Price elasticity of demand (PED) is a crucial concept for investors, especially those interested in companies that operate in competitive markets. It measures how much the quantity demanded of a product changes in response to a change in its price. Understanding this metric can provide insights into a product's potential profitability, market position, and vulnerability to price changes.
Price Elasticity of Demand is defined as:
PED = Percentage change in Quantity Demanded / Percentage change in Price
PED > 1, demand is elastic.
If PED < 1, demand is inelastic.
If PED = 1, demand is unit elastic.
Types of Price Elasticity
Perfectly Elastic (PED = ∞): A small price change results in an infinite change in quantity demanded.
Perfectly Inelastic (PED = 0): Price changes have no effect on quantity demanded.
Unit Elastic (PED = 1): A percentage change in price results in an equal percentage change in quantity demanded.
Elastic (PED > 1): A percentage change in price results in a larger percentage change in quantity demanded.
Inelastic (PED < 1): A percentage change in price results in a smaller percentage change in quantity demanded.
Factors Influencing Price Elasticity
Availability of substitutes: The more substitutes available, the more elastic the demand.
Necessity vs. luxury: Necessities tend to have inelastic demand, while luxuries tend to have more elastic demand.
Time period: Demand can become more elastic over time as consumers find substitutes.
Brand loyalty: Strong brand loyalty can make demand more inelastic.
Definition of the market: The broader the market definition, the more substitutes available, hence more elastic demand.
Implications for Investors
Revenue and Pricing Strategy: A firm with inelastic demand can increase prices without a significant drop in quantity sold, potentially increasing revenue. Conversely, a firm with elastic demand might consider reducing prices to increase quantity sold and total revenue.
Competitive Position: Products with inelastic demand might have fewer substitutes or strong brand loyalty, indicating a strong market position.
Cost Volatility: Companies selling products with elastic demand may experience more volatility in revenue if costs change, requiring price adjustments.
Marketing and Branding: Understanding elasticity can guide marketing strategies. For products with elastic demand, branding and advertising might make demand more inelastic.
Gasoline: Generally, the demand for gasoline is relatively inelastic in the short term because there are few substitutes available. If the price of gasoline rises, people might grumble but will generally continue to buy similar amounts. However, in the long term, if prices remain high, consumers might seek alternatives like electric cars, making demand more elastic.
Luxury Goods: High-end luxury goods like designer handbags or luxury cars typically have more elastic demand. If the price goes up significantly, consumers might forgo the purchase or seek alternatives.
For investors, understanding the price elasticity of demand for products sold by firms in their portfolios can offer insights into potential revenue impacts from price changes, the competitive position of the firm, and the overall market dynamics. It's an essential tool in the toolkit for evaluating potential investments and forecasting future performance.