Price Elasticity of Demand
Jul 8th, 2007 by William Jones
This hypothetical scenario will provide information for effectively using pricing tools.
The goal of every business is to make a profit, and if a business is not profitable as a whole or in certain areas, to identify opportunities to achieve profitability. Global Mobile is such a business with a particular mobile phone rate plan that has been slowly declining over the past couple of months and caught the concern of management.
I will identify an under performing rate plan, point out factors causing its under performance, create a price elasticity of demand for a range of possible rate plan prices, analyze the table results, and finally review what would happen if Global Mobile did not change the price of the rate plan at all.
Global Mobile is considering a decision to either increase or decrease the price of their 200 minute rate plan in order to increase the company’s revenue. In order to determine whether to increase or decrease the price of the rate plan, the price elasticity of demand will have to be consulted. First, let’s look at the current situation.
Global Mobile’s 200 minute plan has done well to increase the number of monthly subscribers with its entry-level nation wide calling plan for the cost-conscious. To date, it has been one of the most the popular plans. The 200 minute plan costs $29.99 a month and includes free nation-wide calling and the standard features that are usually expected with similar plans. Sales have gradually been dropping over the last couple of months despite the various advertising efforts. The Global Mobile marketing team has realized that other competitors such as Horizen, Z-mobile, and Singularity have come out with almost similar entry-level mobile phone plans to compete with its 200 minute plan. The price of the other closely related alternatives are taking away subscribers from Global Mobile. Campbell McConnell and Stanley Brue (2004), in their book titled Economics: Principles, Problems and Policies, confirm this behavior by stating the price of related goods, one of the determinants of demand, will change the demand schedule for an item. Global Mobile has to do something to combat this situation.
By closely examining various factors of the 200 minute rate plan situation, Global Mobile can likely turn this problem into an opportunity. The price elasticity of demand tool will be used to evaluate the various pricing schedule to determine if the price should be lowered to entice more subscribers, or to raise the price of the rate plan and add more features to make it a more attractive buy.
The price elasticity of demand is measured by “the responsiveness (or sensitivity) of consumers to a price change,” according to Campbell McConnell and Stanley Brue (2004, p.356). For example, restaurant meals are considered relatively elastic because consumers are extremely responsive to price changes, while a product like salt would be deemed inelastic due to small changes in the amounts purchased.
Global Mobile wants to see what the impact on revenue will be if the $29.99, 200 minute plan is either increased or decreased a few dollars. The law of demand asserts that as prices fall, the quantity demanded increases, if all other things are equal, which will be the basis for the projected quantities in the price elasticity of demand table.
The national monthly revenue for the $29.99 rate plan is roughly $689,000.00, with around twenty one thousand units sold each month. To find the price elasticity of demand for the 200 minute rate plan, the coefficient(Ed) for the midpoint formula will use the averages of two rate plan prices and two quantities as a reference point.
The formula is
change in quantity / (sum of quantities/2)
Ed = ______________________________
change in price / (sum of prices/2)
The price ranges of $31.99 to $24.99 will be evaluated to see what the best price is. Using the above formula, the quantity projections, elasticity coefficient, and total revenue can be calculated as shown in Table 1.
(Download Elasticy Spreadsheet used in Table 1)
The table shows that $29.99 is in the elastic price range and should be adjusted to affect revenue. If the price is increased to $30.99, an elastic price because of the 1.36 coefficient, there will be fewer consumers buying the higher rate plan, thus reducing revenue by $8,000.00 to $681,780. It does not make sense for further price increases as this will increase the elasticity coefficient even higher and reduce revenue even more. Now let’s look at price reductions. Decreasing he price to $28.99 increases demand, which increases sales. The elasticity coefficient of the new price is 1.25, which is better then the last price range since revenue is up by around $6,000.00 resulting in $695,760.00, but could still be better since the coefficient that is desired is 1. Jumping ahead a couple of dollars, table 1 shows that the price range between $26.99 and $25.99 is a unit elastic price that will bring in revenue of about $701,730.00, almost $12,000.00 more then the $29.99 price. Global Mobile will choose the $26.99 and $25.99 price range for its 200 minute rate plan.
A less likely alternative option would be to not change the rate plan price at all. What affects would this have? Not changing the price of the 200 minute rate plan would likely cause the downward trend in revenues to continue as consumer purchase the less expensive related plans of competitors. Not changing the price would cause Global Mobile to miss out on customer who upgrade from the entry level plans to ones that have more minutes. For example, once these new customers have used their phones for a month or two, they would have a better idea of which plans would be more appropriate to their calling needs. A number of customers may feel that the 200 minute plan is insufficient for their calling habits and upgrade to a higher minute plan, resulting in more revenue for Global Mobile.
In summary, I have identified the under performing 200 minute rate plan, pointed out similar plans from competitors that were causing its under performance, created a price elasticity of demand table for the $31.99 to $24.99 price range, analyzed the table results and identified that $26.99 and $25.99 is a unit elastic price range, and finally reviewed what would happen if Global Mobile did not take any action in changing the price.
Global Mobile has used the economic tools available to identify a price point with its 200 minute rate plan that is both an enticing bargain for its entry level customers and a revenue booster.
Reference
McConnell, C., Brue, S. (2004) Economics: Principles, Problems and Policies (16th ed.). New York: McGraw-Hill Companies.