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Monday, May 15, 2017

What is the Significance of Elasticity of Demand?

Elasticity of demand is a concept that is tied into the subjective value of the individual actors, to wit, buyers of the good or service. It is a concept that can be used to analyze how to target a particular group of potential buyers for a product or service. It is a way to attempt, for business owners,  to measure how consumers will respond to the price of a good or service. This concept is the foundation of many uses in business, specifically, revenue optimization.

Price Discrimination with Elasticity of Demand

Airlines may implement “price discrimination” by segmenting the price of their services, as this is a means to optimize revenue. This notion is based on the principle of elasticity of demand. Some customers are willing to pay more for a seat, e.g. First class passengers, for the exact same flight. Whereas other passengers are less willing to pay for a first class seat, but are willing to pay for a coach seat. Airlines then will attempt to optimize their marginal benefit by allocating a certain number of seats for 1st class, followed by the rest of the seats for coach passengers on one flight. Hotels utilize a similar strategy to fill up hotel rooms. They will price the rooms higher for business clients, who typically stay Monday through Friday. The hotel will lower the price on the weekends to drive up demand for the non-business clients. Using this pricing strategy, hotels can maximize their revenues to cover the costs to run the hotel.  In both cases, prices still can be further segmented in both of those respective groups.

Consider another example of Price Discrimination: Cell Phones. When the latest version of a cell phone is marketed to the public, the news will show clients standing in long lines for hours, as they are willing just to obtain this latest cell phone. Cell phone producers know this, as this segment pays a higher price for that cell phone. Buyers who are more responsive to price increases, will simply wait until the price of the cell phone falls, then attempt to obtain the latest model. The cell phone manufacturer optimizes its profits for the economic costs to produce and bring that phone to market.

The significance of the elasticity of demand is that individuals value things differently. An increase in price, or costs from the business owner, simply can not be passed onto customers on an absolute scale. If the price is raised too high, then many customers will simply look for alternatives for that good or service. When this happens, the business owner will see a decline in revenue. Yet, if the business owner locates the proper price point, he/she can optimize their revenues and make a profit, relative to their costs to run the operation.

Products that are 100% Inelastic, do they exist?

No good, service or product is 100% Inelastic.  Mainstream economists will teach that Insulin, for example, is absolutely inelastic. This is not true. Yes, it is relatively more inelastic as compared to other goods. But, when dealing with humans, each of us value things differently....as value is subjective. In short, if the price of insulin was too high, humans would seek other means to deal with their diabetes issues. Those options maybe so extreme to the point that they stretch out how frequently they utilize insulin. Or, they may resort to stealing the insulin, or other extreme measures. The point is that there is no way to absolutely predict what all humans' actions would be based on raising the price to the point of beyond anyone's reach. And, the business owner, in turn, would eventually lose money...even with insulin if the price was raised egregiously high.

A thought exercise: If Insulin was absolutely inelastic, then drug companies could charge whatever price needed to make an egregious amount of profit.  However, they do not, since they need consumers to continue to purchase the insulin on a regular basis. It makes no sense to charge too much, as consumers would reduce their purchase of insulin, and the drug companies would take a loss on the profits of that drug. Remember: Drug companies inject large amounts of capital to manufacture drugs, and these companies want to earn a profit to provide a return on capital for that large capital investment.

To assume no elasticity, or a good that is 100% inelastic, would assume no scarcity, as this is a false concept. The next blog article will discuss the notion of scarcity, and the origins of this concept. Scarcity is the foundation of the Science of Economics.

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