Around half of adults are buying less food:
Price Elasticity of Demand and Current Inflation
This is a shocking headline!
We are well aware that many of our favourite brands have been costing more recently. We wrote here about whether current food price inflation is partly attributable to supermarket “greed”. But when a firm raises the price of its product, what happens to demand for it? The most “normal” response would be that, as the price of something increases we do, in general, buy less of it. And that indeed is what the image above would suggest is happening to our demand for food. But as ever, things are not quite so straightforward.
When a firm raises the price of its product we expect demand for that product to fall. The responsiveness of demand to a change in the price of a product is measured by a concept known as the Price Elasticity of Demand.
It is measured as follows:
Percentage Change in Quantity Demanded of the good
Percentage Change in Price of the good.
So: if a 5% increase in the Price of a Good causes demand to FALL by 10%, then the PED is:
10% Fall in Demand = -10% = -2
5% Rise in Price +5%
Note that the PED will nearly always be negative, as a rise in price leads to a fall in demand, and a fall in price leads to a rise in demand.
When we calculate PED we get different values according to how much demand for a good changes in response to a change in price.
Price Elasticity of Demand is important for firms: it tells them what will happen to their revenue when they change their price.
The Total Revenue of a firm = Price x Quantity Sold or TR=PQ
There are three basic cases
- PED is Inelastic (<1)
In this case, if a firm cuts its price the increase in demand will be less than the % reduction in price and Total Revenue will Fall. By contrast, if the firm raises price by a % demand will fall by a smaller % and Total Revenue will increase. So: If a firm wishes to raise revenue it should increase its price.
2. PED is Elastic (>1)
In this case, if a firm cuts price by x % demand will increase by more than x% and Total Revenue will Increase. If it raises price by x% demand will fall by more than x% and Total Revenue will Fall. A firm wishing to increase its revenue should reduce its price.
3. PED is Unitary Elastic (=1)
If PED is one then a % change in price will produce an equal % change in demand and Total Revenue will remain constant.
With this in mind, let’s look at the latest sales and price data for various well-known brands.
Two main things strike us here:
1. The data as it stands suggests that for all these products Price Elasticity of Demand is inelastic. When they raise price by a percentage, sales volume falls by a smaller percentage. For example, when Nestle raised its prices by 10%, demand fell by about 1%. This gives a PED of -1%/10% = — 0.1, which is very inelastic. When Pepsi raised prices by 16%, demand fell by -2%, giving a PED of 2%/16% = -0.13. So when prices rise, consumers hardly cut back their consumption — a phenomenon economists attribute to brand loyalty. We are committed to certain brands and are prepared to pay more to experience them.
2. We also see that when some firms raise their prices, like Coca Cola, sales volume actually went up! This goes against our theories and seems curious at first glance: why would I buy more cans of coca cola if the price increases?
We need to think about these figures more carefully. Our figures so far are not really accurate. Why? Because these price rises occur in the context of general inflation of about 10%. This means that all prices are rising on average at 10%. Why is this an issue? Because PED measures responsiveness of a change in demand to a change in the price of one good, the prices of all other goods remain the same. It shows the effect of a rise in the real price of a product relative to all other products. The figures above don’t show that — they show price rises for goods in the context of a general rise in all prices. To capture the rise in RELATIVE prices we need to subtract the inflation rate from the given price rise. Take the case of Pepsi. Its price rise was 16%, but inflation was 10%, so its real price rise was about 6%. In this case its PED is 2%/6% or 0.33. This is still inelastic but more elastic than the earlier figure of 0.13. So things aren’t quite so good for most firms than the graph suggests. In the case of Proctor and Gamble, their prices have remained constant in real terms but their sales volume has actually fallen by 3%, suggesting that while people are still eating chocolate and drinking coca cola during the cost of living crisis, they are cleaning their homes less.
Second, we need to be aware of relative price movements. Return to the curious case of coca cola, whose demand increased even as it increased price. Note first that its real price increase was 11% — 10%(inflation) = 1%. A small increase. Second note that Pepsi increased its price in real terms by 6%. So what may have happened here? Yes, consumers are likely to have shifted from Pepsi to Coke as the relative price of Pepsi has increased. Economists measure this affect on demand for one product of a change in the price of another through a measure called Cross Elasticity of Demand:
If the goods are substitutes then XED is likely to be a positive number. So if B is Pepsi, then a rise in the price of Pepsi is likely to cause a increase in demand for Coke as people switch from Pepsi to Coke, which is a substitute good.
So Cross Elasticity of Demand helps us to make better sense of the data and helps explain how Coca Cola has seen demand grow despite increasing its own price.
Another factor is income. Inflation has caused most people’s real incomes to fall. For most goods a fall in income leads to a fall in demand. But for some goods we call inferior goods, people buy more when real income falls. Chocolate is close to being an inferior good — poorer people tend to buy more chocolate than richer people, so maybe the fall in real incomes has led people to buy more chocolate and less cleaning products, giving a boost to Mondelez, which makes many crisp and chocolate brands like Cadburys.
Finally, PED figures are only valid for small price changes. As the first graph shows, in the UK food price inflation is running exceptionally high. With such big increases, our habits and consumption patterns begin to change.
But what the figures suggest is that we are loyal to our favourite brands and this does give firms an incentive to raise prices if they can for they are likely to experience an increase in Total Revenues if they do.