M03EFA: ECONOMIC ENVIRONMENT OF BUSINESS

(October 2011)

AN ESSAY ON OWN PRICE AND INCOME ELASTICITY DEMAND

Shreenath Nair (ID: 3989438)

(MBA General Management)

Module Leader: Dr. Keith Gray

INTRODUCTION

The decision which deals with the setting of price for a particular product is

considered very crucial for a company’s success. The understanding of the

responsiveness of the change of price of the products is inevitable for a

product’s success. The main objectives of a firm can only be fulfilled if a

“best price” is decided for its products .Many firms fail to consider the critical

concept of changing demands with changing price. The proper pricing

strategies in an organization leads from proper management activities within

the organization .The crest and trough in the profits of an organization is the

direct measure of efficient and poor management respectively. The

economist’s view towards any business with respect to pricing strategies

always boils down within the conceptual framework of price elasticity and

how each elements associated with it changes with changes in external and

internal factors. A deeper analysis of own price elasticity and income price

elasticity has to be brought about in an organization while dealing with

decisions on price setting.

THEORY

The sensitivity of the consumers towards a price change , with respect to

different markets, is different . “This reaction is measured using elasticity”

(Begg and Ward 2009:29) .

“Price elasticity of demand is a measure of the responsiveness of demand for

a product to a change in its own price”(Griffiths and wall 2011: 40)

Price elasticity of demand (PED) = Percentage change in quantity

demanded

Percentage change in price

The Price elasticity of demand helps to determine the change in demand if

the price of a product is increased or decreased with respect to

organizational strategies and targets. The important elasticity measures is

brought out by different elasticity values which can be described as perfectly

inelastic demand , inelastic demand , unit elasticity demand, elastic demand

and perfectly elastic demand for PED values of 0 , <1 , 1 , >1 and infinite

respectively .The key price elasticity of demand determinants are ,the

product life cycle , the proportion of income spent and the number/

closeness of substitute goods.

The income elasticity of demand measures the responsiveness of change in

demand to a change in income in percentage terms.

Income elasticity = Percentage change in demand

Percentage change in income

If the income elasticity measure is < 1 then the product is supposed to be

income inelastic and the demand doesn’t vary significantly with changing

income levels of the consumers .If it measures >1 then the product is said to

be income elastic which means the change in income levels causes radical

changes in the quantity of demand .

CONCEPT

The total revenue will increase if the rate at which the demand decline is

comparatively lower than the rate at which the price is changed .The

consumers will demand less quantity of a particular product for which the

price is set high .The proper price of the products should be set by analyzing

the demand curve which gives the forecast of the response change in

demand with change in price.

Figure 1 : The Demand Curve

It is evident from the demand curve that if the price of a product is increased

slightly from P2 to P1then it will result in a massive decrease in demand

(shift from D to C) where the demand curve is said have high price elasticity .

On the other hand, the demand curve with low price elasticity will result in

comparatively less decrease in demand with slight increase in price. “Know

your customer. This phrase means

understand the demand curve and know the values of elasticity measures”

(Boyes, 2004: 77)

APPLICATION

The concept of own price elasticity and income price elasticity demand has

predominant application in various firms . BSA guns is one of Britain’s

important industrial groups .This group started as a small union of gun

smiths in 1689 and carried many munition works and manufacturing rifles

are their main activities .Although, munition works were given up lately and

the company owned  factories in Coventry, Birmingham, Redditch ,

Sheffield and Co. Durham along with many dispersal units and shadow

factories was in operation (BSA guns 2011). After the Coventry Blitz BSA

guns stopped its supply to military armed forces and now manufactures air

rifles , sports guns and hunting rifles and exports 557 products to different

countries in the world.

BSA guns skim most of its initial revenue by setting a high price for its

products for export and local sales. The reputation of BSA is deeply rooted in

UK because it is considered as an important industry group in UK and BSA

guns uses their brand power towards their high price strategies. The

variations in the economy of UK has direct effect on the buying power of its

customers and it has been seen recently that the economy of UK is dwindling

down . The air rifles , hunting guns and sports guns are products whose

demand can vary significantly with slight increase in price under the

conditions of economy downturn. The selection of “best price” is the greatest

challenge for any company because it decides the future of the product. The

knowhow of the concept of own price elasticity demand and the income price

elasticity demand is very important for BSA guns because the economy

variations are very much prevalent in UK.

The mean income per week for the year 2009-10 was 517 pounds which was

earned by individuals who were just under a million in number .The analysis

of the income distribution helps to determine the “best price” which can be

set for the guns of BSA so as to target maximum sales .In 2009 -10 the UK

economy was struggling which resulted in the change in the income

distribution and also changed the gross domestic product values .BSA guns

should be aware of the buying power of its customers so as to maintain the

steady flow of guns .The rise in unemployment during the recession years in

UK affects the pricing strategies of an organisation and UK is under the

threat of another forecasted recession in near future , hence it becomes

mandatory for the firms to study their sales and review their strategies

inorder to achieve the set milestone. From May 2008 to May 2009 the

unemployment level in UK increased radically from 1.61 million to 2.38

million and for most of the time in year 2010 the unemployment level

hovered just below 2.5 million (Economic Review 2010). In UK the level of

unempoyment has almost reached a steady value but the duration of

unemployment has increased which is an indication of the decline in the

buying power of the consumer and the dimnishing consumer surplus.It has

become a neccessity for an organisation based in UK to study the trends of

changing economy inorder to fix a price for its products which will increase

the sales and where comes the concepts of own price and income elasticity

of demand in to picture.BSA guns being based in UK has to consider theses

crucial concepts of economics which allows efficient management outcomes

to be implemented effectively.BSA guns has variety of products which

includes different types of barrels, rifles – spring guns , rifles –

precharged ,pellets, scope mounts, gun safes , silencers and adaptors , torch

and laser set and foldaway target holder. The target sales of these products

can be achieved if the demand of these products can be forecasted

approximately which eventually depends heavily on the core products ,which

are air rifles and sports guns , whose sales generates potential for the sale

of other relative products .During the recession In UK nearly 1 million jobs

were lost and the Consumer Price Index (CPI) reached 3.2 and the monthly

changes in its values indicated the change in the short term prices of food ,

beverages, tobacco , fuel , footwear and clothing .The forecast of the

changing Consumer Price Index during the period of economy downturn will

help BSA guns to vary the price of their product for short term so as to match

the expected target . BSA guns exports its 557 products to different

countries which implies that the application of concepts of own price and

income elasticity demand for different countries will help BSA to skim the

initial revenues because if the economy is low in UK it can gain the consumer

surplus from other countries where the economy is booming and hence

cover the fixed costs and variable costs .The arbitrage concept can be

applied here which will allow BSA guns to produce units in one market and

sell the product in another market and can generate revenue untill “one

price” is agreed on to its products which is “law of one price” and this agreed

price should fall under the range of “best price” set by the company for

different products with reference to proper study of income distribution and

responsiveness of demand for the products.

According to a research made in European journal of scientific research , the

application of the concept of own price elasticity demand and income price

elasticity demand on the cellular services in UK ,with respect to fixed

landlines and mobiles , lead to the conclusion that for every 1 % increase in

price of their services the demand will decrease by 0.53% on average .The

usage of mobile telephone was found to be positively related to the GDP of

UK which means that the income price elasticity of demand is also a key

deciding factor for price setting which varies with the changing economy .

The case study that was carried out in USA for Spaghetii sauces in order to

determine the variation in quantity demanded in different regions with

change in price of the product and the change in income of the consumers

brought in light the importance of the concepts of own price elasticity and

income elasticity demand .The differences and the similarities between the

price elasticity and income elasticity were carried out for different regions

and under different markets .The result to the research pointed out that the

six major spaghetti sauce brand’s demand vary significantly in different

regions with slight changes in the “best price” set. By understanding the

price elasticity concept the manufacturers of these brands are now in a

position to plan and implement appropriate pricing and promotional

strategies which increase the revenue of the company.

In Conclusion, the elasticity of demand for BSA guns products vary substantially across different

income groups.Therefore, it is very important to estimate the gun demand elasticity specific to

income groups. The increase in population and an increase in per caita income will increase

the demand of guns and their related accessories .The estimated income elasticity of demand

tends to be higher in poor households as compared to affluent members of the society. The

income

distribution of these members varies with changing economy and income elasticity of demand

again tends to be high in case of economy downfall . The know how of the economic concepts of

price elasticity and income elasticity of demand becomes mandatory because of the dependence

of sales on the income distribution . The results of the worthful endeavour of analysis of income

distribution and decisions dealing with setting a “best price” are crucial for the future modeling

and analysis of the airgun sector in UK. Dissaggregated price and income elasticity will be

helpful for policy planners who are interested in future investment and development of the

company.

REFERENCES

Umar Farooq.S , Imran Ullah . M , Rahamani .R . (2010) ‘The Analysis of Cellular Services and Estimating Fixed to Mobile Price Elasticities -A Case Study of United Kingdom’ European Journal of Scientific Research 40 (3) 428-440.

Seo .S.c , Capps .O.Jr. (1997) ‘Regional Variability of Price and ExpenditureElasticities: The Case of Spaghetti Sauces’ Agribusiness 13(6) 659-672.