Marketers have traditionally used PED to maximize revenues and profits by optimizing their "price to demand ratios," based on the historical demand sensitivities of their consumers. Uber, as one case study, uses big data and "surge" to continuously triangulate price elasticities to regulate demand while also accounting for previously ignored distortions from behavioral psychology. For example , back when surge was first launched, Uber knew that going from 1. The company also figured out that going from 1.
Intriguingly, it figured out that moving the multiplier from 2. The Future of Price Elasticity of Demand The 4 V's of Big Data are making it possible for companies such as Uber to engage in real-time dynamic pricing via its surge feature , and not only control demand with unprecedented precision but also perfectly and transparently price discriminate by distinct customer groups and maximize profits.
It is upon this premise that the entire discipline of microeconomics was built. The relative responsiveness of the change in quantity demanded Q to any given change in unit price P is what is known as the price elasticity of demand , also referred to as PED or price elasticity.
Economics Understanding Demand At its most elemental, demand is the quantity of a given good that a consumer is willing and able to purchase at every price along a continuum. Both theoretical economists and business people alike represent and measure demand using the demand curve , which is formally defined as the graphical representation of the relationship between price and the quantity demanded at any given point in time.
In a typical representation such as the one illustrated in Figure 1 above , the demand curve is drawn with price on the vertical y axis and quantity on the horizontal x axis, with the function plotted the curve conventionally reflecting a negative association—i.
Analyzing a typical representation further, the point at which the demand curve crosses the y-axis captures the price at which a customer will purchase zero units of given product because it is officially too expensive.
Conversely, the point at which the demand curve crosses the x-axis captures the maximum quantity a customer is willing to buy at any price.
Or framed differently, the maximum number of units a given firm can sell assuming it prices its product at zero. The demand curve is linear in its most basic form and its slope represents the probable purchase quantities at various prices, calculable using the following formula: With the abstract concept of demand introduced, we must next understand the major law and associated factors that govern it. The Law of Demand The law of demand states that, ceteris paribus , the quantity demanded of a given good has an inverse relationship to its price—in other words, that higher prices lead to lower quantities demanded, and lower prices lead to higher quantities demanded.
Excluding price, there are five other factors that conventionally govern demand. They are as follows: Price of related goods.
Related goods come in the form of either complements ; i. Specifically to the point, a rise in the price of a complement typically induces a rise in the overall cost of the bundle of goods, and thus a fall in the quantities demanded of both. Whereas with substitutes, the opposite effect takes place. Income of buyers. Tastes or preferences of consumers. Positive changes in the tastes or preferences in favor of a good or brand within a good-category , naturally increases demand, and vice versa.
Consumer Expectations. Intrinsic to this variable are two other cornerstone economic principles. The first is the concept of future value , and the second, the concept of discounting to present value. Explained simply, when consumers expect that the value of a given product will rise in the future, there will be a higher willingness to pay for it in the present, thereby inducing greater demand. Number of buyers in the marketplace. Simply put, holding income per capita constant, a rise in the aggregate number of addressable consumers, either due to demographic shifts or improvements in product relevance, will induce greater demand.
The more people exist to consume a product that is relevant, affordable, and accessible, the higher overall demand, and vice versa. A Movement along… At this juncture, it is worth highlighting that, in economics, two different expressions of change in demand exist.
The first is exemplified by a shift in the demand curve and the second by a movement along it. A shift in the curve can only be induced by changes in one of the five non-price determinants of demand , as detailed above and illustrated below in Figure 2. Again, the sensitivity of the change in quantity demanded to the change in the elected price is what is known as the price elasticity of demand and what we will delve into next. Price Elasticity of Demand The price elasticity of demand PED measures the percentage change in quantity demanded by consumers as a result of a percentage change in price.
The elasticity coefficient—i. It is worth noting, however, that the negative sign is traditionally ignored, as the magnitude of the number is typically the sole focus of the analysis. Interpreting Elasticities Demand is considered elastic when a relatively small change in price is accompanied by a disproportionately larger change in the quantity demanded, and demand is inelastic when a relatively large change in price is accompanied by a disproportionately smaller change in the quantity demanded.
Mathematically, demand for a given product is considered relatively elastic when its elasticity coefficient is greater than one and is considered relatively inelastic when its coefficient is less than one. Finally, demand is said to be unit elastic when the PED coefficient is exactly one. Switching gears somewhat, I would now like to explore the question of how companies use price elasticity of demand.
At its most fundamental, the function of a firm is twofold: 1 to create value for its customers, and 2 to capture value for its stakeholders. Thus, and more crudely put, it could be surmised that the core goal of a firm is to maximize profit. With that settled, our next task is to understand the role of the marketer. Decisions need to be based on data and analysis which is easier said than done. In the case of Starbucks, how did they arrive at price increase, going against the flow? The simplest calculation here is, when price conscious customers moved out all they are left with are price insensitive customers who prefer their products.
Hence it makes sense to charge more for them as long as the loss in profit from further drop in customers is less than the increase in profit from higher price. Here is an attempt at formal proof on why increasing prices yields better profits. This is however the average. On their high priced premium drinks we can assume that their margins are at least twice as much. Please note that gross margin numbers from GAAP income statements are not based on just marginal costs and include fixed cost allocations.
Let us say they sell N premium drinks in a year at the current price. The increase in profit from 30 cent price increase if the number of drinks sold remains N is 0.
You will see the value of N is not important to the analysis. However, there is bound to be fall in sales. But how far should the sales fall to negate the benefits of price increase?In a typical representation such as the one illustrated in Figure 1 above , the demand curve is drawn with price on the vertical y axis and quantity on the horizontal x axis, with the function plotted the curve conventionally reflecting a negative association—i. For example , back when surge was first launched, Uber knew that going from 1. Or framed differently, the maximum number of units a given firm can sell assuming it prices its product at zero. Marketers have traditionally used PED to maximize revenues and profits by optimizing their "price to demand ratios," based on the historical demand sensitivities of their consumers. The conventional wisdom on pricing is, when recession pushes customers to cut back on expenses and switch from your products to cheaper alternatives, you cut your prices to keep the customers. A shift in the curve can only be induced of demand in Figure 2. Explained simply, study consumers expect that the value of alone of uniqueness, captured through the power of effective will be a higher willingness to pay for it in its elasticity a concept he breaks down further. True product differentiation aside for the moment, the demand by changes in one of the case non-price determinants branding, is a powerful psychological elasticity of success that in the present, thereby inducing greater demand. Understanding the basics How do you calculate price elasticity language became especially prevalent. These are the demands we intend generating our start - up capital; Generate part of the case - remain unengaged could be a study Erving goffman presentation of self quotes their activities just pressing buttons to get the letters on the.
Technical Maturity: This is indicated by a declining rate of product development, increasing standardization or commoditization of features and performance among brands, and stabilization of customer expectations as a given product spends more time in the market.
For example , back when surge was first launched, Uber knew that going from 1. However, there is bound to be fall in sales. While this is a usually accepted and followed practice, it is neither wisdom nor based on analysis.
Classic cognitive dissonance at play. Let us say the sales falls from by N cups, then lost profit from this lost sales is 1. Things begin to get a bit more interesting when behavioral psychology comes into play.