Price elasticity describes how much the demand for a product or a service changes, if its price changes. Most entrepreneurs and executives want to charge the highest possible price for their product and service, without losing too many customers. Without knowing or at least assuming a price elasticity, you can never find the best price for your service and product.
- Price elasticity describes how much the demand for a product or a services changes if the price changes. If a price change a huge impact on the demand, we call this demand very elastic. However, if a price change has little or no impact on the demand, such a demand would be considered inelastic. Let's say you are a graphic designer charging an average of $60 per hour. If you bill 150 hours a month, you will realize a total revenue of $9,000.
Your fixed cost are $2,000, so your gross profit is $7,000. Your tax accountant tells you that you are too cheap and you should increase your prices. Well, since charges $120 an hour and drives a very fancy car, let's consider her suggestion. If you were to charge 10% more for your service, would your business be more profitable, or at the rate of $66 per hour will you lose customers? So, here's the managerial decision you have to take.
Are you keeping your fee at $60, or are you raising it to $66? In order to answer the question and figure out which price leads to the higher profit, you need to know how much the demand is going to change. This change of demand due to a change of price is called price elasticity. Let's start with the most simple example, which is a price elasticity of minus one. If you increase the price by 10% and you lose 10% of the demand the elasticity is minus one, or in more technical terms, if you increase the price by X percent you lose X percent of the demand.
Vice versa, if you decrease the price by X percent your demand increases by X percent. Now, this is important. Assuming the price elasticity's minus one, does a price increase make sense for your graphic design business? Right now, your gross profit is $7,000. If you increase the price to $66, which is a 10% increase, your demand goes down by 10% to 135 hours. The revenues are $8,910 and the gross profit is $6,910, which is less than before.
Let's run a different calculation assuming the price elasticity is zero. That means, most of your clients are very loyal to you and the price increase of 10% would not make them leave. Well actually, some will leave, but in all likelihood you can replace them with new customers. At the price elasticity of zero, a price increase to $66, and 150 hours a month the result is an increase in revenues of 10%, which is $9,900.
Gross profit is now $7,900. So, an inelastic demand means you can raise the price and your customers are still loyal to you. An elastic demand means you might lose customers with even a small increase in price. Elasticity is a key concept in managerial economics. Most entrepreneurs and executives want to charge the highest possible price for their product and service without losing too many customers.
Without knowing, or at least assuming a price elasticity, you can never find the best price for your service and product.
- 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