Elasticity Case

Memo

To: TBD

From: Junior Staff Analyst

Date: October 12, 2011

Subject: Elasticity - draft for Mr. CEO

Elasticity is a measure of how responsive consumers are to price changes. Price changes can trigger increase or decrease in demand for a product depending on how elastic the demand is for a product. Elasticity of demand is defined three ways:

1. Elastic Demand - a percent change in price results in a larger, inverse percentage change in demand. For example, if the price of a product increases by 10%, the demand for the product decreases by more than 10%, and vice versa. Increasing price lowers total revenue while decreasing price raises total revenue.

2. Inelastic Demand - a percent change in price results in an inverse, smaller percent change in demand (usually applies to goods considered necessities). Increasing price increases revenue while decreasing price lowers total revenue.

3. Unitary Demand- a percent change in price yields an equal but inverse percent change in demand. If elasticity is unitary, a change in price does not change total revenue.

Several factors contribute to a product's demand elasticity:

1. Availability of Substitutes - Elasticity will be greater when there are more identical or similar substitute goods available - for example, there is often little difference among competing brands. If no identical or substitute goods are available, the demand will be inelastic. Examples of inelastic goods are salt, gasoline and coffee.

2. Level of Necessity (or Luxury) - the more necessary a good, the more inelastic (for example, flour) whereas an elastic good will generally be considered luxurious in nature.

3. Time - the more longevity a price change, the greater a good's elasticity since consumers will have more time to search for alternatives or substitutes.

4. Proportion of Income or Budget - the higher the percent of budget or income that a item consumes, the greater its elasticity. Additionally, the income source is another item for consideration - who pays for the item? Is it financed by an expense account or directly by the consumer? The former can reduce an item's elasticity whereas the latter can result in higher elasticity.

Given that the demand for widgets is elastic, a price increase will result in a proportionately larger percent decrease in the demand for product and vice versa. A noteworthy item in this case is brand loyalty. If a consumer is attached to a particular brand, it can overrule other factors that would otherwise deem an item's demand elastic.