What is price elasticity, and do you need to consider it when pricing your products or services? Today, we’ll strive to answer those questions and provide in-depth, useful information for determining the optimal price points for your products.
The basic definition of price elasticity of demand is the measurement of the change in demand for a product in relation to a change in its price. Price elasticity of supply is the measurement of the responsiveness of the supply of a product after a change in its market price.
The price elasticity of demand is calculated by this mathematical calculation:
Price elasticity of demand = percentage change in quantity demanded / percentage change in price
The price elasticity of supply is calculated by this mathematical calculation:
Price elasticity of supply = percentage change in quantity supplied / percentage change in price
Together, these two (price elasticity of demand and price elasticity of supply) measure how much the supply or demand for a product changes based on a change in its price. This measurement is used to determine what products are produced at what prices. Today, we are mainly looking at the price elasticity of demand.
Price elasticity of demand is used as a basis for:
The price elasticity of demand can be categorized into types based on the calculation provided above.
To illustrate the concept of elasticity, let’s look at some examples of elastic goods. Elastic goods tend to be comfort goods, commodities, and luxuries. They are items that are not essential to life.
While soft drinks may taste great; they aren’t necessary items. If a soft drink manufacturer raised prices significantly, people would stop buying their brand and possibly look at other, cheaper brands. If that same manufacturer decreased its soft drink prices, customers would keep buying it, and the pricing would likely attract new customers.
No matter how much we love Lucky Charms cereal, it isn’t a necessity. There are a lot of cereals, so if Lucky Charms started to cost more than the competing cereals, demand would drop for it.
Buyers have thousands of options for all kinds of clothing. Demand is largely affected by price because there are so many alternative products and brands to choose from.
Some people have a specific make and model of a car in mind when they’re making a purchase, but there are many options available. Price increases will prompt buyers to look at other models, and decreases will attract more buyers to the less expensive models.
You may see your gym membership as a necessity, but it’s a luxury. You could find a membership at one of many gyms or even exercise at home. As a commodity, a gym membership is an elastic product.
Inelastic goods tend to be necessary goods and commodities. Supply and demand are less sensitive to changes in changes in price.
When someone requires medication to live, such as insulin, they will need to buy it no matter the cost. Changes in price won’t create much change in demand because the medication is a necessity.
Electric cars are on the rise, but a majority of cars still use gasoline for fuel. People buy gasoline regardless of price changes because we need it to get to work, appointments, and anywhere beyond walking distance.
Similar to gas, electricity is integral to our lives. Changes in prices won’t greatly impact demand. Most people won’t switch to alternative energies like solar, and if they decide to limit their electricity use, it won’t be significant enough to influence the overall demand.
You may wonder about cigarettes being a “necessity.” Because they’re addictive, quitting isn’t a viable option for everyone. Most people will keep paying for cigarettes despite price increases, maintaining a steady demand.
Some career choices require certifications or degrees that must be obtained through colleges or universities. Tuition increases have little to no effect on the demand for post-secondary education.
So, what factors affect the price elasticity of a product? There are three main factors: the availability of substitutes, the urgency of the need for the product, and the duration of the price change.
In cases where it’s easy for a person to substitute one product for another when one increases in price, the price of the other decreases.
For example, let’s look at two cola drinks, A and B. If the price of A goes up, many people will simply switch to B, and the demand for A will fall—and vice versa. Brand A and Brand B are considered suitable substitutes for customers wanting a cola drink.
Gandhi said, “Distinguish between real needs and artificial wants and control the latter.” We often weigh needs vs. wants when considering a purchase. Our needs and wants have varying levels of urgency. The more urgent your need is, the more you’re willing to pay. With more discretionary purchases, price increases will cause demand to fall.
As an example, you’re shopping for a new dishwasher. Your old dishwasher still works, but you’re shopping for an upgraded model. It happens that right at the time you’re looking for a dishwasher, prices of new dishwashers are high. Because your old dishwasher is still working (the purchase isn’t urgent), you’re likely to delay your purchase until either prices are lower or your old machine stops working.
Another factor in price elasticity is the duration of the price change. Short-term demand will increase on days with sales and deals, and then demand will drop after that brief time. Sellers need to understand the part that time plays in the elasticity of demand.
The best example of this is buying during the holiday season. Outside of sales, consumers expect seasonal price inflation, especially during holidays. But they still choose to shop during that time rather than shopping earlier, when prices were lower. Demand will fluctuate when there’s a price change for a short period of time vs. a price change of months and years.
It’s important to have a good understanding of price elasticity when setting the prices for your products or services. Now that we’ve set the tone, we can discuss finding your optimal price point using price elasticity.
Elasticity can be difficult to calculate. It changes along the demand curve based on the influence of internal and external factors. However, if the price elasticity is known, you can use it to determine your optimal product or service price.
First, we need to calculate marginal cost, the change in total production costs from making or producing one unit (product).
Marginal cost = change in cost / change in quantity
Then we plug the marginal cost into the following equation.
Optimal price = marginal cost * (price elasticity / price elasticity +1)
So, if know your company maintains a relatively constant marginal cost of $6.00 on a product, and the price elasticity for the product is -4.0, you can find your optimal price.
Optimal price = 6.00 * (-4.0 / -3.0)
The optimal price for the product is $8.00.
An easier method of finding the optimal price for your product is the Van Westendorp Price Sensitivity model. The valuable tool, developed by Dutch economist Peter Van Westendorp, is used to determine optimal prices based on price sensitivity. The model indirectly measures the target market’s willingness to pay, providing you with a range of prices. It is one of the most effective and popular pricing strategies in the market research industry.
The Van Westendorp model uses a survey to obtain data from a target market. The last four questions on the survey are variations of these four:
These questions are specifically designed to provide a more comprehensive understanding of the price range customers are willing to pay for your product. Check out our Price Testing Template, which can be customized with the right questions to fit your pricing survey needs. Or visit Momentive, maker of SurveyMonkey, to see its Price Optimization Solution.
Price elasticity measures how much the supply or demand for a product changes based on a change in its price. Elasticity is influenced by the availability of substitutes, urgency, and length of price change. If you can calculate the elasticity, you can use this data to determine the optimal price for your product. An easier method is using the Momentive Price Optimization Solution, which employs the Van Westendorp model for willingness to pay.