When consumers are sensitive to price changes they either purchase substantially more or less relative to decreases or increases in price, respectively. The elasticity of demand is the ratio of the % change in demand divided by the % change in price. When the ratio is less than -1, it implies that a consumer is price sensitive and that the demand for this good/service is price elastic. A ratio less than -1 also shows that a 1% decrease in price effects more than a 1% increase in demand.
For this blog entry, I will complete the exercise for my marketing lecture, “Pricing Strategy Part 1”.
Would you expect demand for a hotel to be elastic or inelastic? Why?
Several criteria will be used to determine elastic or inelastic demand for a hotel below:
Substitution Effect: Commercial properties including hotels are typically homogeneous; that is they contain many distinct features that contribute to differences in value. Features such as elevators, sprinkler systems, electrical systems, room count and size, maintenance costs, infrastructure (plumbing, electrical, foundation) are all value determinants. There are however, many comparable hotels with similar features and operating expenses. For this exercise we assume there can be found many substitutes within a geographical area of interest.
With many substitutes available, the consumer has choice. This means that if the price of the hotel increases, the consumer would be price sensitive; he or she would look for an alternative hotel that is very similar(offers the same amenities and benefits) and negotiate towards a better deal.
Nature of the Purchase: From an investor’s perspective, a hotel would be a luxury good. It would be nice to have a hotel in the portfolio; but, by no means would the investor need to have it. Similarly, a consumer would have no need to live in a hotel; he or she would logically seek out a residential property to live within. Reasonably, a hotel should be considered a luxury.
Consumers are more price sensitive to luxury goods. Consumers, however, are less price sensitive to necessities as they are forced to make the purchase to fulfill immediate needs. For example, electricity is a necessity and one cannot go without it even for a day without suffering great inconvenience-a situation worth avoiding.
Urgency of Time: Savvy investors follow a good guideline to not be in a rush when making real property purchases. Urgency would ruin quality negotiations and is considered a disadvantage, say, when a seller is in a rush to liquidate (sell) his property. The seller in this case would very likely lower the price and grant more favorable concessions in contractual arrangements.
Time-Length of Price Shift: If an investor had the economic and market data to predict when trends in real estate pricing he or she should be able to determine how long a price should last; part of this analysis entails a bit uncertainty. So, if the investor expects a price to lower in the near future, then the transaction could comfortably be postponed. The risk, however, would be that someone else grabs it first.
Income Effect: In general, when consumers feel (perceive) an increase to their wealth, spending should increase. So, if a wealthy investor like Donald Trump wants to add another property to his portfolio, he could comfortably do it since he has a substantial periodic income to back up his purchases.
Proportion of Budget: Unlike multi-billionaires, the typical consumer considers the purchase of a hotel beyond his or her means. Financing is needed, typically funded by a mortgage loan. An investor when short of collateral assets would likely gather a group of like minded investors to help fund his purchase and spread out the risk. In any case, since the hotel purchase would be a big ticket one, the typical consumer would be very price sensitive-demand would be very elastic.
Our criteria show that a hotel purchase can reasonably be described to elicit price elastic demand.