[MUSIC] In the previous module we discussed the demand curve. One of the great values in capturing the demand for a product at various price points is the resulting understanding of how responsive, or we could say how elastic, a consumer's demand for a product is to a change in price. Economists refer to this as the price elasticity of demand. The price elasticity of demand measures the percentage change in quantity demanded by consumers as the result of a percentage change in price. The following graph illustrates two extreme cases of price elasticity of demand. The inelastic and the elastic case. In an inelastic scenario, we see that significant changes to price have hardly any impact on the overall demand, while in the elastic case we see that sometimes tiny changes in price will have tremendous effects on the overall demand. Products that are typically considered being inelastic are basic necessities of life. Luxury items, on the other hand, are typically following a more elastic price elasticity of demand. Mathematically price elasticity of demand can be captured as follows. This formula usually yields a negative number. The negative sign is traditionally ignored as the magnitude of the number is the focus of interpretation. Consider the demand curve for a car manufacturer which is shown in this graph. The point at which the demand curve crosses the vertical axis indicates the price above which no consumer will buy the firm's product, because it just is simply too expensive. At a price of $250,000 for instance. Demand for this firm's cars appears to dry up completely. Similarly, the point at which the demand curve crosses the horizontal axis indicates the maximum number of units the firm could sell if it offered the product for free. Let's now calculate the price elasticity of demand. The demand curve suggests that we will sell 1,000 cars at a price of $200,000. But the quantity demanded will increase to 1,500 if we lower the price to $175,000. For this part of the demand curve, the resulting elasticity is minus 4. But what does this tell us? It essentially tells us, that within this particular price range, a small percentage change in price will lead to a relatively large percentage change in quantity. More specifically, a 1% decrease in price will lead to a 4% increase in quantity. It is important to note that the price elasticity of demand will typically vary along a demand curve. While the price elasticity of demand is 4 in the $175,000 to the $200,000 price range, it is far different at a lower price point. For instance, the demand curve suggests that lowering our price from $75,000 to $50,000 will increase demand from the 3500 to 4000 units. Using the same formula as before, this will result in an elasticity of -0.43. In other words, the 33% drop in price will only result In a 14.3% increase in demand. This is typically referred to as inelastic demand. Research has shown that most products have a price elasticity between 1 and 3 as we see in the following chart. Understanding price elasticity of demand is critical for marketing managers as the following sample might illustrate. Let's consider the launch of the Q7 produced by Audi. As you see from the information provided it was actually a quite successful product launch. Audi could have sold more cars than they were able to produce. One very simple solution to the problem would have been to a simply increase the production capacity. However, this is a pricing course so, we going to find a pricing solution to the problem because the alternative would be to simply increase the price adequately in order to sell as many cars as Audi has in terms of production capacity. Let's go back to the mathematical formula that we used before in order to calculate the price elasticity of demand. With some reconfiguration of the formula, we now can use information about price elasticity in order to pluck this data into the formula. The result of this reformulation indicates that we could have increased our price quite significantly. More specifically, you could have increased our price from 55,000 euros to more than 58,000 euros. This would have led to an increase in Audi's profitability of 240 million euros. This example nicely illustrates that the formula we have seen before can not only be used to calculate the price elasticity of demand, it can also be used in order to see how certain changes in price will affect our demand, or what kind of price changes we can afford if we want to reduce or increase, for instance, our sales volume. [MUSIC]