A Refresher on Price Elasticity of Demand
No matter what products or services your business is selling, determining the price is among the most important decisions you’ll have to make. That, however, is a complex process and you should ensure you understand all the different elements of a successful pricing strategy.
One of the essential concepts to understand is price elasticity.
This guide will explain to you 1) what price elasticity is and 2) how to calculate it regarding your own products. We’ll also explain 3) the importance of determining what is the price elasticity of your product and 4) how to avoid making common mistakes during the process.
WHAT IS PRICE ELASTICITY OF DEMAND?
Price tends to be an important metric for people making purchase decisions. A customer might buy less of a product if the price will increase and shop more if the price will decrease. Therefore, knowing how the price affects customer behavior is important for any business.
Price elasticity is a measure, which shows how responsive customer demand is regarding the price of a product. Therefore, price elasticity shows the impact that changes in price have on the demand of the product. In other words, price elasticity of demand measures the customers’ price sensitivity.
The conventional understanding of price elasticity is based on the following assumption: The more prices increase, the more customer demand for the product will decrease. But in reality, price elasticity hardly functions in a direct causal line. This is because products tend to fall into different categories depending on their value and importance to the consumer.
There are different ways of categorizing consumer goods, but the three main groups are:
- Convenience goods
- Shopping goods
- Specialty goods
Furthermore, products are often further classified into two additional categories of:
- Emergency goods
- Unsought goods
For each of the above categories, price tends to play a different role in deciding whether to buy or not. Each product category will also feature further division in terms of being an essential or a non-essential product for the consumer.
Therefore, price elasticity is a great metric for understanding how demand changes with price.
Price elasticity of demand can present itself in the following ways:
- Relatively or perfectly inelastic – This means the demand doesn’t change dramatically when the price changes. If a change is manifested, it is only in cases of large price changes, which result in small drops or increases in demand.
Relative or perfect inelasticity tends to manifest in goods that are essential for the consumer. For example, gasoline often showcases relative inelasticity. People need gas and small price changes are unlikely to stop people from buying it, even if they moan about the price. Only a dramatic increase in price can cause people to think twice. A product with perfectly inelastic prices is for example a cancer drug, that patients need to survive. The patient will buy it, no matter how much the prices go up. However, it’s not only the good itself that has an impact on price elasticity. Strong branding, for example, can also help businesses to achieve relative inelasticity.
- Unit elastic – Unit elasticity means the change in demand is equal to the change in price. Whilst this is often the expectation, unit elasticity hardly happens in real life.
- Relatively or perfectly elastic – The demand can change dramatically when the price of the product changes. The change in demand is noticeable, even if the change in price is small.
Products that fall under relative or perfect elasticity tend to be commodities. The brand is not meaningful to the customer or the product itself isn’t a necessity. Food commodities, such as beef are good examples for relative or perfect elasticity. There are many competitors offering a very similar product. Hence, if one company increases prices, customers will just buy their beef from another company. Moreover, there are substitute goods available. If beef becomes more expensive, I might just buy pork instead.
By understanding price elasticity, you can better understand how customers will react to price changes. In the following section, we will further examine the importance of price elasticity for businesses.
Some practical examples on elasticity of demand.
HOW IS PRICE ELASTICITY CALCULATED?
Price elasticity of demand can be calculated by using the following formula:
Price elasticity of demand = Percentage change in quantity demanded / Percentage change in price
How does this work in reality? Consider a shoe business raises the price of its stilettos from $100 to $120. The price increase would be calculated by subtracting $100 from $120 and dividing it by $100. The price increase would be 0.20 or 20%.
The change in the price would also have resulted in a decrease in demand. Under the old price, the business sold 2,000 stilettos and after the price-increase, the number of sales has dropped to 1,600. The demand change would be calculated by subtracting 1,600 from 2,000 and dividing it by 1,600. Hence, the demand change would equal 25%.
If you insert these figures into the formula, you’ll receive a price elasticity of demand of:
So, how to interpret this result? Above, we examined the different ways price elasticity can manifest. There are five zones of elasticity and the calculation will determine the zone for each product. The zones are:
- Perfectly inelastic if the value equals to 0.
- Relatively inelastic if the value equals between 0 and 1.
- Unit elastic if the value is 1.
- Relatively elastic if the value is slightly above 1.
- Perfectly elastic if the value is well above 1.
The above example would therefore mean the product is relatively elastic. This means the demand of the product changes, as the price has changed. The figure can now help the shoe company to better understand the consumer behavior and the relationship with the particular product.
When calculating price elasticity it’s important to understand the figure could technically be negative. But the negativity is traditionally ignored in the calculation and the price elasticity of demand would simply be the resulting number. For example, if the price increase is 20% and the demand change is -10%, the resulting price elasticity would be -0.5 or 0.5. All that matters is the magnitude of distance to zero, it doesn’t matter whether the number is positive or negative.
It’s important to understand the number itself isn’t the key thing to understand, but rather the elasticity zone the product belongs to.
Check out the below video for further examples on how to calculate price elasticity of demand:
WHY DOES PRICE ELASTICITY MATTER?
Now that you understand how price elasticity works and how it is calculated, it is time to take a closer look at the reasons why it’s important for any business.
Price tends to be an important part of consumer shopping decisions and companies should understand just how important price is for consumers by calculating price elasticity of demand.
In fact, price elasticity of demand is one of the key metrics for businesses. It can be used to improve the company’s operational strategy.
Firstly, since price elasticity measures the impact of price changes on demand, it helps the company to answer one of the most important questions, “How can we set prices?”
If you find your product to have inelastic prices, this means you are able to increase the price significantly without diminishing demand and sales. A number of companies already do this with their products. For example, infamously pharmacy companies tend to have expensive prices on products, which people need to survive. On the other hand, non-essential drugs, such as nose spray, tend to be cheaper. If the customer needs a drug to survive, the price doesn’t impact the demand. Of course, cancer drugs and the like have much higher development costs and significantly fewer buyers, which has an impact on the price, too. Nevertheless, price inelasticity plays a role here as well.
On the other hand, if your product is elastic, you must be much more careful with the price. Goods like apples will simply be left on the shelves if the price goes up, as consumers won’t feel the need to buy the product. They will just buy their apples in the store around the corner, or buy a banana instead.
Whilst price elasticity can often tell whether consumers consider the product you are selling as a necessity or not, it can also reveal something about the brand. Non-essential items can still be price inelastic, simply because the branding of the product has been successful.
Apple is a good example for a company that has been successful in terms of product and brand marketing. Although consumers could easily find a cheaper smartphone from other brands, many feel the Apple brand is worth the money.
Therefore, by understanding your product’s price elasticity you can understand the attitude customers have towards your product and brand. This allows you to set an appropriate price for the product, as well as learn how much customers appreciate your brand.
This leads to the second important aspect of understanding price elasticity: Your products won’t necessarily enjoy the same price elasticity at all times. Customer appetite towards a specific product can change. Something deemed as a non-essential item can become an essential product during a crisis or change in conditions. For example, bottled water could become inelastic if the region suffers from water shortage or water poisoning.
But a disaster isn’t the only reason a product’s price elasticity might change. Increased competition in the market could also change customer behaviour towards your products. A crowded market could turn a product more elastic, even if you previously enjoyed relative inelasticity.
Therefore, it is important to pay attention to price elasticity and to regularly monitor it in order to learn more about the current market situation.
Overall, price elasticity can support your marketing and pricing strategy.
Since you’ll understand customer behavior towards the product and you’ll learn more about the elasticity in relation to competition, you can react and market your product accordingly. If you have an elastic product, you can try to add more brand building to your product, for instance.
Price elasticity can help you further understand your revenue structure as well.
Since you can better understand the relation between demand and price, you can predict sales numbers and adjust your pricing strategy. For instance, price elasticity can be great for understanding whether promotions will dramatically increase sales or whether a price-hike would significantly impact your revenue stream.
If you find out your product is perfectly inelastic, you could increase prices without hurting demand. This could provide more revenue for the firm and improve profit margins.
WHAT TO REMEMBER ABOUT PRICE ELASTICITY?
As the above shows, price elasticity is an important metric for defining product and marketing strategies. But you should be aware of some of the common pitfalls businesses fall into when it comes to using price elasticity.
First, measuring price elasticity can be challenging. In order to calculate the correct price elasticity, you naturally need two reference points for the price. This means you need to change the price from A to B in order to get an accurate reading. But changing prices dramatically for a longer period isn’t always a viable option for a business. After all, if demand drops dramatically, you can potentially hurt your business revenue and consumers might move elsewhere in search of cheaper products.
To overcome the issue, businesses often test the price change virtually, without actually changing the price. They rely on consumer questionnaires and interviews, which they use to ask how consumers would react to different price changes.
The problem with this type of measurement is that the sample sizes can be relatively small. A company might not get an accurate image of consumer behavior because they could only get the view of 1,000 consumers. But if the product sales stand at 100,000, the sample size will be a limited look into consumer behavior.
Furthermore, consumer questionnaires only provide a hypothetical response from the consumer to the price change. If you ask someone, whether he or she would pay $2,000 for a sofa instead of $1,000 in a questionnaire, the answer can be different than the reaction in real life. Consumers don’t always behave rationally and even if they think they would buy the sofa, they might not actually do so when the situation would actually occur. Spending hypothetical money is different from spending real money.
The other way businesses try to overcome the issue is by using old data or statistics. For example, they might look at competitor’s data and calculate price elasticity based on this information. On the other hand, businesses might look at how a consumer behaved five years ago, when the price was different to what it is now.
But the past consumer behavior can be different to current behavior for a variety of reasons. For example, the economic climate might be different. Consumers, who were willing to pay $500 for a massage ten years ago, might not feel the same way now if the economy is suffering.
Therefore, real life changes to product prices will always be able to provide you a more accurate picture. You should consider changing your product prices even for a short period. The figure will still provide a more accurate representation of a real life shopping decision than relying on survey-based or past results.
Learn from this case study on retail pricing using price elasticity of demand.
A good way to test price elasticity would not be comparing the current price with a changed price, but rather test price A and price B. Price A could be slightly higher than the current price and price B could be a reduction in price. This allows you the monitor the demand during a similar period.
Chains can conduct testing easier, as the business can simply change the price in a single store, for example. The key to efficient price and demand testing is to conduct it in small scale. Never introduce a large-scale price change solely to test the customer’s reaction, as you could potentially damage your business.
Finally, you should be careful on how your business reads into the price elasticity metric. You don’t want to treat it as a number, but more like an indicator of consumer behavior. A business should never simply calculate the number and conclude the product is elastic or inelastic. You should instead look beyond the number and examine the reasons behind the result.
You’ll have more success with price elasticity if you use it to understand underlying consumer behavior. Once you calculate the product’s price elasticity, conduct qualitative research into consumer behavior. For example, is the elasticity more a result of the current market conditions, external economic factors or simply an indicator of the customers’ quality expectations towards your product?
Be patient with your calculations. By understanding the underlying reasons for consumer behavior, you can get an accurate image of the real price elasticity. Remember consumers will need some time adjusting to price changes and aligning their behavior with the product’s value proposition, so don’t make rash decisions based on your readings.
THE BOTTOM LINE
Price elasticity is an important metric that decision-makers should understand. Price does matter and consumers make decisions based on the price. But the impact price has on demand can vary between products and it’s important to understand the product-specific relationship between demand and price.
Businesses can benefit from understanding the nature of price elasticity. It can help to devise a more cohesive pricing strategy, but it’s also an essential factor in shaping the marketing strategy for the product. By understanding price elasticity, businesses can get a more accurate picture of how consumers view the product.
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