Elasticity of Demand: Business Insights for Decision-Making

Elasticity serves as a cornerstone concept in economics, offering critical insights into how demand reacts to changes in price and promotional efforts. This article explores Price Elasticity of Demand (PED) and Promotion Elasticity of Demand (PrED) with mathematical precision, connecting these frameworks to real-world scenarios. We will integrate the effects of price and promotional changes to determine demand, classify elasticity levels, and discuss implications for managerial decision-making.

Price Elasticity of Demand (PED): The Basics and Beyond
Price Elasticity of Demand (PED) measures how sensitive the quantity demanded of a product is to changes in its price. Price elasticity is the most commonly employed measure of market responsiveness to changes in price. Mathematically, PED is expressed as:

PED = % Change in quantity demanded/% Change in price.
PED = (Q2-Q1)/(P2-P1) × P1/Q1
PED = Slope×P1/Q1

For instance, if PED = -1.5, a 10% increase in price results in a 15% decrease in quantity demanded. The negative sign reflects the inverse relationship between price and demand.
Consider a linear demand function of Price:
Q = 100 - 2P
At P=20, the quantity demanded (Q) is 60.  To compute elasticity:
PED = Slope × P/Q = (-2) × 20/60 = -0.67
Negative Slope suggests an decrease in demand as price increases.
In reality, diminishing returns may occur at higher promotional levels, necessitating a non-linear model for more accuracy.

Key Characteristics of Price Elasticity of Demand (PED)
1. Magnitude and Direction-
Elastic Demand (|PE|>1): Demand is highly responsive to price changes.
Inelastic Demand (0<|PE|<1): Demand is less responsive to price changes.
Unitary Elasticity (|PE|=1): Percentage change in price equals the percentage change in quantity demanded.
2. Negative Value-

PED is usually negative, reflecting the inverse relationship between price and demand (higher price, lower demand).
3. Varies Along Demand Curve- 

PED changes at different price points on a linear demand curve. Higher prices often result in more elastic demand.
4. Determinants-
Substitutes: Availability increases elasticity.
Necessity vs. Luxury: Luxuries tend to have higher elasticity.
Proportion of Income: Higher-cost items have greater elasticity.
Time Horizon: Elasticity increases in the long run as consumers adjust.
5. Revenue Implications-
Elastic Demand: Lower prices increase revenue.
Inelastic Demand: Higher prices increase revenue.
6. Perfect Elasticity and Inelasticity-
Perfectly Elastic: Infinite demand at a specific price (e.g., perfectly competitive markets).
Perfectly Inelastic: Quantity remains constant regardless of price (e.g., life-saving drugs).
7. Interaction with Market Dynamics-
PED influences pricing, market entry, and competitive positioning.

Promotion Elasticity of Demand (PrED): Expanding the Elasticity Framework
While PED focuses on price, Promotion Elasticity of Demand (PrED) evaluates how promotional activities affect demand. It is defined as:
PrED = % Change in quantity demanded /% Change in promotional spending.
PrED = (Q2-Q1)/(Pr1-Pr2) × Pr1/Q1
PrED = Slope × Pr1/Q1

Promotional elasticity often varies across industries, with some goods showing highly elastic responses to promotions (e.g., FMCG products) and others being less sensitive (e.g., luxury goods).
Real-World Example:
Suppose a company increases its promotional spending by 20%, resulting in a 10% rise in demand. The PrED is:
PrED = 10%/20% = 0.5
Consider a linear demand function of Promotion:
Q = 100 + 5P
At Pr =10, the quantity demanded (Q) is 150 . To compute elasticity :
PED = Slope × Pr/Q = 5 × 10/150 = 0.33
Positive  Slope suggests an decrease in demand as price increases.

Key Characteristics of Promotional Elasticity (PrED)
1. Responsiveness-
High PrED (>1): Demand responds significantly to promotions (e.g., FMCG).
Low PrED (0<PrED<1): Minimal impact of promotions (e.g., niche or essential products).
2. Diminishing Returns-
Additional promotional spending yields smaller demand increases over time.
3. Product Dependency-
Impulse goods show high PrED, while essentials exhibit low responsiveness.
4. Market and Consumer Factors-
PrED varies with market saturation, consumer price sensitivity, and seasonality.
5. Short-Term vs. Long-Term Effects-
Promotions create immediate spikes (short-term) or lasting demand shifts (long-term).
6. Cross-Category Impact-
Promotions can drive demand for related products (e.g., discounts on coffee increasing mug sales).
7. Interaction with Price Elasticity-
Promotions amplify the impact of price changes, enhancing demand responsiveness.
8. Industry Trends-
High PrED in consumer goods, low PrED in luxury markets due to exclusivity concerns.

Classifying Elasticity Levels and Coefficients
Both PED and PrED can be classified based on their coefficients.
Price Elasticity of Demand (PED) Examples-
1. Perfectly Inelastic (|PE|=0): Demand remains constant regardless of price changes. Example: Life-saving drugs such as insulin for diabetics. Even if prices double, patients will still purchase the same quantity.
2. Inelastic (0<|PE|<1): Demand changes less than proportionally to price changes. Example: Gasoline. A 10% price increase might only lead to a 5% decrease in demand because consumers still need to drive.
3. Unitary Elasticity (|PE|=1): Demand changes proportionally to price changes. Example: A specific brand of coffee. If the price increases by 10%, the demand decreases by exactly 10%, leaving total revenue unchanged.
4. Elastic (|PE|>1):Demand changes more than proportionally to price changes. Example: Luxury goods such as designer handbags. A 10% price drop might lead to a 20% increase in demand as consumers perceive the product as more affordable.

For Price Elasticity:
1. If demand is elastic, a price decrease raises total revenue.
2. If demand is inelastic, a price increase boosts total revenue.
3. At unitary elasticity, revenue remains unchanged.

Promotion Elasticity of Demand (PrED) Examples-
1. Perfectly Inelastic (|PrE|=0): Promotions have no impact on demand. Example: Essential utilities like electricity or water. A promotional campaign may not lead to increased consumption as people consume only what they need.
2. Inelastic (0<|PrE|<1): Modest demand response to promotional efforts. Example: Basic household staples like rice. A 20% increase in advertising might result in only a 10% rise in demand.
3. Unitary Elasticity (|PrE|=1): Proportional change in demand due to promotions. Example: Mid-tier smartphones. A 25% increase in promotional efforts results in a 25% increase in sales.
4. Elastic (|PrE|>1): Significant demand response to promotions. Example: Seasonal products like ice cream during summer. A 10% increase in promotional spending could lead to a 30% rise in demand.
Elasticity and Total Revenue: A Managerial Perspective
The relationship between elasticity and revenue provides actionable insights:

For Promotion Elasticity:
Higher PrED values signify that promotional spending effectively drives revenue. However, diminishing returns often occur as spending increases.

Integrating Price and Promotion Elasticity

To holistically understand demand, businesses integrate price elasticity and promotion elasticity into a unified model. This enables a deeper understanding of how changes in price and promotional efforts jointly influence demand.  Elasticity  is not the same as the slope of the demand function, as elasticity depends on relative percentage changes rather than absolute changes.

Composite Demand Function:

A combined demand function may take the form:

Q = a - bP + cPr

Q: Quantity demanded.

a: Baseline demand (independent of price and promotion).

b: Sensitivity to price (P).

c: Sensitivity to promotion (Pr).

Example:

Given the demand function,

Q = 200 - 3P + 5Pr

Current price (P) = 30

Current promotion spending (Pr) = 20

Initial Demand Calculation:

Q = 200 - 3(30) + 5(20) = 200 - 90 + 100 = 210

Here, Slope (P) = -3, Slope (Pr) = 5

PED = -0.43, PrED = 0.48

If Price increases by 10% (30 to 33) and Promotion spending rises by 25% (20 to 25)

Recalculate demand:

Q = 200 - 3(33) + 5(25) = 200 - 99 + 125 = 226

Slope is constant but Elasticity Changes as New levels of elasticity.  Here, PED = -0.44, PrED = 0.55

Key Insights:

1. Elasticity vs. Slope:

▪️Slope (b) measures the absolute change in quantity for a unit change in price or promotion.

▪️Elasticity incorporates the relative percentage change, offering a more nuanced perspective on responsiveness.

2. Interplay of Elasticities:

▪️A price increase reduces demand, but higher promotional spending can offset this effect.

▪️In this example, despite a price increase, demand rose due to the stronger promotional response.

3. Strategic Implications:

▪️Businesses can leverage promotion to counteract negative effects of price increases, especially in inelastic demand scenarios.

▪️Accurate elasticity estimates allow for better pricing and promotional strategies to maximize revenue.

Understanding and applying the concepts of Price Elasticity of Demand and Promotion Elasticity of Demand empowers businesses to make data-driven decisions. By quantifying how price and promotional efforts impact demand, managers can:
▪️Optimize pricing strategies.
▪️Allocate promotional budgets efficiently.
▪️Anticipate revenue outcomes under varying market conditions.
Mastering these elasticity metrics transforms complex consumer behaviors into actionable insights, offering a strategic advantage in competitive markets.