Price Elasticity

Price elasticity tells you how much a price increase or decrease will impact on the demand of a product.

Overview

The elasticity levels are: Perfectly inelastic (no change in volume) relatively inelastic (change in volume is less than in price), unit elastic (the change in percentage is the same in volume and price), relatively elastic (the percentage change in volume is greater than that in price – so raising the price already affects to sales negatively), perfectly elastic (any change in price will drop the volumes to zero immediately).

Price elasticity is how we measure the relationship between the changes in quantity demand and the change in prices of a particular product or service. Most often the term “price elasticity of demand” (PED) is used by economists when they talk about how price is going to react to supply and demand of a product.

Formula

Here’s the formula that is used to calculate PED:

Price Elasticity of Demand = Percentage Change in Demand of Quantity/ Percentage Change in the Price of the Product

If there is a small change in the price of a product but a considerable change in the demand, the product is called elastic which technically means it is responsive to the price change. Whereas if a product’s demand is not affected by a considerable change in its price, the product is said to be inelastic.

Example

For instance there is a manufacturer Acme Computers, who builds personal computers. To ensure their new series of computers are bought by customers, they reduce the price to half as an introductory offer. Now if this price cut creates an upsurge in demand of the computers, we can say that the computers are elastic. If there is no change in the demand, the computers were to be called inelastic.

Why is Price Elasticity so important?

Information on 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. By knowing the price, you can forecast your sales and even set up prices for the future.

When a business has good information of PED, it can help them decide whether they should be raising or lowering prices. In some cases a business can also think about price discrimination.

What is price discrimination? It is a policy adopted by businesses to create different prices for the same product.

Consider this, if the demand of the product is elastic, a business can earn a profit by reducing the price. But if the demand if inelastic, then a company would be better off by increasing their prices of the products. Also when the PED is very elastic, businesses tend to rely on advertising and other techniques to make sure the elasticity can be toned down.

With knowledge of PED, businesses can find out how consumers respond to price changes. Let’s look into some examples:

Uniqueness and competition

If a product is unique and is incredibly desirable, consumers will buy the product irrespective of the price tag. Mercedes, iPhone or PlayStation are the best examples where the demand is inelastic since these products are priced at premium but people still buy them.

But consider a packet of sugar. If a company increases its price of sugar, consumers will simply switch towards an alternative that offers the same amount at a lesser price.

This is because if the product is unique like a new Mercedes AMG, then its demand will be inelastic and consumers will pay for it whatever the price.

Habitually consumed products

For businesses that are selling products that are consumed due to habits like cigarettes or tobacco, price change is not really a big concern for consumers. Habitual products are a necessary expense and whether the price drops or increases, consumers will purchase them.

If for instance, the government decides to increase tax on alcohol, then consumers will be little angry about it but will not stop consuming it. The demand will be inelastic because there is no better alternative to alcohol.

Customer Loyalty

Some businesses also enjoy demand inelasticity because their consumers love their products and services. For consumers, changes in prices are of no concern since they like the products and will buy them.

Necessity over affordability

Some products are necessary and cannot be switched. Like bread or gasoline. For items like these, price again is of no concern since the demand will be inelastic and consumers will want to buy these products. Often in fuel crisis or shortages of bread, there are long queues of people waiting to get them because they are integral part of our lives.

Product life Cycle and Price Elasticity

Every product has its own life cycle and price elasticity is directly related to it. When you launch your product and there are few competitors, the demand will inelastic. This is where businesses tend to promote their products and price their products to ensure they can sell as much as they can.

When other competitors start to jump in, the demand starts to become elastic since slowly, consumers start to find out about new alternatives.

Once the product comes near to its maturity stage, the consumers start reacting to price. Businesses then tend to rely on promotional offers and discounts.

Price elasticity is an important concept for those that are involved in making pricing decisions. Knowing when the demand is elastic or inelastic can help you decide what price you should really charge. And this is just not for big companies as small businesses can also learn quite a lot from price elasticity. If a small café finds out that another has opened nearby, they can reduce prices, offer new delicacies and even offer new flavors in coffee to ensure the demand remains inelastic.

Are you keen to learn more about pricing? Head to our Pricing Academy, from there you can find our latest articles about pricing and other free resources related to pricing, be sure to check them out!

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