A quick primer: What is price elasticity in e-commerce and in general?
Let’s start with a quick summary of the basics.
In short, price elasticity tells you how much a price increase or decrease will impact the demand for a product. For a more detailed explanation, we would recommend reading this article about the definition and causes behind price elasticity.
The majority of all products sold in the world are elastic – some more than others – which means that their demand will go up when prices go down or vice versa. Some products, on the other hand, are relatively inelastic – meaning that their demand won’t be affected much by changes in price (but this is not very common in e-commerce).
Let’s first see a few examples of both categories to get a better grasp on the difference.
Products with extremely elastic prices are typically luxury or nice-to-have goods where the consumer has a lot of room for choices and where there are a lot of alternatives at the time of purchase, such as:
- Consumer electronics. Most consumer electronics have multiple options at varying price points. If you are selling wireless earbuds and you increase your prices by 20%, you’ll probably see a significant drop in both demand and revenue.
- Clothing. If you think about generic white t-shirts, sweaters, or jeans, consumers have a massive number of substitute options at hand, which means that in many cases, the demand of your white t-shirt is largely affected by price. Conversely, people will typically pay “extra” for luxury goods with added perceived value.
Products with extremely inelastic prices are typically necessities with no substitutes available, monopolized products, or products with extremely tough competition (let’s get back to competition in a minute) or poor availability, such as:
- Insulin. If a person needs a life-saving drug like insulin, they’ll need to buy it, no matter the price. Changes to price will have a small effect on the demand (until it’s not affordable anymore).
- Toothpaste. Most people agree you need toothpaste to keep your teeth clean. If the price fluctuated a little, most consumers would still be likely to purchase it because of its usefulness.
If you want to understand better what actually causes price elasticity in e-commerce or inelasticity, we recommend reading our complete guide to price elasticity here.
Benefits of pricing based on price elasticity – and the risks of not understanding it
All this being said, it’s obvious that elastic and inelastic products should be treated differently when it comes to pricing. This is also why understanding the concept of price elasticity will help you make better and more profitable pricing decisions — regardless of if your products are elastic or inelastic.
Some of the benefits of pricing according to a product’s price elasticity include:
- Understand your buyers’ behavior better to inform your pricing strategy: Understanding how consumers will respond to price changes can not only help in mitigating the risks involved but also help in reducing the uncertainty in making pricing decisions.
- More accurate sales forecasting: By knowing the optimal price of a product, you can forecast your sales and even set up prices for the future.
- Increased profit margins: If you’re selling inelastic products, you might have more flexibility when it comes to increasing the prices of your products because people won’t be turned off by the increased price. If you’re selling elastic products, you can increase demand by giving out discounts and see an increase in revenue.
In turn, failing to understand how price elasticity affects demand can do a lot of harm to your profitability. A typical scenario is that the price elasticity of a product is not taken into account in pricing decisions and products are being sold at a too low price, which in turn results in low profit margins.
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5 common price elasticity myths debunked
Myth #1: Taking price elasticity into account always results in lower prices
Probably the most common misunderstanding about price elasticity in e-commerce and in general is that pricing according to your products’ price elasticity always results in lower prices.
Good news: you don’t have to be the cheapest on the market to benefit from pricing based on price elasticity.
In our experience, the optimal price point (where profit margins are at the highest) is actually often a lot higher than the starting price — which means many companies are essentially leaving money on the table.
Myth #2: The more you decrease prices, the more demand you will have
Decreasing a product’s price often results in increased demand, but not always. There are a few (surprisingly common) scenarios where this logic fails miserably:
- Sometimes if you decrease the price of a product too much, people can get suspicious and may start questioning the quality of the product, and therefore the demand can drop (e.g. if a $1.000 iPhone is sold at $500).
- You can run out of stock faster than expected, in which case the increased demand won’t help.
- You’ve already reached the whole market (or a big enough proportion of it), which means lowering prices won’t help you to acquire new customers — because there are not potential customers left in the market.
- In some cases, no matter how much you lower your prices, your competitors will match your price, while the size of the market stays the same — and all of you will be left with lower profit margins and nothing more.
Myth #3: Price elasticity is something intangible and non-scientific that cannot be verified
Wrong! Price elasticity is not just a gut feeling that you could maybe charge more; it can indeed be calculated and verified in a very precise way which helps you as a merchant to find the optimal price point for each product.
In mathematical terms, price elasticity can be calculated in a couple of different ways (disclaimer: which formula you should use depends on the situation, and the example presented here is just for the sake of illustration).
One way to do this is to divide the percentage change in quantity demanded by the percentage change in price.
Let’s say you’re selling shirts online for $80 each and currently, you sell 500 shirts a day. You decide to increase the selling price by 12.5% which adds up to $90 for a shirt. Because of the price increase, your sales drop from 500 shirts sold every day to 400 shirts sold — a 20% decrease.
Now, if we use the formula above, we get the following result:
20% / 12.5% = 1.6.
Price elasticity of demand is then 1.6. So, what does this value tell us?
Here’s what different price elasticity values signify:
- Value is 0: Perfectly inelastic product → Price changes have no effect on demand
- Value is between 0 and 1: Relatively inelastic product → Big price changes have a small effect on demand
- Values is exactly 1: Unit elastic product → Increase in price and decrease in demand are equally matched
- Value is greater than 1: Price elastic product → Demand affected significantly with a change in price
Myth #4: “We have too much competition to benefit from price elasticity”
Newsflash: chances are you actually don’t have as much competition as you think – and even if you did, it still probably makes sense to make small, controlled price adjustments to understand the price elasticity and find the optimal price for the most competitive products, too.
So, what does it mean to be in a ‘competitive’ market, really?
- Scenario 1: When most e-commerce businesses say that their market is competitive, they simply mean that there are other stores selling more or less similar products and that customers have the opportunity to choose from multiple options. In this case, you still have some room for price optimization, even if the changes are modest (but remember: the bigger the sales volumes, the bigger the compound impacts in profits).
- Scenario 2: When we say that a market is competitive, we mean that you’re selling the latest iPhone and you’re fighting for profit margins with everyone else who’s selling exactly the same product for exactly the same price. In this case, you simply can’t change the price without seeing changes in demand right away. If you underprice your iPhones by too much (e.g. sell for 50% lower than everyone else in the market), you’ll see a huge increase in demand but lose in margins. If you overprice compared to everyone else, people will react by going for your competitors.
The second scenario is what we mean by an ‘extremely competitive’ situation, and to be brutally honest – most companies don’t fall into that category, which means they typically have a lot of room for price optimization.
And even if you sold iPhones or other extremely competitive products, making small price changes (think 1% change rather than 10% change) will actually help you find the optimal price point for those, too. Additionally, an iPhone seller is most likely also selling some other products (like phone accessories) with more wiggle room — and therefore has some untapped opportunity in other categories.
Myth #5: It’s not worth the time to optimize all prices based on price elasticity
Having hundreds or thousands of products in your catalog might seem like a lot to manage and reprice.
And we agree: in many cases, it usually doesn’t make any sense to reprice tons of products and analyze data manually.
In fact, it’s typically so time-consuming to make any sense of that much data that it’s practically impossible.
Enter an AI-based pricing tool that can help you automate your price optimization and price changes fully and help you find the optimal price point and maximize profit margins for as many products as you need (we’re talking about hundreds of thousands and up) without any manual work whatsoever
Learn the benfits of pricing with price elasticity
Conclusion: Pricing based on price elasticity is the best choice for (almost) all e-commerce businesses
Hopefully, by now you have a good understanding of why it’s important to understand the price elasticity (or in-elasticity) of all your products, and how this should inform your pricing strategy.
To sum it up:
- Price elasticity refers to the changes in demand when the price changes. This is also the reason why you don’t need any competitor data to benefit from dynamic price optimization that builds on the price elasticity (or inelasticity) of your products.
- The best way to price your products according to price elasticity is a reinforcement learning based pricing tool that helps you automatically find the optimal price point for each product.
Psst! If you’re still not sure if dynamic pricing is the right choice for your business, make sure to check out some of the most common use cases of dynamic price optimization in this article.
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