When speaking of elasticity we must understand that demand is elastic; therefore, sales volumes vary according to fixed prices.

The formula for elasticity is:

[Variation in demand (new Demand - current Demand ) / current Demand] / [ price change ( new Price - old Price ) / current Price]

This has a coefficient which thus reflects a variation of the application (upwards or downwards) resulting in a change of 1% of the price. In economics, we calculate the elasticity of demand for a good relative to its price (also called the price elasticity of demand), to measure the sensitivity of demand-to-price changes. It is intended to measure how big the change in demand is following a price change:

RATE OF CHANGE IN DEMAND / RATE OF CHANGE IN PRICE

An example: If the demand for oranges increases by 10% when the price-per-pound of oranges decreases by 5%, the price elasticity of demand for oranges is -2. Let's explain the effect on the quantity of oranges demanded after a -1% change in price:

With an elasticity of -2, when the price of oranges decreases by 1%, the requested quantities increase by 2%. Or, when orange prices increase by 1%, the quantities demanded decrease by 2%.

In general, the price elasticity of demand is negative. When the price increases, demand decreases. However, it may happen that the price elasticity is positive. This is the case for distinguishing consumption, or Veblen goods, where the higher price encourages consumption by a "sign effect" (this is to show a higher social position or a position to which one may aspire in buying the product). It may also be the case for necessities, or Giffen goods, for households with very low incomes. For example, an increase in the price of bread may prevent buying meat, but instead force the consumer to buy more bread at the higher price.

Methodology in Excel to Calculate Elasticity

1) Elasticity is negative:

Sellers sell more at a higher price. The converse is also true as sellers sell less at a higher price.

For example:

Overall, you sell more at a lower price. This is the case in times of sales. For example, a price reduction encourages customers to consume more of the same good or buy to stock up before the price returns to its customary level.

2) Elasticity is zero (or almost):

Consumers continue to demand the same amount of the good, even if the price increases. This is the case with necessities like gasoline or water.

For example:

Sales remain constant while price goes down. This is a less common case.

3) Elasticity is positive:

You increase your price and you attract more customers or sell more per customer. Your customers are enthusiastic with the new price and put in orders. This is the case when resellers can profit from a higher margin.

For example:

We know that the sales volume influences the cost as variable costs are directly dependent on sales volumes. Fixed costs remain substantially the same, unless in the case of a need to replace an important piece of machinery, unforeseen circumstances or expansion plans.

Cost Analysis and Margin

One can have a negative elasticity that helps generate a large margin. Indeed, fixed costs do not move but variable costs depend directly on the volume of sales. With a lower volume of sales at a high price, a decrease in total sales can be offset by savings in variable costs.

For example:

 

The sales volume decreases from 100 to 62 units. Yet the sales price increased from $99 to $149. The elasticity is negative because sales decline after the price increase. Lastly, the unit margin rose substantially from $69 to $113.

Another example with negative elasticity:

After a decrease in the price of $99 to $79, sales jumped from 100 to 150 units. The elasticity is negative and high, as sales increased by 50% after the price reduction. The unit margin is lower but the decrease was offset by a strong increase in total margin—a result of the strong increase in sales.

The Bottom Line

Elasticity is a concept in economics that created by the demand of customers. Merchants, on the other hand, must deal with the pressure to expand or contract inventories in order to juggle with changes in prices that can result from many factors affecting their business. The demand, depending on what type of good is affected, is positive elastic, inelastic or negative elastic. This concept is also related to supply elasticity

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.