Specific price-level changes Demand analysis One of the main difficulties faced by a company setting prices is predicting market reaction to a real change in selling price (i.e. change other than one to keep pace with general inflation). If a price is increased relative to the general price level, will there be a dramatic or slight fall in the quantity demanded? Equally, if there is a decrease, how great will be the increase in demand? As we will see in chapter 11, in practice this is a complex decision which requires a consideration of all the elements in the marketing mix. Nevertheless, we can highlight some important aspects of this problem by examining basic micro-economic analysis of demand. Let us start by representing the relationship between changes in retail prices and quantity demanded in the form of graphs (see Figure 9.2). There are two extremes of the price quantity trade-off between which many products lie. At one extreme we have a demand curve which is the result of perfect competition. This is illustrated in Figure (a). From an individual firm's point of view, perfect competition implies that all that can be produced can be sold at the market price P, nothing would be sold if the price were above P1, and there would be no point in selling at less than P,. The other extreme is represented by Figure 9.2 (b). Here, a certain quantity, Q1, is demanded no matter what the price. In this diagram demand is insensitive to price. When there is imperfect competition, firms may sell products and services whose demand may temporarily resemble (b). However, relationship (c) will prevail after the market has had time to adjust. In this instance, which is by far the most common, an increase in price will result in a reduction in quantity demanded and viceversa. It is this last case that we shall now examine more closely. The most general statement that one can make concerning Figure 9.2 (c) is that there is a negative relationship (or correlation) between price and quantity - an increase in one implies a decrease in the other. At first sight it might also seem that the slope of the line would be important. The slope is important, but a direct measure is unfortunately affected by the units of measurement that we happen to choose. If Figure 9.3 represents the demand curve for a local shop selling potatoes, the slope may be described as -5p/100lbs or - 0.05, though if we chose kilos instead of Ibs, the slope would be - 5p/45.5 kilos = - 0.11, and if we chose French francs instead of £ sterling, the slope would be - 0.5F/100 lbs = - 0.005. Clearly, the slope does not serve as a useful description of the price/quantity relationship, as it depends upon the scales used. To avoid this problem, the numerator and denominator are expressed in terms of percentage change rather than the absolute amount. The measure is known as demand elasticity and is represented by the formula: (Note the reversal of quantity and price. Also, the negative sign makes our Do it oar most in it resent on. op per cent reute in the demand for potatoes for a 25 per cent decrease in price. Therefore: If we choose the mid-point of the differences, then: The first important observation to make is that elasticities differ at varying points on the demand curve, even though the slope is constant. Secondly, demand is termed elastic where the measure is greater than 1 and inelastic where it is less than 1. Thirdly, where demand is inelastic, an increase in price increases total revenue and a decrease in price decreases total revenue; where demand is elastic, an increase in price decreases total revenue and a price decrease increases total revenue. This is illustrated in Table.