After reading the Learning Activity titled “Elastic Demand,” please answer the following. The section on Market Power contrasts two different companies with different levels of market power. Compare the company given in the text with another example of a company that has high and low market power that was not mentioned in the reading. Then, explain why each of these mentioned companies represent a high or low market power firm. Lastly, provide an example of an industry that you work in or want to work in and identify a company that you feel has a high market power. Explain your rationale.
ELASTIC DEMAND
Elastic Demand
The own-price elasticity of demand (often simply called the elasticity of demand) measures the response of quantity demanded of a good to a change in the price of that good. As your read, think about the answer to the question: How price sensitive are consumers?
Marketing managers understand the law of demand. They know that if they set a higher price, they can expect to sell less output. But this is not enough information for good decision making. Managers need to know whether their customers’ demand is very sensitive or relatively insensitive to changes in the price. Put differently, they need to know if the demand curve is steep (a change in price will lead to a small change in output) or flat (a change in price will lead to a big change in output). We measure this sensitivity by the own-price elasticity of demand, which basically means the percentage change in quantity demanded of a good divided by the percentage change in the price of that good.
When price increases (the change in the price is positive), quantity decreases (the change in the quantity is negative). The price elasticity of demand is a negative number. It is easy to get confused with negative numbers, so we instead use:
which is always a positive number.
- If −(elasticity of demand) is a large number, then quantity demanded is sensitive to price: increases in price lead to big decreases in demand.
- If −(elasticity of demand) is a small number, then quantity demanded is insensitive to price: increases in price lead to small decreases in demand.
Throughout the remainder of this section, you will often see − (elasticity of demand). Just remember that this expression always refers to a positive number.
Calculating the Elasticity of Demand: An Example
Using this example:
Suppose a firm sets a price of $15 and sells 25 units. What is the elasticity of demand if we think of a change in price from $15 to $14.80? In this case, the change in the price is −0.2, and the change in the quantity is 1. Thus we calculate the elasticity of demand as follows:
The interpretation of this elasticity is as follows: when price decreases by 1%, quantity demanded increases by 3%. This is illustrated in Figure 3.22.
One very useful feature of the elasticity of demand is that it does not change when the number of units changes. Suppose that instead of measuring prices in dollars, we measure them in cents. In that case, our demand curve becomes:
Make sure you understand that this is exactly the same demand curve as before. Here the slope of the demand curve is −500 instead of −5. Looking back at the formula for elasticity, you see that the change in the price is 100 times greater, but the price itself is 100 times greater as well. The percentage change is unaffected, as is elasticity.
Market Power
The elasticity of demand is very useful because it is a measure of the market power that a firm possesses. Market power is the extent to which a firm produces a product that consumers want very much and for which few substitutes are available. In some cases, some firms produce a good that consumers want very much—a good in which few substitutes are available. For example, De Beers controls much of the world’s market for diamonds, and other firms are not easily able to provide substitutes. Thus the demand for De Beers’ diamonds tends to be insensitive to price. We say that De Beers has a lot of market power. By contrast, a fast-food restaurant in a mall food court possesses very little market power: if the Chinese fast-food restaurant were to try to charge significantly higher prices, most of its potential customers would choose to go to the other Chinese restaurant down the aisle or even to eat sushi, pizza, or burritos instead.
The Elasticity of Demand for a Linear Demand Curve
The elasticity of demand is generally different at different points on the demand curve. In other words, the market power of a firm is not constant: it depends on the price that a firm has chosen to set. To illustrate, remember that we found − (elasticity of demand) = 3 for our demand curve when the price is $15. Suppose we calculate the elasticity for this same demand curve at $4. Thus imagine that that we are originally at the point where the price is $4 and sales are 80 units and then suppose we again decrease the price by 20 cents. Sales will increase by one unit:
The elasticity of demand is different because we are at a different point on the demand curve.
When −(elasticity of demand) increases, we say that demand is becoming more elastic. When −(elasticity of demand) decreases, we say that demand is becoming less elastic. As we move down a linear demand curve, −(elasticity of demand) becomes smaller, as shown in Figure 3.23.
Measuring the Elasticity of Demand
In 2003, a major pharmaceutical company was evaluating the performance of one of its most important drugs—a medication for treating high blood pressure—in a Southeast Asian country. (For reasons of confidentiality, we do not reveal the name of the company or the country; other than simplifying the numbers slightly, the story is true.) Its product was known as one of the best in the market and was being sold for $0.50 per pill. The company had good market share and income in the country. There was one major competing drug in the market that was selling at a higher price and a few less important drugs.
In pharmaceutical companies, one individual often leads the team for each major drug that the company sells. In this company, the head of the product team—we will call her Ellie—was happy with the performance of the drug. Nonetheless, she wondered whether her company could make higher profits by setting a higher or lower price. In many countries, the prices of pharmaceutical products are heavily regulated. In this particular country, however, pharmaceutical companies were largely free to set whatever price they chose. Together with her team, therefore, Ellie decided to review the pricing strategy for her product.
To evaluate the effects of her decisions on revenues, Ellie needs to know about the demand curve facing her firm. In particular, she needs to know whether the quantity demanded by buyers is very sensitive to the price that she sets. We now know that the elasticity of demand is a useful measure of this sensitivity. How can managers such as Ellie gather information on the elasticity of demand?
At an informal level, people working in marketing and sales are likely to have some idea of whether their customers are very price sensitive. Marketing and sales personnel—if they are any good at their jobs—spend time talking to actual and potential customers and should have some idea of how much these customers care about prices. Similarly, these employees should have a good sense of the overall market and the other factors that might affect customers’ choices. For example, they will usually know whether there are other firms in the market offering similar products, and, if so, what prices these firms are charging. Such knowledge is much better than nothing, but it does not provide very concrete evidence on the demand curve or the elasticity of demand.
A firm may be able to make use of existing sales data to develop a more concrete measure of the elasticity of demand. For example, a firm might have past sales data that show how much they managed to sell at different prices, or a firm might have sales data from different cities where different prices were charged. Suppose a pricing manager discovers data for prices and quantities like those in part (a) of Figure 3.24. Here, each dot marks an observation—for example, we can see that in one case, when the price was $100, the quantity demanded was 28.
The straight-line demand curves that appear in this competency are a convenient fiction of economists, but no one has actually seen one in captivity. In the real world of business, demand curves—if they are available at all—are only a best guess from a collection of data. Economists and statisticians have developed statistical techniques for these guesses. The underlying idea of these techniques is that they fit a line to the data. (You do not need to worry about the details here.) Part (b) of Figure 3.24 shows an example. It represents our best prediction, based on available data, of how much people will buy at different prices.
If a firm does not have access to reliable existing data, a third option is for it to generate its own data. For example, suppose a retailer wanted to know how sensitive customer demand for milk is to changes in the price of milk. It could try setting a different price every week and observe its sales. It could then plot them in a diagram like Figure 3.24 and use techniques like those we just discussed to fit a line. In effect, the store could conduct its own experiment to find out what its demand curve looks like. For a firm that sells over the Internet, this kind of experiment is particularly attractive because it can randomly offer different prices to people coming to its website.
Finally, firms can conduct market research either on their own or by hiring a professional market research firm. Market researchers use questionnaires and surveys to try to discover the likely purchasing behavior of consumers. The simplest questionnaire might ask, “How much would you be willing to pay for product x?” Market researchers have found such questions are not very useful because consumers do not answer them very honestly. As a result, research firms use more subtle questions and other more complicated techniques to uncover consumers’ willingness to pay for goods and services.
Ellie decided that she should conduct market research to help with the pricing decision. She hired a market research firm to ask doctors about how they currently prescribed different high blood pressure medications. Specifically, the doctors were asked what percentage of their prescriptions went to each of the drugs on the market. Then they were asked the effect of different prices on those percentages. Based on this research, the market research firm found that a good description of the demand curve was as follows:
Remember that the drug was currently being sold for $0.50 a pill, so:
The demand curve also told Ellie that if she increased the price by 10% to $0.55, the quantity demanded would decrease to 87 (252 − 300 × 0.55 = 87). Therefore, the percentage change in quantity is:
From this, the market research firm discovered that the elasticity of demand at the current price was:
Note. Adapted from “The Revenues of a Firm,” by Cooper, 2011, Microeconomics: Theory through applications, Chapter 6, Section 2. Copyright 2010 Flat World Knowledge, Inc
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