I know what you woke up thinking this morning: “I sure could use a quick refresher on price elasticity.” If you’re shaking your head saying, “Yes, Meg. Yes!” then I’m so happy to have met your needs with this miraculous piece.

Understanding the price elasticity of your product or service and how it impacts your sales and business strategy is crucial to building a responsive, successful company. It goes a step or two beyond identifying the going rate for your offer and is a more strategic approach to pricing.

Brush up on the basic economics of price elasticity below and, don’t worry, you can thank me later.

Learn about price elasticity of demand.

Learn about price elasticity of supply.

Learn about cross price elasticity.

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Price Elasticity of Demand

This formula (also known as PED) is used to identify how a change in price affects the supply or demand of a commodity. If people still buy a product/service when the price is raised, that product/service is inelastic. A product/service is elastic when demand suffers due to price fluctuations.

For example, research shows that raising cigarette prices doesn’t do much to stop smokers from buying cigarettes, therefore making cigarettes an inelastic commodity. Cable television, however, is a very elastic product. As the price of cable has increased, demand has decreased as more consumers “cut the cord.”

Substitutions like Netflix, Hulu, and other streaming services have made the cable industry elastic. There are also substitutions for Tobacco (i.e., vaporizers, nicotine patches, etc.), but none that have affected their core consumer’s desire and ability to continue buying cigarettes.

If you sell 10,000 reams of paper at $100/ream and then raise the price to $150 per ream and sell 7,000 reams, your elasticity of demand would be -0.88. This would be considered inelastic because it is less than one.

Broken down even further to include the calculation of percent change, this formula looks like:

((QN - QI) / (QN + QI) / 2) / ((PN - PI) / (PN + PI) / 2)

  • QN = New quantity (7,000)
  • QI = Initial quantity (10,000)
  • PN = New price ($150)
  • PI = Initial price ($100)

Our numbers plugged into this formula would be:

(7,000 - 10,000) / (7,000 +10,000) /2) / (150 - 100) / (150 - 100) / 2) 

Head spinning? Check out this free calculator.

This formula is helpful in determining if a product/service is price sensitive. Ideally, you want your offering to be a must-have (inelastic) that consumers consider non-negotiable during price fluctuation, not a nice-to-have (elastic).

Types of price elasticity of demand

1. Perfectly Inelastic Demand - If your PED equals 0, price changes do not affect your product’s demand. Generally speaking, only absolutely essential items and services have perfectly inelastic demand. For instance, if there were a life-saving drug on the market that people would pay any price to obtain, demand would remain the same no matter how much the price might rise. 

perfectly inelastic demandImage Source

2. Relatively Inelastic Demand - If the percent change for demand is less than the percent change of the product’s price. Necessary goods and services that people would be willing to pay more for in most cases have relatively elastic demand.

This often includes goods with no close substitutes like electricity. There's no real alternative to electricity, so people would generally be willing to pay more for it as the price increases. It's not quite as pressing or essential as a life-saving drug, so demand wouldn't be perfectly inelastic. 

3. Unit Elastic Demand - If the change in demand yields a proportional change in price. Imagine you're selling headphones. If demand for your headphones is unit elastic and you raise the price 10%, you will see a 10% decrease in demand.

4. Relatively Elastic Demand - If demand change is greater than the change in your product’s price. Here, a relatively small change in price will make for a very large change in demand. For instance, in the case of airline travel, a small change in flight prices will often make a large base of consumers hold off on taking a vacation or look into other modes of travel.

5. Perfectly Elastic Demand - If demand falls to zero at the slightest price increase or demand becomes great with a slight price decrease. Perfectly elastic demand demonstrates that the demand for a product is 100% directly tied to its price.

Say there are two apple farmers competing in the same local market. One of the farmers sells their apples for $2.00 per apple, but the other one starts selling their apples for $1.50. If the entire market starts buying the $1.50 apples exclusively, that would mean demand is absolutely tied to price. And that demand for apples would be perfectly elastic.

Perfectly elastic demand

Image Source

Price Elasticity of Supply

The price elasticity of supply (PES) measures how responsive the supply of a product/service is when there is a change in price.

If supply is inelastic, it might mean a company is struggling to keep up with demand because they are short-staffed, need longer lead time to produce more of their product, or do not have the resources to expand their facilities.

If supply is elastic, a company might have a surplus of staff or laborers available to increase supply. Knowing PES allows businesses to determine whether a change in price with negatively or positively affect the demand for their product/service.

If supply is inelastic, an increase in price leads to a change in supply that is less than the increase in price, meaning the PES is less than one. If supply is elastic, the price change yields a larger increase in supply making the PES greater than one.

For example, if the price of “World’s Greatest Boss” mugs falls 10% and the supply falls 5%, the PES is .5 and considered inelastic. If the price of bobbleheads increases by 15% and supply increases by 20%, the price elasticity of supply (PES) is 1.3 and elastic.

Cross Price Elasticity

Cross elasticity of demand measures how responsive the demand of a product/service is when the price for another product/service changes. For example, if Hulu with Live TV raises their prices to $45 per month, will customers leave the service for YouTube TV — a similar streaming service charging only $40 per month?

As the price of Hulu Live rises the demand for their competitor’s service rises. Within cross price elasticity, YouTube would be considered a “substitute good.”

If, however, the cost of televisions increased and the number of customers using subscription services like Hulu or YouTube decreased because of the price increase of televisions, this would be called “complementary goods.”

Cross price elasticity allows businesses to price their products/services competitively, plan for risks, and map their market. If your product/service has no real competitor, you do not need to consider cross price elasticity because there is no substitute for your offering. However, if a complementary product/service sees a market fluctuation, you might need to prepare for cross price elasticity.

Want to dig into pricing strategy a bit more? Check out this article on cost-plus pricing or this one on prestige pricing for your premium offers.

Editor's note: This post was originally published in April 3, 2019 and has been updated for comprehensiveness.

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Originally published Apr 20, 2020 3:30:00 PM, updated May 13 2020

Topics:

Pricing Strategy