The price elasticity of demand is a crucial concept in investing. It helps investors understand whether a company has pricing power or not.
Can it boost profits by raising prices, leading to increased profits? Or will the price increase lead to a drop in demand that ultimately hurts profits? A basic understanding of price elasticity will help you answer critical questions about the stock you are considering investing in.
Understanding the price elasticity of demand
It's a simple equation to understand but tricky to sink in, so let's embellish it with some examples. The price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price.
For instance, if Company A raises its product price by 10% and the demand falls by just 5%, its price elasticity of demand is 0.5. Alternatively, if Company B increases its product price by 10% and demand decreases by 10%, its price elasticity of demand is 1.
In this example, you could argue that Company A has more pricing power than Company B because demand for its product decreases less than for Company B. In this example, demand for Company A's product is more inelastic than for Company B's.
The following table illustrates these concepts. According to the table, perfect price inelasticity occurs when demand for a product does not change when the price moves.
An example is a life-saving pharmaceutical. If the drug is going to save a person's life (and they can only get it from one drug company), then most people will still demand it regardless of the price change.
In contrast, perfect price elasticity occurs when demand moves infinitely, given a price change.
An example is two producers of a commodity – say bananas – selling them side by side in a supermarket at the same price. If one changes the price, the lower-priced seller will get all the demand, while the higher-priced seller will get none.
This is because commodities (like bananas) are fungible. One banana is essentially as good as any other (unless you're really into organic bananas), so people will naturally just buy whichever is cheapest.
Unitary elastic demand occurs when a change in price results in a corresponding change in demand.
It's important to note that perfect inelasticity and perfect elasticity are polar conditions used to explain a concept. In the real world, all products have a price elasticity of demand somewhere between zero and infinity.
| Condition | Change in demand | Change in price | Price elasticity of demand | Examples |
| Perfectly price-inelastic | 0% | 10% | 0 | Lifesaving pharmaceuticals |
| Unitary elastic demand | 10% | 10% | 1 | Many goods |
| Perfectly price-elastic | ∞ | 10% | ∞ | Commodity producers selling in an open market |
Why does it matter?
In practical terms, the key to understanding the concept is to appreciate the distinction between a company with price inelasticity (a figure between zero and 1) and a product with price elasticity (a figure between 1 and infinity).
The concept is crucial for understanding how a company's price elasticity of demand changes the nature of its business and how companies try to change the price elasticity of demand for their products.
Going back to the examples above, one key difference between life-saving pharmaceuticals and bananas is that bananas have a readily available substitute (other bananas), while life-saving pharmaceuticals do not.
Therefore, some businesses try to create a 'differentiated' product, meaning one that's not easily replicated. In addition, the price elasticity of demand for a company's products shapes its business model and what investors should look out for.
Some real-life examples…
A pharmaceutical company such as Telix Pharmaceuticals Limited (ASX: TLX) has a biotechnology business that develops diagnostic and therapeutic products using targeted radiation. As such, its business model centres on developing price-inelastic products that typically command high prices.
On the other hand, a copper producer such as BHP Group Ltd (ASX: BHP) has a relatively price-elastic demand. If BHP decides to charge more for its copper, its customers will likely go to another copper miner to buy a kilogram of the metal. As such, BHP's business is about growing revenue and profits by increasing production, cutting costs, and hoping the price of copper goes higher.
US-based industrial conglomerate Honeywell International (NASDAQ: HON) provides an interesting case. It tends to have price-elastic products but can invest in research and development to produce new differentiated products. These products tend to have more pricing power and usually higher margins.
The newer products are more price-inelastic than the older versions, so Honeywell will see less of a drop in demand by selling them at a higher price than by doing the same with older products. Meanwhile, Honeywell can focus on reducing costs with its older, more price-elastic products.
How to invest using price elasticity of demand
Telix's diagnostic and therapeutic services are examples of price-inelastic products. Investors should focus on the company's development program because products will likely command significant pricing power when treatments are approved.
In BHP's case, investors should focus on what the miner is doing to increase production, such as expanding existing mines or developing leaching technology to extract copper from existing stockpiles. Investors can focus less on how BHP competes within its markets since its competitors will roughly receive the same price for copper. In addition, it's essential to view the price of copper over the long term before buying the stock.
In Honeywell's case, looking at what the company is doing to produce innovative new products is important. Given that creating new products means demand for Honeywell's solutions can become more inelastic and its products become less 'commoditised', it's essential for management to keep investing and competing. In contrast to BHP, investors should focus on how Honeywell competes in its end markets to differentiate its products.
Understanding the price elasticity of demand for a company's products also helps you know what to consider when investing in a company and how to monitor its progress.
Frequently Asked Questions
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The price elasticity of demand helps investors determine a company's pricing power in its industry. If a company can increase the prices of its products without significantly impacting demand, its products are considered price 'inelastic'.
On the other hand, if increases in the prices of a company's products would result in a significant drop in demand, the price is said to be 'elastic'.
Clearly, companies with price-inelastic products can generate higher profits. They can maintain higher levels of demand even if they increase their prices, resulting in higher margins. This makes price elasticity an essential thing for potential investors to look out for.
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Price elasticity is an economic metric that provides insight into how changes in a product's price impact demand. As such, it's not really 'good' or 'bad', but it can help you better understand companies and the industries in which they operate.
For example, tech and healthcare companies invest significant amounts of money into research and development to try to make their products more price-inelastic. If companies can differentiate their products from their competitors, they can justify higher prices and bring in higher profits.
However, some companies operate in industries where demand is inherently price-elastic.
For example, commodity producers, like miners or agriculture companies, sell more or less interchangeable products. If you are a zinc miner, chances are your zinc is basically the same as the zinc produced by the next miner. This means you can do little to differentiate your products from your competitors. Instead, in order to maximise profits, you have to look for ways to reduce costs or maximise output.
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If a product is price elastic, it usually indicates that it is easily substitutable for other competing products.
For example, a dairy producer can't realistically raise its milk price and expect that demand for its products will stay the same. There are plenty of other dairy producers out there who haven't raised their prices, and buyers can go to them instead.
Having many competitors in a particular industry also leads to more price elasticity. If output is concentrated in a small number of producers, they have more pricing power.
For example, in monopolies, one company can essentially dictate the price of certain products. However, as more competitors enter an industry, consumers have more discretion over who they purchase goods from, which increases the price elasticity of demand. In other words, pricing power shifts from the producer to the consumer.
