ECON100 CONCEPT OF THE DAY: ELASTICITY
As part of our dual mandate to rebrand the dismal science’s moniker into the ‘decision’ making science as well as to lower the barrier to understand and access economic concepts without a formal economics degree, we’re rolling out a definition of the day (or week) to further these goals. Today’s concept of the day (or week) is: elasticity.
WHAT EXACTLY IS ELASTICITY?
Elasticity, specifically the price elasticity of demand measures an individual’s sensitivity to changes in the market price of a good. Conceptually, if you can understand the law of demand and the inverse relationship between quantity demanded and the market price of a good. Price elasticity of demand informs us by how much the change in a good’s demand will respond to a change in the good’s market price. How do we find that change in demand? The formula for calculating elasticity between two points (aptly dubbed the Midpoint method) is the percentage change in the quantity demanded divided by the percentage change in the price. There are three basic (and two theoretical) conditions for price elasticity of demand:
- Less than 1, or inelastic
- Equal to one, or unit elastic
- Greater than one, or inelastic
We can think of the price elasticity of demand as a proxy for a good’s gravitational pull on a consumer. If a good has a strong pull on a consumer and they purchase it, almost no matter what the increase in cost, you can say that specific customer is very price inelastic (below 1). If the customer is very sensitive to the very slightest increase in the price of a good, you can call that specific customer price elastic, indicating the gravitational pull on that customer towards is weak (more than 1).
There are several factors responsible for increasing or decreasing the price elasticity of demand, but they pretty much revolve around a central theme: additional choices lead to additional elasticity.
- availability of alternatives: as expected, goods with fewer alternatives (like gasoline, electricity, baby formula, or diapers) have lower elasticities compared to goods with many alternatives (like laundry detergent, bottled water, books, movies or toothpaste).
- luxuries versus necessities: you are much less sensitive to changes in the price for those goods which you can categorize as needs (food and shelter) versus goods which you would categorize as luxuries (fancy restaurant meals or foreign vacation travel).
- time horizon: you are less sensitive to goods in which you have limited time to choose. When you have more time to acquire a good you also have more time to search for alternatives.
- budget share: if a good is a small or tiny proportion of your budget (ex: toothpicks, baking soda, or all-purpose flour- literally less than $1/lb- from 2.7¢ to 5.9¢ per ounce) elasticity is lower than goods which are larger portions of your budget (ex: foreign travel, home, or car purchase)
- definition of the market: as a good’s market definition becomes more narrow its elasticity increases as a result of the existence of a larger amount of alternatives. For example, consider food as a broad category. There just aren’t many alternatives to sustain life other than food. However, if we were to look at the price elasticity of demand of a 500mL bottle of Casa Ronaldo wooden barrel aged premium balsamic vinegar there would be literally tons of alternatives (and not just because that brand doesn’t exist).
WHY SHOULD WE CARE ABOUT ELASTICITY?
Elasticity allows you to understand how customers (even yourself as a customer) quantity demanded will respond to a change in the price of a good. Ultimately elasticity will have an effect on the bottom line of your job (or your business), and it may even play a deciding factor in how you choose to position your business. Elasticity has a relationship to a firm’s total revenue (TR). Knowing if a particular good has an inelastic or elastic price elasticity of demand allows the firm selling that particular good to affect (in a good way, we hope) TR.
COMPETITIVE STRATEGY AND ELASTICITY
Porter’s seminal book on business strategy, The Competitive Strategy: Techniques for Analyzing Industries and Competitors, lists three methods to “outperforming other firms in an industry”. ¹
- Overall cost leadership -here we’ll use the term ‘cost leadership’ in which firms focus on providing customers with the lowest prices in an industry through emphasis on economies of scale, tightly controlling costs, R&D, etc. Examples of firms that employ cost leadership strategy include companies like Harbor Freight, Dollar Tree, Dollar General, Amazon, etc.
- Differentiation -we can use the term ‘product’ differentiation, which firms pursue through a multidimensional approach providing a bespoke, unique experience via technology, dealer network, design, and branding. Industry examples include Apple, Lamborghini, Rolex, Berkin, Goldmund (Swiss audio manufacturer), Nuova Simonelli (Italian coffee machine manufacturer), etc.
- Focus -we’ll use the term ‘niche’, which firms pursue by targeting a specific market segment by product line, geography, or other buyer characteristic and prioritizing on best meeting their needs. Executed correctly, it can blend elements of one (or both) of the competitive strategies above. The best example is the Crane Paper company which has been in the paper business since the 1770’s.
As an example, take a look at Business Insider journalist Mary Meisenzahl’s article on Chipotle. Battling against increasing food costs as well as payroll increases, Chipotle implemented three menu price hikes within 18 months. As expected, store traffic dropped by 1%². However, Chipotle and CEO Brian Niccol still take the ‘W’ because 2021 third quarter sales revenues beefed up (pun intended) by a healthy 14% over the year before, in part to the addition of premium priced menu items, such as the garlic guajillo steak. The steak is an item which is comparatively much more expensive than the other basic (or less premium?) menu options. What you should glean from this example is that Mr. Nicool deeply understands the Chipotle brand and their product differentiation strategy. Lowering prices would’ve definitely reversed the flow of customers, however the additional revenue, brought in by increased quantity demanded wouldn’t have covered the lower menu item prices. In fact, it most certainly would’ve burned Chipotle. Here’s CFO Jack Hartung on a July 26, 2022 earnings call:
“Cost of sales in the quarter were 30.4%, about flat to last year. The benefit of menu price increases offset elevated costs across the board, most notably in avocado, packaging, dairy, beef and chicken. In Q3, we expect our cost of sales to be about 30% of sales, as the benefit from the menu price increase will be partially offset by the higher cost of dairy, tortillas and packaging. Labor costs for the quarter were 24.8%, an increase of about 30 basis points from last year”³.
We’ll talk in depth about this in a later post, but for now a company’s profit is defined as:
Profit = Revenue – Expenses
The earnings call by Mr. Hartung outlined all kinds of additional expenses Chipotle had to incur. Although lowering menu prices would have brought in additional revenue, it wouldn’t have increased overall revenue. it would have not exceeded costs. Why? Because demand for Chipotle is inelastic, which by definition is less than 1, necessitating that the effect of changes in quantity demanded will always be smaller than the effect of changes in the price. Try it out for yourself. For a fraction to have a number below 1, the numerator (the top number) must always be smaller than the bottom number (the denominator).
OK, SO WHAT DOES ELASTICITY MEAN FOR YOU?
Understanding the ins and outs of the price elasticity of demand counts for a lot. You’ll have answers to questions like: How much of a price increase will your customers tolerate before they switch to a competitor? Should you consider competing on price (cost leadership) or on some other measure (product differentiation)? Will increasing the price lead to increases in total revenue, or tank revenues? What would happen in the aftermath of a price decrease and its effect on total revenue?
REFERENCES
- Porter, Michael E. The Competitive Strategy: Techniques for Analyzing Industries and Competitors. New York, NY, Free Press, 2004.
- Meisenzahl, Mary. “Chipotle Customers Aren’t Skimping on Guac or Steak.” Business Insider, Insider Inc, 26 October 2022, https://www.businessinsider.com/chipotle-customers-arent-skimping-on-guac-or-steak-2022-10. Accessed 8 November 2022.
- Chipotle Q2 Earnings Call. “Chipotle Mexican Grill, Inc. (CMG) CEO Brian Niccol on Q2 2022 Results – Earnings Call Transcript.” Seeking Alpha, 26 July 2022, https://seekingalpha.com/article/4526074-chipotle-mexican-grill-inc-cmg-ceo-brian-niccol-on-q2-2022-results-earnings-call-transcript. Accessed 9 November 2022.
Check out the video below to watch the WSJ’s Sharon Terlep coverage of elasticity’s role within the US economy among sustained high levels of inflation.