The Importance of Price Elasticity of Demand in Investing

“The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”

Warren Buffett

When making investments, Warren Buffett doesn’t give a company’s leadership much thought; instead, he evaluates companies based on their capacity to raise prices.

One of the most fundamental concepts that organizations must comprehend is price elasticity.

Having a handle on the price elasticity of their products is essential for companies to:

  • Create accurate forecasting
  • Develop a sensible pricing plan
  • Create a flexible, profitable business

The ability to raise prices and not impede demand provides great signs of a strong company. Each company that can raise prices exhibits a moat. These companies are the ones we want to target as investors.

In today’s post, we will learn:

Okay, let’s dive in and learn more about price elasticity of demand with examples.

What is Price Elasticity of Demand?

Price elasticity of demand measures how much a product’s usage changes compared to price changes.

Price elasticity is a tool used by economists to analyze how supply and demand for a product change in response to price changes. Supply has an elasticity, or price elasticity of supply, much like a demand. Price elasticity of supply is the correlation between a price change and a supply change.

a picture frame with best price within

We can compute price elasticity by subtracting the percentage change in price from the percentage change in quantity delivered. The two elasticities work together to define what products the company produces and at what costs.

Most consumers in most markets are price sensitive. It is generally believed if a good or service is more affordable, more people will buy it, and fewer people will buy it if it is more expensive.

Price elasticity demonstrates how sensitive client demand is for a product based on its price—making the phenomenon more quantitative than that.

How Do We Calculate Price Elasticity?

The quantity demanded of a good or service divided by the percentage change in price is the price elasticity of demand.

supply and demand

We can express this idea in a formula:

Price Elasticity of Demand = % Change in Quantity Demanded / Percentage Change in Price

As a general rule, we can deem a product elastic if the amount required or purchased changes more than the price. For instance, the price increases by 5% while the demand decreases by 10%.

The product is said to have unit (or unitary) price elasticity if the change in the quantity purchased is the same as the change in price (for example, 10%:10% = 1).

We would consider the product inelastic if the quantity demanded changes less than the price. For example, -5% demanded for a +10% change in price.

Consider this example to determine the price elasticity of demand:

Assume that the cost of a pineapple drops from $1.99 to $1.87 (-6%). Grocery customers raise their purchases of pineapples by 20% in response. Pineapples have an elastic modulus of 0.20 / 0.06 = 3.33. The demand for pineapples appears quite flexible.

Let’s examine another case in point.

Let’s imagine that a clothes retailer increased the cost of one of its coats from $100 to $120. There is a $120-$100/$100 or 20% price rise.

The increase resulted in sales dropping from 1,000 coats to 900 coats. Demand has decreased by 10% overall. By entering those figures into the formula, you would obtain the following price elasticity of demand:

Price Elasticity of Demand = -.10 / .20 = -.5 or .5

The magnitude of the distance from zero is what matters, not whether the value is positive or negative. Negative values should be ignored; we use the absolute number value to interpret the price elasticity meter.

Five Zones of Price Elasticity of Demand

The five major categories into which we can categorize elasticities are:

  • Perfectly elastic
  • Elastic
  • Perfectly inelastic
  • Inelastic
  • Unitary

If the elasticity remains larger than one, it indicates the demand or supply is very responsive to changes in price. A demand or supply that is inelastic is one whose elasticity is less than one, showing low responsiveness to changes in price. Unitary elasticities indicate the proportional responsiveness of either supply or demand.

chalk writing with the word pricing

We refer to the two elasticity extremes as perfectly elastic and perfectly inelastic. A change in price causes the quantity to decrease to zero, which we refer to as perfectly elastic. When the quantity remains completely inelastic, there is no change in it when the price changes.

Here is a chart to help us understand the numbering better, where PED equals price elasticity of demand:

  • PED equals infinity = Perfectly elastic
  • PED is > 1 = Elastic
  • PED equals 1 = Unitary
  • PED is < 1 = Inelastic
  • PED equals zero = Perfectly inelastic

Let’s define the five zones of Price Elasticity of Demand for the products and services they can offer:

Perfectly Elastic: when any very slight change in price causes the amount needed to fluctuate. The majority of the items in this category are simple commodities. Customers have no real emotional connection to the product, and there is no brand or way to differentiate the goods.

Elastic: when a little adjustment in price results in a big shift in the amount demanded (the result of the formula is greater than 1). A relatively elastic product is beef, which is a perfect example.

Unit Elastic: when a price change corresponds to an equal change in quantity (where the number is equal to 1).

Inelastic: where modest changes in demand result from large price changes (the number is less than 1). Most people need gasoline, so demand isn’t much affected even when costs rise. Building brand equity is a wise investment because items with stronger brands tend to be less elastic.

Perfectly Inelastic: when price fluctuations do not affect the quantity needed. Consumers cannot get the items in this category from any other source since they are necessities. Only in situations when a company has a monopoly on the demand do we observe this. You still have to buy from me, even if my price changes.

Understanding Price Elasticity of Demand

The pricing of some items is particularly inelastic, according to economists. In other words, neither a price decrease nor a price increase affects demand.

calculator in the background, with wooden dice spelling prices in the foreground

For instance, the price elasticity of gasoline demand remains low. Drivers, airlines, the trucking industry, and other buyers will continue to make purchases.

Since the price elasticity of other items is higher, changes in their price have a significant impact on either their supply or demand.

It is not surprising that marketing experts remain interested in this idea.

We can even argue that their main goal is to increase inelastic demand for the goods they market. They do this by identifying a significant distinction between their items and others on the market.

A product is elastic if, in reaction to price changes, the quantity requested changes significantly. In other words, the product’s demand point has expanded from its previous location. It is inelastic if the quantity purchased changes only when the price changes. The quantity barely changed from its starting point.

Factors Affecting Price Elasticity

We have three factors that can impact the price elasticity of demand.

  • Availability of substitutes
  • Urgency
  • Duration of price change
a picture of yellow plastic tiles spelling price on a blue background

Let’s define these terms:

Availability of substitutes

The price will decrease as customers may switch out one item for another. For instance, if everyone in the world enjoys both coffee and tea, the demand for coffee will decline if coffee prices rise because people will easily switch to tea. This is because we see tea and coffee as good alternatives to one another.

Urgency

A purchase’s amount of demand will decrease in response to price rises the more discretionary the product. In other words, the product demand offers more elasticity.

Let’s say you are debating purchasing a new washing machine, but the one you already own is still functional despite being dated. If the cost of a new washing machine increases, you can decide against making the purchase immediately and hold off until the price drops or the old machine malfunctions.

A product’s demand will decline less as its discretionaryness increases. People purchase luxury goods because their brand names offer an example of an elastic example. Addictive products and necessary add-on items, like inkjet printer cartridges, are inelastic.

All of these products share the disadvantage of having poor alternatives. A Kindle Fire won’t do if you want an Apple iPad. Higher costs do not deter addicts, and only HP ink is compatible with HP printers (unless you disable HP cartridge protection).

Duration of Price Change

The duration of the price change also has importance.

For a price adjustment that lasts for a season or a year, the demand response remains different than for a one-day promotion.

To comprehend demand’s price elasticity and compare it with other items, we must define temporal sensitivity. Consumers could be willing to put up with a seasonal price shift rather than altering their routines.

Examples of Price Elasticity of Demand

Let’s now work through some examples of price elasticity of demand.

picture of value and price

Below we can see some examples of inelastic price demand, where the price changes don’t alter the demand much.

Close replacements impact the elasticity of demand for a good. Consumers will rapidly convert to the alternative product if the price of your product rises or the price of the alternative product falls if we can easily substitute another product for it—for instance, all meat items, including beef, pork, and chicken.

Recent years have seen a decrease in the price of poultry, which has led to a rise in the consumption of poultry at the expense of beef and pork. Therefore, the demand for products with near replacements is often elastic.

Gas: People who own cars must purchase gas and there are few alternatives to gasoline. For many people, driving is essential. There are inadequate alternatives, including the train, bus, and walking. However, demand is typically quite inelastic when gas prices rise.

Diamonds: Diamonds are the ultimate luxury, purchased extremely infrequently, and there aren’t many exact substitutes. Although you could purchase other expensive gems, they might not be as alluring as diamonds. Price reductions wouldn’t significantly boost demand.

Apple Products: Because of the well-known Apple brand, many customers are willing to pay more for Apple goods. Many people will keep purchasing Apple iPhones even if the price goes up. You would anticipate demand to be price elastic if it were a lesser-known brand, like Dell computers.

Monopoly products or services: Any product created by a monopoly is probably inelastic demand. For instance, many football fans would be willing to pay more if the NFL increased the cost of pay-per-view, although demand can be less elastic than, say, gasoline because it is not a need.

Examples of elastic demand

Campbell Soup: Campbell soup is now one of several available options. People will move to less expensive types if the price goes up.

Kit Kat Bar: If Kit Kats increases in price, people will switch to a cheaper chocolate bar.

Porsche: Given that a Porsche consumes a significant percentage of household income, demand will likely be elastic if the price increases and the increased price will deter buyers. There are further options as well, such as Jaguar or Aston Martin. This is a little less obvious, though. Even if the cost increases, some auto fans might desire to own a Porsche.

Consumer Durables: Like a washing machine or a car, these are infrequently acquired things that consumers can put off if the price increases. For instance, car discounts have been quite effective in increasing car sales by lowering prices.

Investor Takeaway

Finding companies with pricing power remains a superpower and one that Warren Buffett has shown the ability to do. Companies like Coke, Apple, and Nike can raise prices without impacting demand.

These companies have a strong moat and the ability to continue growing long into the future. Finding these companies takes some searching, but they all have strong capital returns and the ability to reinvest at high rates.

Understanding pricing power and the price elasticity of demand will help us find these companies.

Why is the price elasticity of demand important?

Understanding price elasticity can help one predict how a market will respond to changes in pricing. This is crucial for companies setting prices because changing prices will immediately affect the volume of sales. Companies must consider the price elasticity of demand as a critical element in determining the appropriate pricing goals for their niche.

And with that, we will wrap up our discussion on price elastic demand examples.

Thank you for taking the time to read this post, and I hope you find something of value. If I can be of any further assistance, please don’t hesitate to reach out.

Until next time, take care and stay safe out there,

Dave

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