Price Elasticity of Demand for a Firm

Price Elasticity of Demand

For a firm looking to boost its profits, it must consider how a change in price might affect the total profits. The most important concept to this analysis is price elasticity of demand. The underlying principle of price elasticity of demand is that a change in the price of a good will result in a change in demand. The degree to which this occurs is the rate of elasticity. Price elasticity of demand is determined by dividing the change in demand by the change in price. Alternatively, a variety of price points can be graphed and the slope of the demand curve can be determined (NetMBA, 2010).

In either case, a company that is seeking to maximize its revenues will need to determine the point at which it has achieved the optimal price and demand. This is the point at which the price multiplied by the demand is the highest. In analyzing this for the point of maximum profit, both fixed and variable costs will need to be analyzed as well. If price elasticity of demand is high, then the demand will change dramatically in response to a change in price; if the elasticity of demand is low, then demand will not change much when price is changed. Occasionally, goods have a negative price elasticity of demand, where an increase in price increases demand for the good. Many luxury goods fit this definition.

There are a number of considerations that impact on a firm's price elasticity of demand. This report will focus on Starbucks. The coffee chain has traditionally built a business model that allowed it to enjoy a relatively low price elasticity of demand. Starbucks was able to foster brand power and positive customer associations with its products that allowed it to charge higher prices for its products that its competitors. Because coffee is a habitual product, those customers once captured were unlikely to stop purchasing in the event of an increase in price. As a result, Starbucks was largely able to set its prices at the level of optimal contribution.

However, the price elasticity of demand for Starbucks evolved. Increased competition and a deterioration of the global economy combined to increase the price sensitivity of coffee drinkers. Many were less inclined to pay premium prices for their coffee, and more intense competition from McDonald's and Dunkin' Donuts in particular gave many consumers a lower-priced option (AP, 2007). The combined effect was the increase price elasticity of demand for Starbucks. Demand fell, and the company was forced to increase its prices in response, in order to spur sales (Jargon, 2009). While there is no direct way to measure the success of this measure -- the company knows but is not publishing that information -- the restoration of revenue growth at Starbucks indicates that the move may have been successful.

This indicates that Starbucks has a moderate to high price elasticity of demand. The company clearly believes that on certain products it can spur sales simply by lowering the price, and in doing so it will increase its profits. Because this move was in response to a variety of threats, one of which was the economic downturn, it is worth considering the elasticity of the income of the customers in determining the optimal price for Starbucks. That is to say, that the income of the customers appears to have had an impact on demand for Starbucks coffee, and it was that change in income that led the company to adjust its prices downward. This is especially the case for Starbucks because while coffee is a fairly basic commodity, Starbucks has built differentiated status for its coffee in the marketplace.

It is predicted, therefore, that if coffee customers see their income increase by 10%, this will result in an increase in demand for Starbucks product. If coffee drinkers see their income decrease by 10%, this will see a decline in demand for Starbucks. However, it is worth considering that the rate of elasticity -- that is the slope of the demand line -- may differ on the upside vs. The downside. On the upside, Starbucks must effectively build its brand back up in order to earn premium pricing ability. Thus, it is unexpected that an increase in 10% in consumer earnings will result in an increase in sales at Starbucks of 10% if the company does not change anything in the way it markets its product.

However, a decrease of 10% is more likely to result in a decrease of 10% in demand. This would be the result of some consumers reducing the cost associated with their coffee habits. The habitual nature of coffee drinking implies that perhaps elasticity will remain below 1.00 on the downside, but it will be closer to 1.00 than it is on the upside. Starbucks consumers will still want coffee and some may have compelling reasons not to break their habits, so will continue to be consumers of Starbucks. Other customers will have compelling reasons to cut back their coffee spending. It is believed that the former will outweigh the latter, based on past experience, but that the decline in demand if consumers lost 10% of their income would be noticeable.