Pricing Strategy: Price Elasticity of Demand Theory
Price Elasticity of Demand (Theory)
The price elasticity of demand is the way to measure the responsiveness of your customers demand for your product in reaction to a change in price. By understanding and measuring this metric, you’ll have a better idea of what to expect to happen to your revenue after making a price change.
The own-price elasticity of demand for a product is calculated as the percent change in quantity of a product demanded in response to a percent change in that own product’s price¹.
For example, if you’ve sold 100 units at $50 per unit and after changing the price to $55, you sell 95 units, then your own-price elasticity of demand is -0.5. This result is a unit-less (because it is measured in percentage changes), negative number (because changes in price move in the opposite direction as changes in quantity)² between 0 and negative infinity.
The most important aspect of the price elasticity of demand is how it relates to -1. If the price elasticity of demand is between 0 and -1, then the percent change in quantity is smaller than the percent change in price. You would make more revenue by raising price since the number of lost sales is made up by the higher price for the units sold. Because of this, when price elasticity of demand is between 0 and -1, it is called inelastic, because customers are not sensitive to your changes in price.
On the other hand, if price elasticity of demand is less than -1, then the opposite is true. You would make more revenue by dropping price since the number of new sales will make up for the lower price point. In this case, the price elasticity of demand is called elastic, because customers are sensitive to changes in price.
Measurement and use
There are a few ways to measure the price elasticity of demand using survey techniques, such as choice-based conjoint analysis or the price sensitivity meter. However, surveys need to be taken with a grain of salt due to a number of factors, such as the incentive structure and potential biases. The most accurate view of price elasticity of demand for your product is by making price changes to see how customers respond.
It is important to keep in mind that the price elasticity of demand is not typically a constant value for all consumers, at all times. You should estimate the price elasticity of demand for each customer segment and when demand shifts due to seasonal effects, for example.
Even if you don’t conduct surveys or change prices to compute the price elasticity of demand, there are many factors that influence it that you should always have in mind. In particular, products that have many close substitutes are highly elastic because it is easy for customers to switch to a cheaper option. Also, products that are considered luxury goods are highly elastic because if the price changes significantly, the customer can move on without it. These concepts reflect what should be a driving goal for your company – to create a unique product that is deeply ingrained into a customer’s life or workflow.
Tomorrow I’ll provide an example of how to use the price elasticity of demand for my hypothetical company, Doug’s Desserts.
Recipe of the day: Cook’s Illustrated Quick Cinnamon Buns with Buttermilk Icing (free trial / subscription required; I do not receive any compensation for this link)
¹ There is a related concept of cross-price elasticity of demand, which measures the demand for one product in response to a price change of another product.
² In other words, increases in price cause decreases in demand, which is true the vast majority of the time. Because of this, you’ll often see the price elasticity of demand written as a positive number instead of a negative number. I personally don’t like that practice because I like having the negative sign remind me that prices and quantity move opposite of each other.