Price Elasticity of Demand: Definition, Formula [+Free Tool]

Price elasticity

Price elasticity measures the change in demand when you change price of a product up or down. Price elasticity is an important factor to understand when you price your products. It helps you to set prices that capture the demand and let you optimize your market share.

Price elasticity refers to the extent to which changes in price affect the demand for a product. In other words, it measures the responsiveness of consumers to changes in the price of a product. If a product is price elastic, a small change in price will result in a large change in the demand for that product. On the other hand, if a product is price inelastic, changes in price will have little effect on the demand for that product.

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This concept is relevant for retailers and ecommerce businesses as it helps them determine the optimal price for a product. If a product has high price elasticity, it may not be possible to charge a high price without negatively impacting demand. In this case, it may be better to lower the price to increase demand and sales. On the other hand, if a product has low price elasticity, a business may be able to increase the price without significantly affecting demand.

It is important to note that price elasticity can vary greatly depending on the product and the market. For example, necessities such as food and medicine tend to have low price elasticity, while luxury items may have high price elasticity.

Retailers and ecommerce businesses can use market research and consumer data to determine the price elasticity of their products. This information can be used to set prices, develop promotions and sales strategies, and make informed decisions about product pricing and margins.

In ecommerce and retail businesses, understanding price elasticity can impact pricing in the following ways:

Profit maximization: Businesses can use data on price elasticity to determine the optimal price point for a product or service in order to maximize profits.
Market positioning: Businesses can use price elasticity data to position their products in the market, such as setting a higher price for luxury products or a lower price for budget products.
Cost-based pricing: Businesses can use cost-based pricing, where prices are set based on the costs of production, to determine the appropriate price point for a product or service.
Price anchoring: Businesses can use price anchoring, where they set a higher price for a product and then offer a discounted price, to create the perception of a better deal for consumers.
Promotions and discounts: Businesses can use promotions and discounts to appeal to price-sensitive consumers.
Long-term impact: Businesses can use data on price elasticity to predict the long-term impact of changes in price on demand and revenue.

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Summary

Price elasticity refers to the degree to which the demand for a product or service changes in response to changes in price. Understanding the elasticity of price is crucial for ecommerce and retail businesses to determine the optimal price for their products and make informed pricing decisions. By taking into account the responsiveness of consumers to changes in price, businesses can maximize sales and profits while maintaining customer satisfaction by creating the perception of a better deal, appealing to price-sensitive consumers, and predicting the long-term impact of changes in price.

FAQ

Most frequent questions and answers

What is meant by price elasticity?

Price elasticity of demand (PED) measures the responsiveness of the quantity demanded for a product or service to a change in its price. It’s a dimensionless ratio, calculated by dividing the percentage change in quantity demanded by the percentage change in price. The concept is fundamental in understanding the market sensitivity to price changes and plays a crucial role in pricing strategies and demand forecasting.

What is a good price elasticity?

The value of price elasticity can be interpreted as follows:

If PED is greater than 1, demand is said to be ‘elastic.’ That means customers are price sensitive, and sales quantity can significantly change with a small change in price.
If PED is less than 1 but greater than 0, demand is said to be ‘inelastic.’ Customers are less sensitive to price changes. A significant change in price results in a less than proportionate change in quantity demanded.
If PED equals 1, demand is said to be ‘unit elastic.’ A percentage change in price will result in an equivalent percentage change in quantity demanded.

A “good” price elasticity is subjective and depends on a company’s objectives. If the goal is to increase revenue, then it might be desirable to have a product with inelastic demand so the firm can increase prices without significantly reducing the quantity sold.

What are inelastic and elastic products?

Elastic products are those for which demand significantly changes with price fluctuations. They often have close substitutes or are non-essential goods. Examples might include luxury goods, brand-name clothes, or restaurant meals.

Inelastic products, on the other hand, are those for which demand does not significantly change when the price changes. These are typically goods that are essential or do not have close substitutes. Examples might include gasoline, medicines, or staple foods like rice or bread.

How can I use price elasticity?

Understanding price elasticity can be incredibly useful for businesses, as it impacts revenue, demand, and profitability. Here’s how it can be used:

Pricing Strategy: If a product has elastic demand, a company might lower prices to increase total revenue. Conversely, if a product has inelastic demand, a firm may increase prices to boost revenue. A worth while information to create a good pricing strategy.
Product Positioning and Marketing: If a company wants to make a product’s demand more inelastic, it could invest in brand building and differentiation, reducing the perceived availability of substitutes.
Revenue Forecasting: By understanding how changes in price impact demand, businesses can more accurately forecast future revenues and profits.
Demand Forecasting: During periods of supply constraints, companies might increase prices to manage demand levels, provided the demand is price elastic.

When it comes to pricing and choosing the right price for a product, one of the first things you will stumble upon is the discussion of supply and demand. And why shouldn’t you? It’s the pillar that almost all pricing related theories are built around. However, you don’t need to dig very deep into the concept before you start to hear talk of elasticity, price elasticity and price elasticity of demand. Even the myths about price elasticity.

Price elasticity measures the way consumers, individuals or producers respond to changes in price with change in demand or supply of a product. Understanding price elasticity in pricing is important. You can do profit optimization easily in eCommerce with profit optimization algorithms.

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Price elasticity can be divided into two different types

1. Price elasticity of demand

Price elasticity of demand refers to the degree to which the effective desire for something changes as the price changes.

2. Price elasticity of supply

Price elasticity of supply is a measure of how sensitive our quantity supplied is to a percentage change in price.

Let’s take a simple example to illustrate price elasticity. Think of a product like insulin. The drug is vital for people suffering from diabetes and having to live without it is not an option for millions of people around the globe.

In essence, changing the price of insulin is not going to reduce its demand and thus volumes sold. Of course we know that at some point no one will be able to afford the product any more but for a long time the price will be inelastic meaning that the price goes up and the demand stays the same.

Now take 1 euro for instance. If you offer someone the chance to buy 1 euro from you for 1 euro no one is going to do that (unless the buyer is a coin collector and your coin happens to be way nicer than his, in that case someone might go for it but other than that, it’s a no go).

Now what would happen if you sold 1 euro for 85 cents? Someone would probably already buy it. Lower the price further and more people would buy until you reach a point where the demand evens out. Still, the euro is a good example of an elastic price.

The elasticity of price is affected by both internal and external factors, in this case factors relating to
the product and other factors. The most important internal factors affecting price elasticity are:

Degree of necessity
Being time-bound
Accessibility of substitutes

The outside factors affecting price elasticity will be covered with a more detailed approach later in this article and in our eBook about AI in pricing. So let’s look more closely at the internal factors and use our example of insulin to illustrate.

The degree of necessity with a product like insulin is of course very high. The higher the need, the more inelastic the price is. People won’t stop needing insulin just because the price went up. If we look at something like fuel, it’s still considered inelastic but less so than insulin. People need fuel to commute to work for example but at some point when the prices rise people are going to find other means of transportation. Now if you look at something like indoor plants, they are a necessity for very few which means their price will be elastic and the demand will drop if the prices rise.

Preferences and buying behaviors may change over time which leads us to our second factor; price elasticity being time-bound. Let’s think of insulin again. Are people’s preferences or buying behaviors when it comes to insulin likely to change over time? Well no, not really. Unless you are cured, you’ll be buying insulin for the rest of your life. Fuel is a good example in this context as people have become more aware of the effects of global warming and some are already committed to driving electric cars or cycling to work.

Another example of how demand can change over time is the seasonal products related to weather. Bobsleighs are a lot more likely to be extremely elastic in price during summer but during a winter with heavy snowfall you might already be able to hike up your prices quite a bit before it will show on your sales volumes.

COVID-19 also provided a great example when people started hoarding toilet paper and hand sanitizer. These products suddenly had such a huge demand that some retailers were able to triple the price and still sell the products.

The last factor relates to the accessibility of substitutes. Now this is quite logical isn’t it? The more substitutes that are available, the easier it will be for a consumer to buy a substitute instead of paying more. If you have only one pharmaceutical company producing and selling insulin, they can hike up the prices a lot before people will stop buying but if you have ten producers on the market for this kind of drug, you are most likely all going to be pricing your products nearly exactly the same.

We’ve all been to a pharmacy and been asked if we want to switch out whatever the doctor ordered for a cheaper substitute from another manufacturer and quite a lot of us have at one point said yes.

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What if the product seems inelastic?

Sometimes a product can seem inelastic and typically in those situations we are either too cheap (always selling a lot) or too expensive (never selling anything). Because of this we have not achieved the elastic curve and the only situation where the product’s whole elastic curve is truly inelastic is when the market is at 0 (i.e. no products are sold to anyone). This is what we mentioned earlier, even though insulin is vital, at some point it will be too expensive for anyone to buy.

What if the product seems elastic?

If the product seems elastic it can mean a couple different things. First it can mean that the price points that have been tested have all been in the “sensitive area” meaning that the changes have all led to change in demand. Another thing that can lead to a product seeming like it’s elastic is simply by chance.

The dynamic nature of price elasticity

When reading the text above, one might get the feeling that a product’s price is either elastic, inelastic or something in between. This however isn’t really the case. Price elasticity actually has much more of a dynamic nature that is present in two different ways:

Product lifecycle and price elasticity

It is vital to understand that price elasticity changes during product lifecycle. Products price elasticity changes because product maturity, market competition and other economic factors – such as inflation – change the value people perceive in your products.

Therefore the size of the elasticity or inelasticity depends on the price point based on how people perceive the price.

If we start by looking at the first statement; price elasticity changes during the product life cycle. This of course means that during the different stages of a products life cycle the product price can be either completely elastic, completely inelastic or anything in between.

Examples of product lifecycle and price elasticity

A new product introduced to the market surrounded by hype can have a huge demand, people don’t care about the price, they have to have it. At this stage the product’s price is nearing inelasticity.

The other extreme is when the product is at the end of its lifecycle, there is a lot of competition and your product only gets sold when the price is just right. In this situation the price is very elastic.

The value in understanding price elasticity is very much dependent on understanding that the price elasticity is so dynamic. Of course it would be nice if we could study the price elasticity once, decide on something and then use the same hypothesis when pricing the product in the future but unfortunately that is a bit too optimistic. Lucky for us, we have computers who can help us follow the elasticity of a product’s price and suggest how we should capitalize on the knowledge.

Understanding the amount of price elasticity

The other factor to take into consideration when it comes to the dynamic nature of price elasticity is that the amount of elasticity or in-elasticity varies depending on the price point.

If you look at price elasticity as a curve that is made up of price points and then connected to form a continuous line, it is easier to understand why the dynamic nature is present all the time. Now let’s move one step forward and start imagining price elasticity as something that there can be more and less of. Instead of thinking of it as a value that just describes the price’s elasticity, also think of it as a scale in between inelastic and elastic. Since the price evolves and price elasticity is calculated between two price points it means that the value defining the amount of elasticity is different depending on the price points used for the calculation. A product can be almost inelastic at some points and elastic at another, depending on the price.

Outside factors affecting price elasticity

As mentioned earlier, price elasticity is based on internal factors ( degree or necessity, being timebound, accessibility of substitutes) and outside factors. Now it’s time to look at the outside factorswhich can be boiled down to:

1. Market size
2. Market competition
3. Customer characteristics
4. Events in the world

Market size and price elasticity

If we start with market size, it is quite obvious that the amount of customers and the amount of actors affects the pricing and therefore the price elasticity. If you have a market of 100 people vs. 100 000 the difference between the customers is already something that is quite noticeable. In a smaller market you might have to think about capturing everyone on the market to be a success whereas on a large market that is rarely the case. The size of the market and its effect on price elasticity mostly boils down to how consumers differ and the more consumers there are on the market, the more different individuals there are who you have to get to buy your product.

Competition and price elasticity

Competition affects price elasticity by adding the element of having to consider at what price consumers are likely to buy from a competitor instead of from you. The more competitors, the more you have to focus on where your pricing strategy should be in comparison to your competition and the overall flexibility of setting prices tends to diminish.

Demographics affecting price elasticity

As mentioned above, customer characteristics are a big influencer. No two people are alike and the more potential customers your market consists of, the more different kinds of demands are you able to/required to meet and sell to. Changes in people’s way of thinking is one way that really affects price elasticity. We all know that being environmentally friendly is becoming a bigger thing and businesses selling eco-friendly products can see a more inelastic price compared to their not so-eco-friendly competitors. This is all due to the customers way of thinking about what is important in a product. Another good example is how certain brands have a luxury-image in people’s minds and customers are therefore willing to pay more since they have a stronger belief that a raise in price makes the product more desirable.

There is no more powerful example right now of how events in the world affect price elasticity than the COVID-19 pandemic. In a matter of weeks almost the entire world had to shut down, people retreated into their homes and prepared to stay there for a long time. This led to products that you normally buy once in a while without thinking being the most sought after and the demand skyrocketed when people started hoarding things like toilet paper, hand sanitizer, hygiene products and canned foods.

Before the pandemic, hand sanitizer was sold in moderation by pharmacies and grocery stores but as soon as the pandemic was a reality, suddenly every store wanted to carry something similar to hand sanitizer and while the hospitals were first in line for all produced products, small companies switched focus and started producing and selling hand sanitizer at a huge markup.

There is no doubt that price elasticity is as much affected by internal as external factors, making it challenging to estimate. Luckily AI and especially reinforcement learning has proven quite successful at generating forecasts in the most sensitive area, something we will discuss more in our eBook about AI in pricing.

How eCommerce Managers can utilize price elasticity

Segment your customers by demographics, interests, buying behaviors, income levels and their perception of your product – then use this data to come up with effective pricing and promotional strategies.

You also need to take into account how competitors are pricing products and how your potential customers perceive these products.

As a business, your end goal is to differentiate your brand in the market – this will happen when you can set the prices that your target audience identifies with.

For instance, Lamborghini (a highly price elastic brand) would have a much higher price point, but for the Ibuprofen (a medicine – relatively price inelastic), the price point would be considerably lower.

However, pricing strategies alone will not get you there – you need to conduct focus groups, surveys and employ other research techniques to help you find out your target audience’s perceptions, demographics, buying behaviors and interests pertaining to your market.

Supplement qualitative with quantitative research to make sure your pricing and promotional strategies are successful and so is your business. LetPricen help you find the right data and make sense of it.

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