When you run an eCommerce store, knowing how to price your products effectively can make or break your business.
You may consider a variety of factors when pricing:
- supply and demand vs. production costs.
- competitor prices.
- customer segmentation analysis.
- the actual value to customers.
But one factor that can have an even more significant influence on pricing than all these combined: Price Elasticity of Demand (PED).
Price Elasticity of Demand (PED) is a crucial economic factor that can help you unlock various opportunities for your business. Understanding the different factors that can influence PED is essential in forecasting how demand will change following a price variation or any other changes you make to your products or services.
PED measures the relationship between price and demand. In simple terms, it tells you how sensitive your customers are to changes in pricing.
Think of it in terms of elasticity - just like a rubber band, when it is stretched or compressed, its shape changes. The amount of force needed to change the shape of the rubber band is known as elasticity. Similarly, when a price changes, customers either increase or decrease their demand.
If the PED is high, a slight price increase may lead to a significant decrease in demand. If it's low, then a slight adjustment won't have much impact on sales volume - giving you that much more leeway in pricing.
What Is Price Elasticity of Demand?
To understand PED, you must know price elasticity - the relationship between demand and price. Price elasticity shows how responsive customers are to changes in prices. It is typically expressed as a percentage or ratio – for example, “price elasticity of demand is -0.75”.
In economics, the PED measures the responsiveness of quantity demanded to a change in price. The higher the PED, the greater the responsiveness of quantity demanded to a change in price.
- A PED greater than 1 indicates a product is elastic, meaning demand decreases with a price increase.
- A PED below 1 indicates that the product is inelastic, meaning demand remains relatively unchanged when prices are increased.
There's a huge gap between theory and practice regarding pricing, and many factors can affect the PED. Many speak of PED in terms of ‘elastic’ or ‘inelastic’; the math behind it is simple: the higher the elasticity, the more impactful a price change will be on sales.
A few data points are needed when calculating PED, such as:
- Total Revenue: compile sales data from customers
- Market Price: look at what prices consumers are paying for the product
- Volume Sold: measure how many units of the product have been sold
- Price Change Over Time: compare sales before and after price changes
The key to using PED in your pricing strategy lies in understanding the factors that can impact the PED of a particular product.
Knowing the why and how of price changes will give you an edge in the market and help you effectively make informed decisions for your eCommerce business. Let’s look at some of the factors affecting PED - and how you can act accordingly.
What Factors Affect Price Elasticity of Demand?
There are a variety of factors affecting PED - from the availability of substitutes to the urgency of purchase. The factors can range from those that explicitly impact the price to those that don’t, such as psychological pricing behaviours.
Availability of Demand
The first factor to consider is the availability of demand. This refers to the availability of substitutes for a particular product that could increase or decrease the demand when a price change happens. If there are alternatives, it is more likely to affect the PED than if there were no substitutes.
For instance, products such as gasoline, milk, or eggs may have fairly consistent demand regardless of price change because there are limited alternatives and the need is urgent. On the other hand, products such as electronics can easily be replaced by cheaper and more efficient models that could lead to a larger reaction to a price change.
eCommerce sellers that offer customisable products, such as personalised clothing or jewelry, have a unique opportunity to adjust the price according to demand. The ability to offer different levels of customisation will also affect how much elasticity you can expect from shoppers.
The Urgency of Purchase: Is The Good a Luxury or A Necessity?
What factors affect price elasticity of demand? The concept of urgency may surprise you. This refers to whether or not a consumer needs to buy the product being considered (necessity) or if it’s something they just want (luxury).
Luxury items are more affected by price changes than necessities. For instance, when buying medicine such as insulin, consumers will be forced to buy it regardless of price. Whereas with a luxury item, like jewelry or electronics, they may be more likely to shop around for the best deal before making a purchase.
This can give eCommerce sellers an advantage regarding pricing elasticity if they understand their target customer’s needs and preferences. With luxury items, prices can be adjusted to be more competitive in the market. With necessities, prices can remain consistent as there is less risk of losing customers.
The Amount of Income Spent on The Good
A significant impact on pricing elasticity is the amount of income spent on the item itself. The higher the amount, the more prices can be adjusted to reflect customer demand.
Necessities will typically be more inelastic as consumers are less likely to change their spending habits regardless of price. Luxury items, on the other hand, may show a different curve when it comes to pricing elasticity as customers are willing and able to spend more on these items under certain circumstances.
A good example is the airline industry - when belts get tight, people may opt for a cheaper flight or switch to another airline altogether (which is generally more elastic than the former).
The Amount of Time Passed Since Previous Price Changes
Time plays an exciting role in influencing elasticity. Generally, if a price change has just happened, customers will immediately respond as they adjust to the new pricing.
After some time, buyers tend to forget about previous price changes and focus on the current one. This can reduce elasticity over time since people have adjusted their spending habits accordingly.
An excellent example of this is fuel prices. People initially look for alternatives when there’s a sudden hike in petrol/diesel prices. However, as time passes, they get used to the change and continue buying fuel at a higher price. Over time, they may not even realise how far the prices have increased.
The power of branding continues to drive demand and influence elasticity. Consumers with brand loyalty can be quite price inelastic, as they tend to stick with the same brands no matter what. This could cause them to pay higher prices than they would for similar products from other manufacturers.
Take Apple products, for example. The recent announcement of the Vision Pro AR headset - at a shockingly-high price of $3,500 - means that the purchase would take up a large portion of most people’s income.
This would normally be a case of price elasticity, as people would likely opt for cheaper alternatives. But brand loyalty means that many Apple fans will most likely purchase the product regardless of the cost.
Levels of Competition
What's the competition like in the market? Do you find your customers are leaking away to other businesses? Are there a lot of substitutes that are easier to find?
When customers have multiple options available, they tend to compare prices and go for whatever is cheaper. This drives down the elasticity as they quickly adjust according to the best deal available - creating an environment of price wars.
The Available Information On A Product
There was once a time when products had to be released before anyone knew what they were. However, in the internet age, information is available before a product even launches.
The availability of information can influence the elasticity of demand for a product. Customers can assess if the product matches their needs and decide if it is worth the cost. If they can find a similar product cheaper, they are less likely to purchase yours - leading to a decrease in elasticity.
Why Knowing What Factors Affect Price Elasticity of Demand Matters for eCommerce
Now that you know the main factors that impact the price elasticity of demand, you can start to understand why it’s so important to keep an eye on them for your eCommerce store.
1. Calculate the Optimal Pricing For Your Product
If you understand the factors that affect PED, it will be much easier to determine the optimal price for your product. You can calculate the ideal range and set prices within that range according to your competitors’ prices.
2. Increase Demand During Promotions or Discounts
Offering deals and discounts can be challenging with high competition and limited product information. But with PED knowledge, you can tailor promotions to increase demand and maximise sales without harming the brand or profitability.
3. Maximise Profits During High Demand Periods
Surge pricing boosts profits during high demand. Raise prices at peak times by identifying price-elastic products to increase profits without losing customers.
4. Improve Your Understanding of Customer Buying Behaviour
Analysing factors impacting the elasticity of demand can help understand customer behaviour - and offer insight into why they make certain purchases over others. These invaluable insights are useful for setting prices and targeted marketing campaigns.
5. Throttle Your Supply Strategically
As a retailer, understanding the factors that affect the price elasticity of demand can help you to better manage your supply.
By making sure you are not overstocking items with a low-price elasticity of demand, you can avoid prices dropping due to excess supply. This will ensure that you remain competitive in the market and maximise profits.
Take Advantage of PED To Drive Your Pricing Decisions
Over the years, PED has caused nightmares for many economists as the outworking of the theory in real-world situations is often much more complex than theoretical assumptions. However, understanding the factors that affect the price elasticity of demand can help businesses maximise profits and better understand customer buying behaviour.
Effectively leverage knowledge to adjust pricing strategies and keep up with market changes. Consider factors affecting customer price sensitivity to optimise your approach with PED.
At BlackCurve, our team is dedicated to uncovering the right pricing strategies for your business. Visit us online today to learn more about how pricing impacts your bottom line - and how you can use theories such as PED to your advantage.