Price Elasticity - A Simple Explanation

Determining price is one of the toughest things to do in business, largely because it has such a big impact on your company’s bottom line. One of the critical elements of pricing is understanding what economists call price elasticity.

Definition of Price Elasticity

Do people buy more when prices drop? How much more do they buy? Do they buy less when prices rise – and how much less? These questions can be answered by evaluating a product's elasticity of demand. Price elasticity of demand measures the responsiveness of demand after a change in a product's price.

The price elasticity of demand (PED) is calculated by dividing the percentage change in quantity demanded by the percentage change in price. As a formula it is written thus:

Price Elasticity of Demand = % Change in Quantity Demanded / % Change in Price

As an example, if the quantity demanded for a product increases 15% in response to a 10% reduction in price, the price elasticity of demand would be 15% / 10% = 1.5.

The degree to which the quantity demanded for a product changes in response to a change in price can be influenced by a number of factors - these include the number of close substitutes (demand is more elastic if there are close substitutes) and whether the product is a necessity or luxury (necessities tend to have inelastic demand while luxuries are more elastic).

When a product is price elastic

If a small change in price is accompanied by a large change in quantity demanded, the product is said to be elastic (or sensitive to price changes). Alternatively, a product is inelastic if a large change in price is accompanied by a small amount of change in quantity demanded, and is demonstrated by a practice known as surge pricing.

Types of products that are elastic

Substitute goods, that are readily available. For example, if the price of a particular brand of coffee increases, consumers may switch to another brand or type of coffee without a significant impact on their satisfaction or consumption.

When a product is price inelastic

When the price of a product or service changes and consumers don't react strongly by buying more or less of it. They are not very sensitive to price changes, so the quantity demanded or supplied stays relatively constant. In simple terms, it indicates that people are not easily swayed by price fluctuations.

Types of products that inelastic

Products with stronger brands tend to be more inelastic, which makes building brand loyalty a good investment. Typically, businesses charge higher prices if demand for the product is price inelastic.

Essential goods that are necessary for everyday life, such as basic food items like bread, milk, or eggs, tend to have price inelastic demand. Consumers continue to purchase them even if their prices increase because they are essential for their day to day life.

When a product is price unit elastic

When a product's demand is very responsive to price changes. A small change in price leads to an equal change in the quantity people want to buy. More simply, the demand matches the price fluctuations.

Types of products that price unit elastic

Household essentials like light bulbs, batteries, or toilet paper usually have unit elastic demand. When prices change, consumers can easily switch between different brands or options without having strong preferences for specific features or brands.

How Do Companies Use Price Elasticity?

Price elasticity is one way to measure how you are doing. It points you towards creating products and services that have unique and sustainable value for customers compared with the other options available to them.

Price Elasticity is also affected by the type of product you’re selling, the income of your target consumers, the health of the economy, and what your competitors are doing.

It cannot be looked at in isolation. If you understand why consumers behave in one way to a price change, this is critical to predicting how they will respond in the future and that information will inform your marketing efforts.

It can often however be an inexact calculation because it’s nigh on impossible to know what customers will do at every price point or in every scenario in the marketplace. Also, understanding the price elasticity of demand for your product doesn’t tell you how to manage that product.

Price Elasticity of Demand and Price Elasticity of Supply

Price elasticity of supply and price elasticity of demand are connected concepts that examine how the quantity supplied or demanded of a product responds to changes in its price. While they are related, they each address different aspects of market behavior.

The price elasticity of supply  measures how responsive the quantity supplied is to price changes. If the price elasticity of supply is high, suppliers can quickly adjust their production in response to price changes. If it is low, suppliers have difficulty adjusting production.

Generally, when the price elasticity of demand is high, suppliers are more likely to have a high price elasticity of supply This means that when demand changes, suppliers can easily adjust production. Conversely, when the price elasticity of demand is low, suppliers tend to have a low price elasticity of supply, indicating limited flexibility in adjusting production.

The relationship between the two elasticities can vary depending on market conditions and the nature of the goods or services, so it's important to be aware of the relationship specifically within your industry.

Combat Price Elasticity by Staying Relevant

Ultimately, your business needs to stay relevant to consumers and differentiated from your competitors. Once you achieve that, you can adjust prices up or down to better represent the level of value you are providing to your customers. Your current price elasticity is just one piece of data that helps you make those future decisions, BlackCurve can help you make data-driven pricing decision that grows your profit.

Sources

https://hbr.org/2015/08/a-refresher-on-price-elasticity

Boundless. “Measuring the Price Elasticity of Demand.” Boundless Economics. Boundless, 2016.

The Strategy and Tactics of Pricing, Tom Nagle and John Hogan, 2016.

Marketing: Concepts and Strategies, Lyndon Simkin and Sally Dibb, 2016.

Pricing with Confidence: 10 Ways to Stop Leaving Money on the Table, Reed K Holden and Mark Burton, 2014.

Pricing for Profit: How to Develop a Powerful Pricing Strategy for Your Business, Peter Hill, 2013.

Pricing Strategy: How to Price a Product, Bill McFarlane 2012.

The Undercover Economist, Tim Harford, 2007.

The Art of Pricing: How to find the Hidden Profits to Grow Your Business, Rafi Mohammed, 2005.