Chapter 3 - Demand and Pricing

Decisions related to demand and pricing are usually called marketing decisions. Marketing is an established profession and
an applied academic discipline with a large body of literature. However, economic reasoning and concepts provide much of
the theoretical foundation for marketing practice. In this chapter, we will address these elements from the perspective of
economics.

Theory of the Consumer

Consumer theory is the study of how people decide to spend their money based on their individual preferences and budget
constraints. A branch of microeconomics, consumer theory shows how individuals make choices, subject to how much
income they have available to spend and the prices of goods and services. Trying to understand what goes on in a
consumer’s head and exactly what makes them buy is a goal of every business. The only way to do this is by closely
studying the buying patterns and building theories and models.

Factors that Influence Buyer Behavior

● Psychological - Psychological factors include a person’s attitude, perceptions about a situation, their ability to
understand information, what motivates them, their personality and beliefs. For example, a person who is actively
reducing his plastic consumption will avoid buying from someone who doesn’t believe in climate change.
● Personal - Personal characteristics include age, gender, financial situation, occupation, background, culture and
location. An older person will probably shop in a different way compared to a younger person. The older person may
have a preference for bricks-and-mortar stores (physical store) rather than online shopping.
● Social - Social influences can include a person’s friends, family, community, work or school community, or groups they
associate with such as a local church or hobby group. It can also include social class, living conditions and education.
A shopper might shop for items which are in fashion similar to those worn by his peers.

Why Consumer Behavior Theory is Important

Consumer behavior theory allows businesses to understand more about their target consumers and so be able to craft
products and services that influence buying habits. Consumer behavior theory is the study of how people make decisions
when they purchase, helping businesses and marketers capitalize on these behaviors by predicting how and when a
consumer will make a purchase. It helps to identify what influences these decisions, as well as highlight strategies to
proactively manipulate behavior. It allows a business to understand:
● What consumers think about your brand versus your competitors
● How they choose between different alternatives
● Their behavior while shopping
● How the environment around them influences their behavior
● What marketing messages or pricing strategies they best respond to
● Their preferred methods of paying
● What products or services they are searching for to fill a need

By paying attention to your customers’ buying patterns, you can launch products and services that are likely to influence
more consumers to buy. It will also allow you to make necessary changes to your store environment or online shopping
processes to make it seamless. For example, if you have a large physical store and you notice that shoppers pick up
products to buy, look around for a while, seem to get frustrated and then put them down and walk out without buying, it
might be because you need better ‘Pay Here’ signage directing them to the nearest till.
Types of Buyer Behavior

It’s important to understand that everyone is different and makes different buying decisions. However, these can generally
be categorized into these four types:

1. Routine response
Brand recognition and repetition plays a large part in this type of buying behavior. People will purchase a brand they
recognize, have tried before, or like the best. For example, when choosing a loaf of sliced bread, you’ll probably have a
favorite that you reach for most often. This type of buying doesn’t require much thought.

2. Limited decision-making
Often mid-level, occasional buying decisions fall into this category. They require some research and little amount of thought
before making a choice. For example, you might be going out to the cinema and want to eat dinner beforehand so look at
the restaurants nearby. You pick one that’s within your budget, that offers the food you like, that’s within a short walking
distance and that has a table for the time you’d like.

3. Extensive decision-making
Buying decisions that involve a big financial investment or personal impact fall into this category. Most buyers will spend an
extensive amount of time researching before making a decision. Buying a house is one example. Many in the market for a
new home will research thoroughly, view numerous properties, weigh up different options, visit local areas, check the nearby
schools and facilities etc. before a purchase is made.

4. Impulse buying
An impulse buy has no prior planning. It is a purchase made on a whim and with little thought. It’s often irrational and in the
moment. For example, if you’re waiting in a line to buy your lunch and see a magazine within easy reach with an
eye-catching front cover, then you might pick it up and buy it with no in-depth consideration. These ‘types’ will change
depending on the situation and person. For example, a consumer who has just started a low-fat diet might take longer
choosing a food item by checking the ingredients online and looking at reviews than someone who isn’t. An affluent person
might impulse-buy a car, whereas another might spend an extensive amount of time researching different options and going
for test drives.

And many will spend months researching where they want to spend their two-week holiday, whereas others decide on a
whim where to go and book a holiday at the last minute. And some situations will force a consumer who is usually an
extensive decision maker into making an impulse buy – for example if their laptop breaks down and they need to buy
another quickly without doing their usual due diligence because they can’t operate without one. This is why buyer behavior
is described as being both predictable and irrational.

Types of Buyers

Over the years, psychologists, sociologists and researchers have come up with different models and theories about different
kinds of buyers. One research theory proposes eight characteristic buyers:
● Perfectionist: the customer looks for the best quality of product.
● Brand-aware: the customer prefers brands and designer labels.
● Hedonist: the customer treats shopping as a form of enjoyment.
● Price-aware: the customer seeks low prices, sales discounts.
● Fashion-aware: the customer likes to be up-to-date and seeks variety.
● Impulsive: the customer is prone to spontaneous purchases.
● Confused: the customer experiences too much information or choice.
● Habitual: the customer is loyal to brands and follows a routine.
Analyzing Buyer Behavior

There are various ways to analyze buyer behavior, however these questions from the London School of Business and
Finance are a great place to start:
● Who purchases your products and services? Get a clear idea of your target audience with market research.
● Who makes the decision to purchase your products and services? The purchaser might be different to the actual
person making the decision, e.g., a painter and decorator will buy paint chosen by their customer.
● Who influences the decision to purchase the products? Parents might be the shoppers but they are influenced by
their children.
● How is the purchase decision made? A person employing a gardener for the first time might be told what specific
products to buy by the gardener.
● Why does the consumer buy a product? The rationale behind the purchase. For example, a person on a long
commute might buy a thick milkshake because it lasts a long time and will keep them occupied during the drive.
● Why does a consumer prefer one brand over another? Factors include cost, quality, customer service, previous
experience, brand reputation and packaging etc.
● Where do customers purchase the product? Physical shops, online, face-to-face, via a third party etc.
● When do consumers buy a product? Specific occasions, for example Valentine’s Day or looking for a new gas and
electric provider at new premises.
● What is the consumer’s opinion of the product? Do they view it as value for money, cheap or expensive; is it cool or
functional; is it a throwaway item or do they expect it to be around for years etc.
● What is the role of consumers’ lifestyle in their buying behavior? Fitness fans will be more interested in purchasing
technical clothes for exercise, whereas those who love movies might be inclined to purchase a movie streaming
subscription.

How Consumer Buying Habits Have Changed

Consumer buying habits are continually evolving, and the ways that businesses think about them have changed too. Initially,
it was believed that consumers were rational and behaved in consistent ways. However, as time progressed and more
sophisticated studies were conducted, it became apparent that consumers often behave irrationally with numerous factors
determining decisions and buying habits. Consumers were then segmented, and user experiences were analyzed to
understand how they shaped buying habits. The post-purchase activity and habits were also studied so a customer journey
could be mapped out from first decision, through to consideration, purchase and post-purchase satisfaction.

It’s important to look at trends, for example eating habits have changed dramatically from meat to vegetables, to an appetite
for cuisines from around the world. More people are becoming vegan, and there’s been an increase in demand for
plant-based foods. Payment methods and buying preferences have also evolved. Most people are happy to buy online,
however this was risky back in 1995 when the internet was new and Amazon first launched. Consumers are now purchasing
SaaS (software as a service) services and subscription boxes, streaming movies rather than going to a shop to rent a DVD.
And buying their groceries online without ever having to step foot inside a grocery store.

Putting Consumer Behavior Theory into Practice

Understanding the different types of buying decision and mapping these against your target audience and buyer personas
will help you to craft compelling marketing messages, eye-catching packaging, the right pricing models, deals and discounts
and other benefits to hook in your consumer.

Assessing trends and watching the changes in consumer buying patterns will also ensure you not only to sell a product or
service that people want, but that you can keep up with demand. You’ll be able to make predictions and plan the best times
for launches and special offers.
It’s important to understand that there are numerous variables and that not every consumer is the same. Map out different
scenarios, and attempt to put yourself in the mind of your shopper. For example, a person who is usually an extensive
researcher and is forced to make an impulse decision might appreciate a 30-day cooling off period, allowing them to return
the purchase if it turns out not to be suitable. Spending time getting this right will see you experience a rush from consumers
to buy your new product or service, an increase in customer loyalty and retention and be able to create the right
environments to encourage a purchase.

Determinants of Demand

1. Levels of income
The demand for goods also depends upon incomes of the people. The greater the incomes of the people the greater will be
their demand for goods. In drawing a demand schedule or a demand curve for a good we take incomes of the people as
given and constant. When as a result of the rise in incomes of the people, the demand increases, the whole of the demand
curve shifts upward and vice versa. The greater income means the greater purchasing power. There­fore, when incomes of
the people increase, they can afford to buy more. It is because of this reason that the increase in income has a positive
effect on the demand for a good. When the incomes of the people fall they would demand less of the goods and as a result
the demand curve will shift below. For instance, during the planning period in India the incomes of the people have greatly
increased owing to the large investment expenditure on the development schemes by the Government and the private
sector. As a result of this increase in incomes, demand for food-grains has greatly increased which has resulted in rightward
shift in the demand curve for them. Likewise, when because of drought in a year the agricultural production greatly falls,
incomes of the farmers decline. As a result of the decline in incomes of the farmers, they demand less of cotton cloth and
other manufactured products. A key determinant of demand is the level of income evident in the appropriate country or
region under analysis. As a generality, the higher the level of aggregate and/or personal income the higher the demand for a
typical commodity, including forest products. More of a good or service will be chosen at a given price where income is
higher. Thus, determinants of demand normally utilize some form of income measure, including Gross Domestic Product
(GDP).

2. Individual Taste & Preferences

An important factor which determines demand for a good is the tastes and preferences of the consumers for it. A good that
satisfies the consumers’ tastes and preferences will have greater demand and it’s demand curve will lie at a higher level.
People’s tastes and preferences for various goods often change, and as a result there is a change in demand for them. The
changes in demand for various goods occur due to the changes in fashion and also due to the pressure of advertisements
by the manufacturers and sellers of different products. For example, when Coca Cola was first introduced in New Delhi,
demand for it was very small. But now people’s taste for Coca Cola has become favorable due to large advertisement and
publicity. The result was that the demand for Coca-Cola increased considerably. In economics we would say that the
demand curve For Coca Cola has shifted upward. On the contrary when any good goes out of fashion or people’s tastes
and preferences no longer remain favorable to it the demand for it decreases. In economics we say that the demand curve
for these goods will shift downward. All markets are shaped by individual & collective tastes and preferences. These
patterns are partly shaped by culture and partly implanted by information and knowledge of products and services (including
the influence of advertising). Different societies use forest products differently because of these differences in taste and
preferences. For example, markets for wood products in Japan are commonly recognized as requiring very high product
quality standards, the importance of visual attributes of wood, and other preferences not commonly found in many other
markets.

3. Changes in the Prices of the Related Goods:

The demand for a product is also affected by the prices of other goods, especially those related to it as substitutes or
complements. When we draw a demand schedule or a demand curve for a product we take the prices of the related goods
as remaining constant. Therefore, when the prices of the related substitutes or complements change, the whole demand
curve change its position; it will shift upward or downward as the case may be. When the price for a substitute product falls,
the demand for the main product will decline and vice versa. For example, when the price of tea as well as the incomes of
people remain the same but the price of coffee falls, the consumers would demand less of tea than before. Tea and coffee
are very close substitutes, therefore when coffee becomes cheaper, the consumers substitute coffee for tea and as a result
the demand for tea declines. Changes in the price of complementary products also affect the demand of the other. For
instance, if the price of milk falls, the demand for sugar would also be affected. Hence when people buy more milk to make
milk based desserts such as khoya, burfi, & rasgullas; the demand for sugar will also increase. Likewise, when the price of
cars falls, the demand for them will increase which in turn will increase the demand for petrol. Cars and petrol are
complementary products.

4. The Number of Consumers in the Market:

We have explained that the market demand for a good is obtained by adding up the individual demands of the present as
well as prospective consumers at various possible prices. The greater the number of consumers of a good, the greater the
market demand for it. Consumer substitution where preference for one good is substituted for another is a factor increasing
the demand for one good over the other. Finding new markets for good also increases the number of consumers. Another
Important factor for the increase in the number of consumers is the growth in population. For instance, in India the demand
for many essential goods, especially food-grains, has increased because of the increase in the population of the country
and the resultant increase in the number of consumers for them.

5. Changes in Propensity to Consume:

People’s inclination to consume also affects the demand for goods. Assuming peoples income remain constant; when the
peoples inclination to consume is high, then there is a tendency for them to spend more thus increasing the demand for
goods. On the other hand, if the people are inclined to save, that is, if propensity to consume declines, then the consumers
would spend a smaller part of their income on goods with the result that the demand for goods will decrease. It is thus clear
that with income remaining constant, change in propensity to consume of the people is a factor that will bring about a
change in the demand for goods.

6. Consumers’ Expectations with regard to Future Prices:

Another factor which influences the demand for goods is consumers’ expectations with regard to future prices of the goods.
If due to some reason, consumers expect that in the near future prices of the goods would rise, then in the present they
would demand greater quantities of the goods so that in the future they should not have to pay higher prices. Similarly, when
the consumers hope that in the future they will have good income, then in the present they will spend greater part of their
incomes with the result that their present demand for goods will increase.

7. Income Distribution:
Distribution of income in a society also affects the demand for goods. In places where there is equal distribution of income,
the propensity of people to consume is high and leads to greater demand. On the other hand, in places where there is
unequal distribution of income, the peoples propensity to consume is low. Since the propensity of rich people is to consume
less than poor people, the demand for consumer goods will be comparatively less. This is the effect of the income
distribution on the propensity to consume and demand for goods. If progressive taxes are levied on the goods consumed by
the rich and the money is spent to provide employment for the poor people, the income distribution would become more
equal. With the increased purchasing power of the poor, there will be a corresponding increase in demand for basic goods
consumed by the poor. On the other hand, there would be less demand for those goods consumed by the rich which are
subjected to progressive taxes.

Customer Behavior Analysis:

A customer behavior analysis is a thorough investigation of how customers engage with your company. Using qualitative
and quantitative methods, a customer behavior analysis looks at every step in the customer journey and provides insight
into what's driving consumer behavior. Some of the methods used for customer behavior analysis are as follows:

1. Customer Behavior Modeling

 Consumer Behavior Modeling is defined as the creation of a mathematical construct to represent the common behaviors
observed among particular groups of customers in order to predict how similar customers will behave under similar
circumstances. Customer behavior models are typically based on data mining of customer data, and each model is
designed to answer one question at one point in time. For example, a customer model can be used to predict what a
particular group of customers will do in response to a particular marketing action. If the model is sound and the marketer
follows the recommendations it generated, then the marketer will observe that a majority of the customers in the group
responded as predicted by the model. Unfortunately, building customer behavior models is typically a difficult and
expensive task. This is because the smart and experienced customer analytics experts who know how to do it are
expensive and difficult to find, and because the mathematical techniques they need to use are complex and risky.
Furthermore, even once a customer behavior model has been built, it is difficult to manipulate it for the purposes of the
marketer, i.e., to determine exactly what marketing actions to take for each customer or group of customers. Finally, despite
their mathematical complexity, most customer models are actually relatively simple. Because of this necessity, most
customer behavior models ignore so many pertinent factors that the predictions they generate are generally not very
reliable.

2. The RFM Approach

Many customer behavior models are based on an analysis of Recency, Frequency and Monetary Value (RFM). This means
that customers who spend money more often as well as those who spent the most for a good or service are more likely than
others to spend again. RFM is popular to marketers and business managers because it is easy to understand. It does not
require specialized software and it holds true for customers in almost every business and industry. Unfortunately, RFM
alone does not deliver the level of accuracy that marketers require. Firstly, RFM models only describe what a customer has
done in the past and cannot accurately predict future behaviors. Secondly, RFM models look at customers at a particular
point in time and do not take into account how the customer has behaved in the past or in what lifecycle stage the customer
is currently found. This second point is critical because accurate customer modeling is very weak unless the customer’s
behavior is analyzed over time.

3. Optimove, A Better Approach to Customer Behavior Modeling

Optimove introduces customer behavior modeling methods which are far more advanced and effective than conventional
methods. By combining a number of technologies into an integrated, closed-loop system, marketers enjoy highly accurate
customer behavior analysis in an easy-to-use application. Optimove achieves market-leading predictive customer behavior
modeling with the combination of the following capabilities:
● Segmenting customers into small groups and addressing individual customers based on actual behaviors – instead
of hard-coding any pre-conceived notions or assumptions of what makes customers similar to one another, and
instead of only looking at aggregated/averaged data which hides important facts about individual customers
● Tracking customers and how they move among different segments over time (i.e., dynamic segmentation), including
customer lifecycle context and cohort analysis – instead of just determining in what segments customers are now
without regard for how they arrived there
● Accurately predicting the future behaviors of customers (e.g., convert, churn, spend more, spend less) using
predictive customer behavior modeling techniques – instead of just looking in the rear-view mirror of historical data
● Using advanced calculations to determine the customer lifetime value (LTV) of every customer and basing
decisions on it – instead of looking only at the short-term revenue that a customer may bring the company
● Knowing, based on objective metrics, exactly what marketing actions to do now, for each customer, in order to
maximize the long-term value of every customer – instead of trying to figure out what to do based on a dashboard
or pile of reports.
● Employing marketing machine learning technologies that can reveal insights and make recommendations for
improving customer marketing that human marketers are unlikely to spot on their own.

One way to think of the difference between conventional approaches and the Optimove approach is that the former is like a
customer snapshot whereas the latter is a customer animation. The animated view of the customer is far more revealing,
allowing much more accurate customer behavior predictions.

Forecasting Demand
Demand forecasting is the process of making estimations about future customer demand over a defined period, using
historical data and other information. Proper demand forecasting gives businesses valuable information about their potential
in their current market and other markets, so that managers can make informed decisions about pricing, business growth
strategies, and market potential. Without demand forecasting, businesses risk making poor decisions about their products
and target markets – and ill-informed decisions can have far-reaching negative effects on inventory holding costs, customer
satisfaction, supply chain management, and profitability.

Importance of Demand Forecasting

There are a number of reasons why demand forecasting is an important process for businesses:
● Sales forecasting helps with business planning, budgeting, and goal setting. Once you have a good understanding
of what your future sales could look like, you can begin to develop an informed procurement strategy to make sure
your supply matches customer demand.
● It allows businesses to more effectively optimize inventory, increase inventory turnover rates and reduce holding
costs.
● It provides an insight into upcoming cash flow, meaning businesses can more accurately budget to pay suppliers
and other operational costs, and invest in the growth of the business.
● Through sales forecasting, you can also identify and rectify any kinks in the sales pipeline ahead of time to ensure
your business performance remains robust throughout the entire period. When it comes to inventory management,
most eCommerce business owners know all too well that too little or too much inventory can be detrimental to
operations.
● Anticipating demand means knowing when to increase staff and other resources to keep operations running
smoothly during peak periods.

Types of Demand Forecasting

Most traditional demand forecasting techniques fall into one of these basic categories:
● Qualitative Forecasting - Qualitative forecasting techniques are used when there isn’t a lot of data available to work
with, such as for a relatively new business or when a product is introduced to the market. In this instance, other
information such as expert opinions, market research, and comparative analyses are used to form quantitative
estimates about demand.
● Trade Gecko Demand Forecasting - This approach is often used in areas like technology, where new products may
be unprecedented, and customer interest is difficult to gauge ahead of time.
● Time Series Analysis - When historical data is available for a product or product line and trends are clear,
businesses tend to use the time series analysis approach to demand forecasting. A time series analysis is useful for
identifying seasonal fluctuations in demand, cyclical patterns, and key sales trends. The time series analysis
approach is most effectively used by well-established businesses who have several years’ worth of data to work
from and relatively stable trend patterns.
● Causal Models - The causal model is the most sophisticated and complex forecasting tool for businesses because it
uses specific information about relationships between variables affecting demand in the market, such as
competitors, economic forces, and other socioeconomic factors. As with time series analyses, historical data is key
to creating a causal model forecast. For example, an ice cream business could create a causal model forecast by
looking at factors such as their historical sales data, marketing budget, promotional activities, any new ice cream
stores in their area, their competitors’ prices, the weather, overall demand for ice cream in their area, and even their
local unemployment rate.

Price Elasticity of Demand

Price and demand typically head in the opposite direction, but the demand curve varies greatly based on the product and in
particular, on how necessary the product is. Price elasticity of demand (PED) is a key concept related to the law of demand.
It is an economic measurement of how quantity demanded of a good will be affected by changes in its price. In other words,
it’s a way to figure out the responsiveness of consumers to fluctuations in price (as opposed to price elasticity of supply,
which determines the responsiveness of supply to price). Knowing the price elasticity of a good can offer insight into how a
market will react to price changes. This is really important for businesses that are making pricing decisions as raising or
lowering prices will directly impact the number of sales. Factoring price elasticity of demand is a key step for companies to
determine the right pricing objectives to go after within their niche. There are two types of price elasticity of demand:

A) Elastic Demand - Elastic demand happens when the demand changes for goods is sensitive to price changes.
Common goods typically have elastic demand Elastic demand is used to describe the scenario where the change in
demand is sensitive to a small change in price. For example, if the price of a Lays chips increases, consumers are
more likely to shift to a different brand, driving the demand down and vice versa. This means that chips have elastic
demand due to the availability of close substitutes.

B) Inelastic Demand.. Inelastic demand is when the demand for goods is not affected much by price changes.
Necessary commodities have inelastic demand. Inelastic demand describes the scenario where fluctuations in price
do not change the demand for a good. For example, gas is required for cars to run and there are no substitutes for
the availability of gas. This means that anyone who has a car will have to pay for gas regardless of how high the
prices are, making demand inelastic

Calculating Demand Elasticity

Price elasticity of demand (PED) shows the relationship between price and quantity demanded and provides a precise
calculation of the effect of a change in price on quantity demanded. The price elasticity of demand (which is often shortened
to demand elasticity) is defined to be the percentage change in quantity demanded, divided by the percentage change in
price. The Formula: PED = (% Change in QD) / (% Change in P)

Problem 1
Assuming the price of compact disc increased from $20 to $22, the quantity of compact disc demanded decreased from 100
to 87. What is the price elasticity of demand for CDs?

Solution:
Percentage increase in price (22-20)/20 = 10%
Percentage decrease in demand (87-100)/100 = -13%
PED (-13%/10%) = -1.3
In this case the demand is price elastic. Elastic demand occurs when % change in quantity demanded is greater than %
change in price; when PED >1

Note: Since quantity demanded usually decreases with increases in price, the price elasticity coefficient is almost always
negative. Economists, being a lazy bunch, usually express the coefficient as a positive number even when its meaning is
the opposite. We're a pretty difficult people. It’s important to note, however, a decrease in quantity demanded does not
automatically mean that revenue decreases. The additional profit margin could make up for the slight decrease in purchases

Problem 2
Assuming the price rises from $15 to $30 (100% rise in price) and the quantity demanded falls from 100 to 80 (20% fall).
What is the price elasticity of Demand?

Solution:
PED (-20%/100%) = -0.2
Note: In this case the demand is price inelastic since the % change in quantity demanded is lesser than the % change in
price. When the price elasticity of a good is less than 1, it’s considered inelastic. That means a one unit increase in price
resulted in a less than one unit decrease in demand. On the other hand, if the coefficient (the absolute value) is more than
1, the good is elastic. That means a unit increase in price will cause an even greater drop in demand. Theoretically, revenue
will be maximized when the price elasticity of a good equals 1, or in other words, when demand is unit elastic.

Cross Elasticity of Demand

This is the other concept of elasticity of demand which explains the sensitivity of quantity demanded of any commodity when
the price of the other substitute products changes. The cross elasticity of demand is always positive as the demand for one
commodity will definitely be increased when the price of substitute products increases. For example, if the price of coffee
increases, the demand for tea in the market will increase. Cross Elasticity of demand can be calculated as % changes in the
demanded quantity of product A divided by % change in the price of product B,

Cross Elasticity of Demand (EA.B) = (% Change in Demanded Quantity of Product A) / (% Change in Price of Product B)

Cross Elasticity – Example Problem

Let’s understand this by the example of two coke brands A and B. Suppose in a quarter, the quantity demand for Coke A
increases by 12% due to a 15% price increase of Coke B.

Solution: Cross Elasticity of Demand is calculated using the formula given below

Cross Elasticity of Demand (EA.B) = (% Change in Demanded Quantity of Product A) / (% Change in Price of Product B)
● Cross Elasticity of Demand (EA.B) = (12%) / (15%)
● Cross Elasticity of Demand (EA.B) = 0.8
So when we see that the cross elasticity of demand is positive for Coke A and Coke B, it means these 2 are substitute
products, and the changes in the price of one product would affect the demanded quantity of another product.

Income Elasticity of Demand

Income is another variable that affects the demand for any commodity. Income Elasticity of demand refers to the sensitivity
of the quantity demanded to a change in the income of the consumer for a commodity. It is measured as a % change in the
demanded quantity divided by the % change in the income of consumers for a particular commodity.

Income Elasticity of Demand (EI) = ( % Change in Demanded Quantity/% Change in Income) Or

Income Elasticity of Demand (EI) = (Change in Quantity/Original Quantity) * (Original Income/Change in Income)

The income elasticity of demand could be seen with luxurious commodities. When a person’s income increases, that person
would most likely be spending more on branded and luxurious commodities. Higher income elasticity for a commodity also
means higher sales for that commodity. The income elasticity of demand is also positive since an increase in income also
increases demand. The following are some examples of luxurious commodities: wines, high-quality chocolates, branded
clothes, expensive smartphones, clubs and gym membership, sports cars, private taxis instead of buses or any other public
transport.

Income Elasticity – Example Problem

Let’s assume consumer A had a monthly income of $2000, and used public transport most of the time. He uses a private
cab only 10 times in a month. Lately, his salary increases to $2500. He now spends 20 times more on private cab instead of
public transport in a month. What is the income elasticity for this commodity using the above-mentioned formula?

Solution:
% Change in Demanded Quantity is calculated as
● % Change in Demanded Quantity = (20 – 10) / 10
● % Change in Demanded Quantity = 1

% Change in Income is calculated as

● % Change in Income = 2000 / (2500 – 2000)
● % Change in Income = 4

Income Elasticity of Demand (EI) is calculated using the formula given below.

Income Elasticity of Demand (EI) = ( % Change in Demanded Quantity / % Change in Income)

● Income Elasticity of Demand (EI) = 1 * 4
● Income Elasticity of Demand (EI) = 4
So in the above example, we can see that income elasticity for private taxi services is 4, which is highly elastic. The
consumer tends to spend more on private taxis when they earn more income.

Conclusion

The elasticity of demand is a useful concept in making pricing decisions and determination of output levels. It helps in fixing
the prices of products for businesses and specifically for monopolists. We can come to know the proportion by which
demand will fall in response to the rise in prices if we know the elasticity of demand. If the demand for a product is relatively
inelastic, the seller of a product can charge a high price for it. If the demand is relatively elastic, he can charge a low price.
The elasticity of demand also helps in framing government policies while imposing statutory price control on a product and
levying taxes. The government can levy more taxes on products that have relatively inelastic demand. Knowledge of income
elasticity of demand is useful for forecasting the future demand for a product. For instance, since the general income levels
of people in India are expected to rise, the demand for goods purchased with disposable income will rise by leaps and
bounds. The concept of elasticity of demand is also useful in international trade. There is said to be gained from
international trade for a country if it exports goods that have less elasticity of demand and imports goods that have more
demand elasticity.

Questions to Consider for Your Product

The ultimate goal of doing business is to capture as much cash on the table as possible. As such, you need to make your
product as inelastic as possible, increasing demand, regardless of how expensive you make the product. Essentially, you
want your customers, to not be able to live without your business. The inputs necessary for this phenomenon to occur will
adjust with different customer segments, but the thought process for each segment remains the same. So, how do you
determine your product's elasticity for each segment, and use this knowledge to your advantage? Here are a few things to
think about:

1. Is the product a necessity or a luxury good?

Necessities tend to be inelastic (gasoline, electricity, water, etc.) while luxury ones are the opposite (chocolate, food,
entertainment, etc.), because they are easier to cut out when the going gets tough. For example, you probably won’t stop
buying light bulbs if the price went up by a few percent’s, but you might not book that cruise to the Bahamas if the cost rose.
In this case, light bulbs could be predicted to be relatively inelastic, while cruises unfortunately wouldn’t.

2. How available are close substitutes?

If your product has a lot of competition that is pretty similar, raising prices will most likely drive consumers away. Product
differentiation is important when competition is great. Therefore, build integral features that are essential to the customer
which your competitors don't have.

3. How much does your product actually cost?

The type of product to sell is a factor to be considered. The higher the price of a product, the more elastic it is, due to
psychological pricing. You might sell some of the least expensive cars around, but even a cheap vehicle costs a lot of
money. But then, you probably don’t even know how much a pack of Paper Mate pens cost, so when the price rises by 10%
(just a few cents) you likely won’t notice. But, if the price decreases by 10% on that new car you want (hundreds or
thousands of dollars), then you’re sure to notice.

4. How long will this price change last?

All goods become more elastic in the long run. With time, it is possible to find substitutes or learn to live without something
when it wasn’t possible under the pressure of time. The classic example is oil. If the price of oil rises in the short run (say,
tomorrow), people would grumble over breakfast for a couple days but still fill their tanks. In the long run, however, people
might buy hybrids or smaller cars that use less gas. So even if you determine that your product is inelastic, be careful of
what implications a price change (even a small percentage change) could have down the road.

Overall, price elasticity should be an important consideration when developing your product and marketing strategies, in
addition to being a basic building block behind your pricing. A huge factor that I'll repeat is that the price elasticity for
different customer segments will vary. Thus, your marketing, pricing, and bundling must vary. At the end of the day
remember, pricing is a process that you must integrate into your company's trajectory.

Consumption Decisions in the Short Run and the Long Run

Economists distinguish short-run decisions from long-run decisions. Demand functions and demand curves can be
developed for short-run or long-run time horizons. Elasticities of demand in the short run can differ substantially from
elasticities in the long run.

Short Run Decisions

A consumer decision is considered short run when her consumption will occur soon enough to be constrained by existing
household assets, personal commitments, and know-how. Given sufficient time to remove these constraints, the consumer
can change her consumption patterns and make additional improvements in the utility of consumption. Short-run demand
curves are easier to develop because they estimate demand in the near future and generally do not require a long history of
data on consumption and its determinant factors. Short-run analyses, on the other hand, are feasible for many analysts
working for the businesses that must estimate demand in order to make production decisions.
Long Run Decisions
Decisions affecting consumption far enough into the future so that any such adjustments can be made are called long-run
decisions. Long-run demand must account for changes in consumption styles, it requires longer histories of data and
greater sophistication. Long-run price elasticities for a product are generally of higher magnitude than their short-run
counterparts because the consumer has sufficient time to change consumption styles. There is so much uncertainty about
long-run consumption that these analyses are usually limited to academic and government research.

Price Discrimination

Price discrimination is a selling strategy that charges customers different prices for the same product or service based on
what the seller thinks they can get the customer to agree to. Price discrimination is practiced based on the seller's belief that
customers in certain groups can be asked to pay more or less based on certain demographics or on how they value the
product or service in question. Price discrimination is most valuable when the profit that is earned as a result of separating
the markets is greater than the profit that is earned as a result of keeping the markets combined. Whether price
discrimination works and for how long the various groups are willing to pay different prices for the same product depends on
the relative elasticities of demand in the sub-markets. Consumers in a relatively inelastic submarket pay a higher price,
while those in a relatively elastic sub-market pay a lower price.
How Price Discrimination Works

With price discrimination, the company looking to make the sales identifies different market segments, such as domestic
and industrial users, with different price elasticities. Markets must be kept separate by time, physical distance, and nature of
use. For example, Microsoft Office Schools edition is available for a lower price to educational institutions than to other
users. The markets cannot overlap so that consumers who purchase at a lower price in the elastic sub-market could resell
at a higher price in the inelastic sub-market. The company must also have monopoly power to make price discrimination
more effective

Types of Price Discrimination

There are three types of price discrimination: first-degree or perfect price discrimination, second-degree, and third-degree.
These degrees of price discrimination are also known as personalized pricing (1st-degree pricing), product versioning or
menu pricing (2nd-degree pricing), and group pricing (3rd-degree pricing).

First-degree Price Discrimination

First-degree discrimination, or perfect price discrimination, occurs when a business charges the maximum possible price for
each unit consumed. Because prices vary among units, the firm captures all available consumer surplus for itself, or the
economic surplus. Many industries involving client services practice first-degree price discrimination, where a company
charges a different price for every good or service sold.

Second-degree Price Discrimination

Second-degree price discrimination occurs when a company charges a different price for different quantities consumed,
such as quantity discounts on bulk purchases.

Third-degree Price Discrimination

Third-degree price discrimination occurs when a company charges a different price to different consumer groups. For
example, a theater may divide moviegoers into seniors, adults, and children, each paying a different price when seeing the
same movie. This discrimination is the most common.

Examples of Price Discrimination

Many industries, such as the airline industry, the arts and entertainment industry, and the pharmaceutical industry, use price
discrimination strategies. Examples of price discrimination include issuing coupons, applying specific discounts (e.g., age
discounts), and creating loyalty programs. One example of price discrimination can be seen in the airline industry.
Consumers buying airline tickets several months in advance typically pay less than consumers purchasing at the last
minute. When demand for a particular flight is high, airlines raise ticket prices in response.

By contrast, when tickets for a flight are not selling well, the airline reduces the cost of available tickets to try to generate
sales. Because many passengers prefer flying home late on Sunday, those flights tend to be more expensive than flights
leaving early Sunday morning. Airline passengers typically pay more for additional legroom too.