Elasticity
Elasticity
An elasticity is the percentage change in one variable associated with a 1 percent change in another. Elasticity are valuable tools for managers. Armed only with basic marketing data and reasonable estimates about elasticity, managers can make sales, revenue, and marginal revenue forecasts. In addition, elasticity are ideal for analyzing “what if” question. What will happen to revenues if we raise prices by 2 percent? What will happen to our sales if the price of a substitute drops by 3 percent? Economists routinely calculate three demand elasticities:
Income Elasticity
Income elasticity is the percentage change in the quantity demanded that is associated with a 1 percent change in consumer income. Consumption of most healthcare products increases with income, but only slightly. Consumption of healthcare products also appears to increase more slowly than income. As a result, healthcare spending will represent a smaller proportion of income among high-income consumers than among low-income consumers.
Price Elasticity of Demand
The price elasticity of demand is even more useful, because prices depend on choices managers make. Estimates of the price elasticity of demand will guide pricing and contracting decisions. Economists usually speak of price elasticities of demand (but not other elasticities) as being elastic or inelastic. When a 1 percent increase in price result in less than 1 percent reduction in the quantity demanded, the price elasticity of demand will be between 0.00 and –1.00 and demand is said to be inelastic. When a 1 percent increase in price results in a more than 1 percent reduction in the quantity demanded, the price elasticity of demand will be smaller than –1.00, and demand is said to be elastic.
Using Elasticity
Elasticities are useful forecasting tools. With an estimate of the price elasticity of demand, a manager can quickly estimate the impact of a price cut on sales and revenue. Most estimates of the overall price elasticity of demand fall between –0.10 and –0.40. for the market as a whole, the demand for healthcare products is typically inelastic. For individual firms, in contrast, demand is usually elastic. The reason is quite simple. Most healthcare products have few close substitutes, but the products of one healthcare organization represent close substitutes for the products of another. The price elasticity of demand individual firms face typically depends on the overall price elasticity and the firm’s market share. So, if the price elasticity of demand for hospital admissions is –0.17 and a hospital has a 12 percent share of the market, the hospital needs to anticipate that it faces a price elasticity of –0.17 / 0.12, or – 1.42. this rule of thumb need not hold exactly, but there is good evidence that individual firms confront elastic demand. Armed with a reasonable estimate of the price elasticity of demand, we will now predict the impact of a 5 percent price cut on volume. If the price elasticity faced by a physician firm were –2.80, a 5 percent price cut should increase the number of visits by 14 percent, which is the product of –0. 05 and –2.80. (A prudent manager will recognize that her best guess about the price elasticity will not be exactly right and repeat the calculations with other values. For example, if the price elasticity is really –1.40, volume will increase by 7percent. Or, if the price elasticity is really –4.20, volume will increase by 21 percent.).