profit maximization
- Economics in action