5.2 How Businesses Use Demand Elasticity

Learning Objective Understand how demand elasticity shapes your total revenue and your business strategy.

The price elasticity of demand is a critical factor determining how managers set their business strategy. So far you’ve seen how to measure the price elasticity of demand. As a manager, you will want to use the price elasticity of demand for your product to forecast the likely consequences of any change in price. If you rearrange the formula for price elasticity of demand, you see that:

Percent change in quantity demanded=Price elasticity of demand×Percent change in price

For instance, the price elasticity of demand for eggs is around −0.2. Based on this, you can project the likely consequences of a change in the price of eggs. If the price of eggs were to rise by 10%, you can forecast that the quantity of eggs demanded will decline by around 2%:

Percent change in quantity demanded=−0.2×10%=− 2%

Knowing the price elasticity of demand for your product allows you to forecast how price changes will affect your revenues and profits. Our next task is to explore how the price elasticity of demand shapes your revenues and therefore your decisions.

Elasticity and Revenue

If the market price for eggs is going up by 10% and the quantity sold declines by 2%, what does that mean for total revenue? Total revenue is the total amount you receive from buyers, which equals price times quantity:

Total revenue=Price×Quantity

total revenue

The total amount you receive from buyers, which is calculated as price × quantity.

Total revenue is shown graphically in Figure 4. It’s the rectangle created by price times quantity. So in the example shown, if at a price of $3 a coffee shop sells 100 cups of coffee, their total revenue is equal to $3×100=$300.

Figure 4 | Total Revenue

The introductory text reads, Your total revenue is the amount you receive from buyers, which is calculated as price multiplied by quantity. Remember, the area of a rectangle is the height (price) times the base (quantity). The graph shows a curve labeled Demand with a negative slope and a point (100, 3) marked on it. The distance between 0 and 100 along the horizontal axis is labeled Quantity, and the distance between 0 and 3 along the vertical axis is labeled Price. Two dotted lines from (100, 3) meet the horizontal and vertical axes and the enclosed area is shaded. Text inside this area reads, Total revenue equals price multiplied by quantity that equals 3 dollars multiplied by 100. This gives the value 300 dollars.

Since a change in price leads to a change in the quantity demanded in the opposite direction, the impact on total revenue will depend on the relative magnitudes of the two changes. The price elasticity of demand tells you whether the percent change in price is larger than the percent change in quantity (when demand is inelastic) or smaller than the percent change in quantity (when demand is elastic).

Higher prices lead to less total revenue if demand is elastic.

If your customers are very responsive to price changes—that is, if their demand is elastic—then a modest price rise will lead to a large decline in the quantity demanded. And if you’re charging only a modest amount more, but have many fewer customers, then your total revenue will be lower. To be precise, if the percent rise in price is smaller in magnitude than the percent decline in quantity demanded—that is, if the demand for your product is elastic—then a price increase will lead to a decline in your total revenue. Remember that when demand is elastic, the absolute value of the percent change in quantity is greater than the absolute value of the percent change in price. The left panel of Figure 5 shows this change graphically: When demand is elastic, a higher price yields less revenue.

Figure 5 | Price Elasticity of Demand and Total Revenue

The introductory text reads, The same change in price can cause total revenue to rise or fall, depending on the elasticity.

A curve with a negative slope labeled elastic demand is shown in the first graph. Two points, old revenue and new revenue, are marked on the curve with new revenue near the beginning of the curve. Text above the first graph reads, If demand is elastic, a higher price yields less revenue.

A curve with negative slope labeled inelastic demand is shown in the second graph. Two points old revenue and new revenue are marked on the curve with new revenue near the beginning of the curve. The distance between the points, new revenue and old revenue, is less than that in the first graph. Text above the second graph reads, If demand is inelastic, a higher price yields more revenue.

Higher prices lead to more total revenue if demand is inelastic.

Why would this make a corn farmer happy?

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On the other hand, if your customers don’t respond much to price changes, then even a large price increase will lead to only a modest decline in quantity demanded, which means that your total revenue will be higher. To be precise, if the percent rise in price is larger in magnitude than the percent decline in quantity demanded—that is, if the demand for your product is inelastic—then a price rise will cause your total revenue to increase. Remember that when demand is inelastic, then the absolute value of the percent change in quantity is less than the absolute value of the percent changes in price. The right panel of Figure 5 shows this change graphically. When demand is inelastic, a higher price yields more revenue.

Interpreting the DATA

Why corn farmers are happier during droughts

A drought is a terrible thing. Day after day, the sun beats down, and when there’s no rain, the soil hardens and cracks. Plants die, livestock go hungry, and farmers find themselves producing far less. So how could a drought actually make corn farmers happy? The answer turns out to be all about the price elasticity of demand for corn.

The graph shows a curve labeled inelastic demand with a negative slope, which intersects two curves with a positive slope labeled normal supply and drought supply. An arrow shows the leftward shift from normal supply to drought supply. The graph illustrates that 13 percent less quantity was sold during drought supply, with a 33 percent rise in price than during the normal supply.

Consider the devastating drought that hit the Midwest in 2012. It led the corn crop to fall to a level 13% lower than it was two years earlier. The only way to restore the market to equilibrium would have been if the quantity of corn demanded also fell by 13%. But the demand for corn is quite inelastic, and so the quantity of corn demanded would only fall this much if the price of corn were to rise by far more. And indeed, the price of corn rose by a massive 33%. The result is that farmers sold 13% less corn at a price that’s 33% higher meaning that the total revenue of corn farmers actually rose, despite—in fact, because of—the ongoing drought! When demand is inelastic, a decrease in supply actually increases revenue.

Elasticity and Business Strategy

Our discussion of supply and demand in earlier chapters focused on perfectly competitive markets, where your best strategy is to follow the market price. Recall that in perfectly competitive markets, if you raise your price by even a small amount, the quantity demanded of your products goes to zero (and so does your revenue!) because your customers will all buy the lower-priced identical products offered by your rivals.

In reality, many markets are not perfectly competitive. When your business is operating in an imperfectly competitive market, you face a delicate balancing act. If you set a higher price, you’ll get a bit more revenue for each item you sell, but you’ll sell fewer items. Set it lower, and you’ll sell a larger quantity but get less revenue for each item you sell. When you aren’t in a perfectly competitive market, then your best pricing strategy will depend on the elasticity of demand for your specific product.

If demand for your product is currently inelastic, you should raise your prices.

If you discover that demand for your product is inelastic, you may want to raise your prices. Why? We’ve just discovered that if demand for your product is inelastic, then raising your price a bit will increase your revenue. It will also decrease your costs, because when you charge a higher price you need to produce a smaller quantity. The result is that if demand for your product is inelastic, then increasing your prices increases your profits.

Interpreting the DATA

Why Amazon fought for lower e-book prices

In 2014, Amazon and one of its publishers, Hachette Book Group, were engaged in a bitter dispute over how to price e-books to maximize revenue. Amazon asked the publisher to lower the price of all its e-books to $9.99, arguing that setting a lower price would actually increase revenue. Amazon’s argument follows our analysis above: The revenue implications of a price cut rest on the price elasticity of demand. Here’s what Amazon said:

E-books are highly price-elastic. This means that when the price goes up, customers buy much less. We’ve quantified the price elasticity of e-books from repeated measurements across many titles. For every copy an e-book would sell at $14.99, it would sell 1.74 copies if priced at $9.99. So, for example, if customers would buy 100,000 copies of a particular e-book at $14.99, then customers would buy 174,000 copies of that same e-book at $9.99. Total revenue at $14.99 would be $1,499,000. Total revenue at $9.99 is $1,738,000.

Hachette wasn’t convinced, and wanted to set higher prices. Ultimately Hachette won the dispute, and instead of charging $9.99 as Amazon suggested, it charged a higher price for many of its books. But this wasn’t much of a victory, as the year after Hachette struck the deal, e-book sales declined and so did total revenue.

Use your demand elasticity to choose your pricing strategy.

Southwest is more likely to advertise low prices than cushy service.

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Under what conditions does it make sense to follow a low-price strategy? The answer depends on the price elasticity of demand.

Southwest has chosen a low-price strategy, and Southwest’s prices are usually quite a bit cheaper than its competitors’. This has been a successful strategy for Southwest, because its low prices drew enough extra customers to offset its lower profit margin on each customer. That is, Southwest discovered that low prices are a good choice when demand is very elastic. The result is that Southwest has grown enormously, while its high-price competitors have struggled.

But if demand is inelastic, lower prices will translate into smaller profit margins and not many extra customers, and so a low-price strategy would reduce your profits. If demand is inelastic, it makes more sense to pursue a high-price strategy.

Knowing a market’s demand elasticity can help you decide which market to enter.

Howard Schultz is a billionaire, and it’s all because he understood elasticity better than his competitors. In the mid-1980s, he analyzed the coffee market and noticed that most sellers were following a low-price strategy, selling cheap coffee in gas stations and diners, or selling instant coffee in supermarkets. The coffee was as bad as it was cheap. Schultz believed that this obsession with low prices didn’t make sense, because many coffee drinkers would be prepared to pay higher prices, particularly for better-quality coffee. That is, he thought that the demand for coffee was more inelastic than other coffee sellers believed it to be.

Which has more inelastic demand?

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So he bought a fledgling chain of half-a-dozen Seattle coffeehouses, with an eye to selling freshly brewed coffee at higher prices. His bet that demand was inelastic paid off, big time. You probably know Schultz’s chain—it’s Starbucks—and its high-price strategy has been so successful that its 20,000 stores around the world have transformed the coffee market.

But where has it opened its stores? Starbucks is most likely to succeed in markets where coffee drinkers are not going to be deterred by their higher prices. This has led Starbucks executives to target markets where demand is inelastic. This explains why you’re more likely to encounter a Starbucks in wealthier cities rather than poorer rural areas, and in the busy parts of town where people prize convenience over price. It also explains why Starbucks focuses on specialty beverages such as Frappuccinos, for which there are fewer competitors offering substitutes, rather than simpler products like a brewed cup of coffee.

EVERYDAY Economics

Why inelastic demand means that the war on drugs is a losing battle

The graph shows a curve labeled inelastic demand with a negative slope. Two curves represent old supply and supply after a drug bust. The curve old supply is to the right of supply after a drug bust, and both of them intersect the curve inelastic demand. The graph illustrates that decrease in the supply of drugs leads to higher revenue for drug dealers.

The United States spends billions of dollars a year trying to limit the amount of drugs on the streets. All this effort does succeed in getting some drugs off the street, thereby reducing market supply. Drug dealers also have to spend money to avoid arrest and seizure of their products, which raises the marginal cost of drug sales. Higher marginal costs also lead to a leftward shift of the supply curve. The decrease in supply leads to higher prices. But what happens in equilibrium to the quantity of illegal drugs consumed?

The answer to this depends on the price elasticity of demand. Addiction means that drug users have pretty inelastic demand. As a result, the quantity demanded changes by very little even though the price is rising. Drug users pay a lot more, but only consume a little bit less. Inelastic demand means that the government’s efforts to reduce the quantity of drugs on the street leads to higher revenues for drug dealers!

That’s why some economists argue for less spending fighting the distribution of drugs and more funding for drug treatment programs or for education about the risks of drug use. Helping people fight their addictions can help reduce the elasticity of demand for drugs. As a result, the government gets more bang for its buck when it spends resources reducing the quantity of drugs available if it’s also working to reduce addiction.