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.
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.
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).
Beef is an example of a product that is relatively elastic – because there are alternatives available. Petrol is inelastic because most people need it, so even when prices go up, demand doesn’t change greatly.
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.
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.
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.
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Pricing with Confidence: 10 Ways to Stop Leaving Money on the Table, Reed K Holden and Mark Burton, 2014.
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Pricing Strategy: How to Price a Product, Bill McFarlane 2012.
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