What is the Price Elasticity of Demand?
Price elasticity of demand measures the change in the demand for a product as a result of a change in its price. A product has elastic demand when there's a big change in its demand after a change in its price. Whereas, a product is inelastic if there's little to no change in its demand after a price change.
For example, research shows that raising cigarette prices doesn’t reduce cigarette consumption. This makes cigarettes an inelastic commodity. Cable television is an elastic product today. Streaming services are more common now thereby acting as cable television substitutes. So, it’s elastic due to the emergence of services like Netflix.
What is the Formula of Price Elasticity of Demand?
You can use the formula for the price elasticity of demand to know the nature of your product demand. Here's how to calculate the price elasticity of demand with a simple formula:
% Change in Quantity / % Change in Price = Price Elasticity of Demand
Once you know the elasticity of your product using the formula for the price elasticity of demand, you can set the right pricing strategy. Applying price elasticity and willingness to pay together helps to set optimal prices. You can set prices to gain more margin based on the elasticity score.
Now, the price elasticity of demand formula generates a number that denotes how elastic your product is. If the number you get is less than 1, <1, means that the product is inelastic. If the number is greater than 1 then the product is elastic. In the case of unit elasticity, the number you get is 1. This brings us to discuss these three types of elasticity of demand in the next section.
What are the Types of Elasticity of Demand?
There are mainly three types of elasticity of demand: elastic, inelastic and unit elastic.
- What is a Price Elastic Demand?
- Definition: When a small change in price leads to a major change in the demand, the product has an elastic demand.
- Characteristics: Products with substitutes available have high elasticity. Their demand is more sensitive to price changes as customers tend to opt for other items/offers.
- Elastic product example: If the price of a coffee brand increases, consumers may switch to a different brand. This causes a large decrease in the quantity demanded for the original brand.
- What is an Inelastic Demand?
- Definition: When price changes have little to no effect on the demand, the product has an inelastic demand.
- Characteristics: Consumers show inelastic demand for essential goods. Products with few or no substitutes, or necessities also have inelastic demand. They continue to buy these products despite price changes.
- Example: Diabetics will continue to buy insulin regardless of price changes. Its necessity makes it have inelastic demand. But, inelastic demand examples may not only be necessities. Most luxury brand items have inelastic demand. That's because a higher price will position it as an exclusive item.
- What is Unitary Elastic Demand?
- Definition: When a change in price leads to the same change in the quantity demanded, it has a unitary elastic demand.
- Characteristics: The percentage change in demand exactly matches the percentage change in price. So, the total revenue the product generates remains unchanged.
- Example: If movie ticket prices increase by 10% and the quantity demanded decreases by 10%, the demand is unitary elastic. The increase in price offsets the decrease in quantity demanded, keeping total revenue the same.
Knowing the types of elasticity of demand also helps identify the market behaviour.
If you sell 10,000 PVC pipes of 100 euro and then raise the price to 150 euro and sell 7,000 pipes, your elasticity of demand would be -0.88. This would be considered inelastic because it is less than one.
Broken down even further to include the calculation of percent change, this formula looks like:
((QN – QI) / (QN + QI) / 2) / ((PN – PI) / (PN + PI) / 2)
QN = New quantity (7,000)
QI = Initial quantity (10,000)
PN = New price (150 euro)
PI = Initial price (100 euro)
Our numbers plugged into this formula would be:
(7,000 – 10,000) / (7,000 +10,000) /2) / (150 – 100) / (150 – 100) / 2)
Head spinning? Let SYMSON advice you on price elasticity and the optimal price.
What Influences the Price Elasticity of a Product?
Researchers at the Ehrenberg-Bass institute for marketing science managed to find the key factors which influence price elasticity, and also the factors which are of lesser importance.
Their research found patterns across brands, products, and countries, and some of their findings contradicted popular beliefs about price elasticity. Let’s go through the six main influential factors they found one-by-one:
1. If the cost is the same or higher than the cost of a market leader in a category, the elasticity gets higher as well. The point is not that the price itself matters so much, but the relative price availability, i.e. in respect to the category leader and to the round point (for example, $10). This means if you want to keep the demand of your product optimal, you have to take into account the brand strength of your rival. If you’re a follower in price, calculate the optimal price index relative to the leader.
2. It is commonly believed that the bigger the brand, the smaller elasticity their products will have.This is not always the case, because it also depends on the “commodification” and the product life cycle of the product. Here, the brand value is “diluted” because the quality of commodities such as pvc pipes is less or more the same for every brand. For products like this, the customers will buy a product which is less expensive or better promoted.
3. Nobody likes a significant increase in price, that’s why there is a rule of single-digit price increase (no more than 9,9%). If the price increases by 10%, consumers get nervous and buy significantly less.
4. The mass market has the highest price elasticity. In this segment, the price elasticity increases, if the price is 5% higher or lower than the medium price. However, in general the price elasticity is lower for the economy segment as well as for luxury goods, as they have a loyal customer base.
5. A highlighted discount works 1.5 times better than the discount or another promo which wasn’t highlighted (for example, with different color). The reduced price needs to be “red-labeled”.
6. Price elasticity is higher for the less recent buyers, as they know less about the brand quality and they choose what is cheaper or has a discount. On a similar note, price elasticity increases for those who are more price conscious, though they have the “threshold line” the lowest price at which they are buying goods.
Take a look at SYMSON’s Price Elasticity Algorithm to learn about how it works on a Pricing Platform.
Moreover, the price elasticity is sensitive to multiple other factors that can impact a product's demand. But with the an accurate pricing tool, you can spare such repititive-yet-mature tasks to focus on other crucial aspects of your business. To know more, you can take a look at our comprehensive guide about pricing strategy for industries.
How can SYMSON help you Apply Elasticity Pricing?
As you covered the basic understanding and uses of price elasticity, you can watch our price elasticity webinar for an in-depth explanation. This is ideal for pricing managers or analysts to be able to take your pricing to the next level. You can also watch previous webinars at anytime here on our website.
SYMSON is an AI-powered pricing tool that manages the ins and outs of your pricing process. It conducts deep analysis based on the current markets, historical data and other macro and micro factors. It also tracks your competitors to keep you ahead of the crowd. With those insights, SYMSON recommends optimal prices that help you increase your margin and sales volume.
If you want to get started with price elasticity, you can download our in-depth Price Elasticity Guide which covers it all.
So, price elasticity is the ratio between change in demand and change in price. The higher the elasticity, the more the price influences demand. Price elasticity depends on factors such as the medium market price, brand size, type of customer, type of product and maturity level of product.
Sources:
A Quick Refresher on Price Elasticity (& How It Impacts Your Strategy), HubspotBuying brands at both regular price and on promotion over time, University of South Australia.
Price Elasticity Explained, Comptera
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