Price Elasticity Of Demand And Luxury Goods

Importance of Price Elasticity for Business Firms

Discuss about the Motivation and Purchase Intention Luxury Goods.

Price elasticity of demand refers to the percentage change in the quantity demanded of a good or service due to one percent change in its price (Varian, 2014). The concept of price elasticity of demand plays an important role in the price making decisions of the businesses and price regulatory decisions of the government. It also judges the impact of currency depreciation or devaluation on the earnings from exports (Galí, 2015). This essay focuses on the price elasticity of demand for shoes in general and compares it with that for the shoes of a specific brand, Reebok.

The price elasticity of demand for a product or service is very important for the pricing decisions for a business firm. For setting a particular price for any good or service, it is important to know the market as well as the competition. Various factors affect the pricing decisions of a firm. Price elasticity of demand for a product is the major factor while making any pricing decision for the product, as depending on the coefficient of the price elasticity, the change in price for the product would bring about the change in quantity demanded. This would affect the consumer’s expenditure and consequently affect the revenue of the firm. If a particular product is highly price elastic, then any rise in the price would invariably reduce the demand for it, and would push down the total revenue of the firm (Haynes, 2015). Hence, a price rise, instead of raising the total revenue, would reduce the total demand for the product if the product were price elastic.

However, if the product is price inelastic, then a price rise would not affect its demand, rather, would increase the revenue of the firm. Thus, for getting a profit maximizing price, a firm must consider the price elasticity of demand for its product. If the firm knows the value of price elasticity, then it could decide the amount of price reduction required to get a rise in the revenue to a certain optimum level (Hirschey, 2016).

This also helps in the price discrimination by a firm, especially by a monopolist. If the price elasticity of a product is different in different segments of the market, then a monopolist can successfully execute price discrimination. It can charge a higher price to the demand inelastic customers and a lower price to demand inelastic customers (Hollensen, 2015).

Factors Affecting Price Elasticity of Demand

Goods are classified into necessities and luxuries, depending on its needs. If a good is needed by everyone for living, irrespective of its price, then the good is a necessity. On the other hand, if a good is not really needed for basic everyday living but many people desire to have that, then the good is a luxury (Foxall et al., 2013). For example, shoes are necessary goods. Irrespective of its price, people need to buy shoes for living. Hence, in general, shoes are necessity and price inelastic. A rise in the price for shoes would not reduce the overall demand for it (https://www.ft.com/content/23571378-58a7-11df-a0c9-00144feab49a).

Reebok is a big brand in the field of athletic shoes and sportswear. The Reebok shoes are usually high priced than any local brand of shoes. It is a luxury good, as people want to own a Reebok shoe but this is not a necessity. Hence, Reebok shoes are price elastic. If the price rises for a Reebok shoe, the demand falls. Thus, the price elasticity of Reebok shoes is generally higher than the elasticity of general shoes (https://www.moneycrashers.com/difference-between-needs-wants-luxuries/)

There are various factors that affect the price elasticity of shoes and Reebok shoes in particular (Cameron, 2014).

Price: this is the major factor determining the elasticity of for shoes. Law of demand says that, if the price rises, the demand for a good falls. Thus, generally goods are price elastic.

Availability of substitute goods: shoes as a general product, do not have any substitute product. Hence, even if there is a price rise, people cannot shift to other products to satisfy the need for shoes. On the other hand, Reebok shoes have many substitute products from other brands. Thus, people have the option to buy shoes from other brands, if there is a price hike of Reebok (Nwankwo, Hamelin & Khaled, 2014).

Proportion of consumer’s income: the products that consume a higher percentage of a consumer’s income generally have high price elasticity. Shoes in general do not take up a very high percentage of people’s income, but, a branded shoe is higher priced than a local or non-branded shoe, and thus, it takes up a higher portion of a consumer’s income. Therefore, Reebok shoes are more price elastic than shoes in general (Kim, 2012).

Necessity and luxury goods: Since, shoes are necessary goods, therefore, a rise in price will not have much effect on the demand for shoes in general. However, Reebok is a luxury brand. Thus, people might not want to buy a high priced Reebok shoe when a local brand is available at a lower price (Livingston, 2016).

Illustration with Graphs

Habitual consumption: if people buy shoes out of habit, then the price does not matter much. Even if there is a price rise for shoes, people would still buy it out of habit.

Time for buying: if the time period for purchasing a product is less, then the product is price inelastic. People have less time to decide whether to buy the product or not, irrespective of its price. If the buying time is more, then the product is price elastic, as people have time to consider the price change and shift their preferences. For shoes, since it is a necessary good, people do not spend much time to decide whether to buy it. On the other hand, since Reebok shoe is luxury goods and high priced, people take more time to decide whether to buy it (org., 2016).

Figure 1 shows the inelastic demand curve for shoes and the effect of price rise on its quantity demanded. The demand curve is steeper, shown as D. As the price rises from P1 to P2, there is a small fall in the quantity demanded, from Q1 to Q2. Similarly, when price falls from P1 to P3, then the rise in quantity demanded is not much, shown by a shift from Q1 to Q3.

Figure 2 shows the elastic demand for Reebok shoes. The demand curve is less steep than that for the general category of shoes, shown by the curve D_R. Since, it is a luxury good, when price rises from P₀ to P₁, the fall in quantity demanded is bigger, shown by the shift from Q₀ to Q₁. Similarly, when price falls from P₀ to P₂, the rise in the quantity demanded is bigger compared to that of the shoes in general category, shown by the movement from Q₀ to Q₂.

The above figure shows the effects of increase in the supply of shoes on the price elasticity. Initially the supply curve was S1, equilibrium is at point E1 with corresponding price P1, and quantity demanded Q1. As supply increases, the supply curve shifts upwards from S1 to S2. Due to this, there is a rise in the price from P1 to P2. New equilibrium is at E2. Since, the demand is inelastic for shoes; the quantity demanded does not fall much and reaches to Q2.

Figure 4 shows the effects of an increase in the supply of Reebok shoes on the price elasticity. Since, Reebok shoes are luxury, the demand curve is less steep than that of the necessary goods, shown by D_R (Belleflamme & Peitz, 2015). When there is a rise in the supply of the rebook shoes, the supply curve shifts upward from S₁ to S₂ and as a result, price rises from P₀ to P₁. Equilibrium rises from E₀ to E₁. Since, the demand is price elastic; the rise in price has a wider effect on the quantity demanded, as it falls from Q₀ to Q₁. The magnitude of the decline in the quantity demanded of Reebok shoes is greater than that for the shoes in general category.

References:

Belleflamme, P., & Peitz, M. (2015). Industrial organization: markets and strategies. Cambridge University Press.

Cameron, P. (2014). Price Elasticity of Demand. Learning.hccs.edu. Retrieved 7 May 2017, from https://learning.hccs.edu/faculty/pamela.cameron/price-elasticity-of-demand

Foxall, G. R., Yan, J., Oliveira-Castro, J. M., & Wells, V. K. (2013). Brand-related and situational influences on demand elasticity. Journal of Business Research, 66(1), 73-81.

Galí, J. (2015). Monetary policy, inflation, and the business cycle: an introduction to the new Keynesian framework and its applications. Princeton University Press.

Haynes, W. W. (2015). Pricing Decisions in Small Business. University Press of Kentucky.

Hirschey, M. (2016). Managerial economics. Cengage Learning.

Hollensen, S. (2015). Marketing management: A relationship approach. Pearson Education.

Kim, K. (2012). Demand analysis of clothing and footwear: The effects of price, total consumption expenditures and economic crisis. Journal of the Korean Society of Clothing and Textiles, 36(12), 1285-1296.

Livingston, A. (2016). Difference Between Needs & Wants (Luxuries) and How to Draw the Line. Money Crushers. Retrieved 7 May 2017, from https://www.moneycrashers.com/difference-between-needs-wants-luxuries/

Nwankwo, S., Hamelin, N., & Khaled, M. (2014). Consumer values, motivation and purchase intention for luxury goods. Journal of Retailing and Consumer Services, 21(5), 735-744.

Stlouisfed.org. (2016). Elasticity of Demand, Economic Lowdown Podcasts. Stlouisfed.org. Retrieved 7 May 2017, from https://www.stlouisfed.org/education/economic-lowdown-podcast-series/episode-16-elasticity-of-demand

Varian, H. R. (2014). Intermediate Micro economics: A Modern Approach: Ninth International Student Edition. WW Norton & Company.