Price elasticity is one of the most fundamental, essential economic concepts any business owner or sales professional needs to understand. Having a pulse on the price elasticity of your offerings is central to forecasting effectively, structuring a sound pricing strategy, and building a responsive, successful company.
But what is price elasticity? How do you calculate it? What are the different types of price elasticity? And what do they mean for your business? Here, we'll answer all of those questions and more. Let's dive in.
What is price elasticity?
Before we break things down, let’s begin by level setting on price elasticity in general. Price elasticity measures how sensitive the demand and supply of your product are to changes in price. For example, the price elasticity of demand measures many customers will continue to purchase your product or service if you increase the price.
Price elasticity can fall into one of three buckets:
- Price elastic — where price changes greatly affect the supply or demand of a product or service.
- Price inelastic — where supply and demand will work inversely (a.k.a. in the opposite direction) to price changes.
- Price unit elastic — where a price change is proportional to the change in supply and demand and they move at the same rate.
Now that we have a feel for what price elasticity is, let's take a look at how to calculate it.
How to Calculate Price Elasticity
To calculate price elasticity, divide the change in demand (or supply) for a product, service, resource, or commodity by its change in price. That figure will tell you which bucket your product falls into.
- A value of one means that your product is unit elastic and changes in your price reflect an equal change in supply or demand.
- A value of >1 means that your product is elastic and changes in your price will cause a greater than proportional change in supply or demand.
- A value of <1 means that your product is inelastic and changes in your price will result in a smaller change in the supply or demand for your product.
To illustrate these economics, here’s a chart that shows all three buckets:
How can you apply price elasticity?
Price elasticity gives you some useful information on how to best price your products and services.
If you have an elastic product, then you should be cautious about raising prices since a price increase will greatly impact purchases (demand) and production (supply). But if your offering is price inelastic, then you can adjust your prices with less caution since you know that the change will have a smaller impact on supply and demand.
Now that we’ve covered how price elasticity impacts your business, let’s break things down even further.
Price Elasticity of Demand
The formula below (also known as PED) is used to identify how a change in price affects the supply or demand of an offering or commodity. If people still buy a product, service, or resource when the price is raised, that offering is inelastic. An offering 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 — 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 (including alternatives like vaporizers and nicotine patches), but none have affected their core consumer’s desire and ability to continue buying cigarettes.
Price Elasticity of Demand Formula
% Change in Quantity / % Change in Price = Price Elasticity of Demand
If you sell 10,000 reams of paper at $100 per 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 or 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. Very few — if any — products or services like that exist, making perfectly inelastic demand a mostly hypothetical concept.
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.
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 have relatively elastic demand — in most cases.
This often includes goods or resources with no close substitutes like electricity — a near-essential resource without any viable alternative. Losing access to it would have massive implications on your daily life, and you'd have nowhere else to turn when that happened.
For the most part, people would be willing to cover any price increases to keep their power on. That said, electricity isn't as critical as a life-saving drug, so some people would be willing to go without it if the price were too steep — making demand for it relatively inelastic.
3. Unit Elastic Demand
If the change in demand for a product or service yields a proportional change in price — meaning a price raise of X% leads to an X% decrease in demand — the offering in question has unit elastic demand.
This type of price elasticity of demand is purely hypothetical. There are no actual examples of unit elastic demand in practice. Demand is never completely linear. Though there is obviously a direct relationship between price and demand, that relationship is never squarely one-to-one.
If a brand were to slightly raise its prices, it would still likely have consumers who prefer it to its alternatives enough to continue to buy its products or services — so a 10% raise in price wouldn't mean exactly 10% of existing customers automatically turn to that company's competitors.
In a similar vein, an extremely radical price hike for a nonessential product or service might turn off a disproportionately high number of customers, relative to the percentage change in prices. If a brand decided to raise prices 40% without warning — more than 40% of its existing customers might jump ship.
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. Relatively elastic demand is typically associated with items that have several substitutes.
For instance, let's say there's an electronics manufacturer that sells 40-inch smart TVs for $250. All of its competitors sell similar products for the same price — and those competitors' TVs have virtually indistinguishable resolution and features from the manufacturer in question.
If the manufacturer were to raise its price from $250 to $275, consumers would likely be less inclined to pay an additional $25 for a product that's so fundamentally similar to its slightly less expensive competition — and demand for the manufacturer's TV would drop fairly radically, making its demand relatively elastic.
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.
Like unit elastic demand, there are no actual examples of perfectly elastic demand in practice. Demand for a product or service is never linear enough to make any change in price prompt an absolute drop in demand.
There will always be some people who have preferences that are often unshaken by slight price changes. If the price of a bottle of Sprite was to increase by $1, there will still be consumers willing to pay more for it over alternatives like Sierra Mist or 7Up.
While some offerings have particularly price-sensitive customer bases, there aren't any that consumers will totally abandon as soon as that good costs even one cent more than it did before.
Price Elasticity of Supply
The price elasticity of supply (PES) measures how responsive the supply of a product or service is when there is a change in price.
If supply is inelastic, it might mean a company is too short-staffed to keep up with demand, needs a longer lead time to produce more of its product, or doesn't have the resources to expand its facilities.
If supply is elastic, a company might have a surplus of available staff to increase supply. Knowing PES allows businesses to determine whether a change in price will negatively or positively affect the demand for its product or service.
Price Elasticity of Supply Formula
Price Elasticity of Supply = % change of supply / % change in price
If supply is inelastic, an increase in price leads to a change in supply that's 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 price elasticity of demand measures how responsive the demand for a product or service is when the price for another product or service changes. For example, if Hulu with Live TV raises its 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 its 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 or services competitively, plan for risks, and map their market. If your product or service has no real competitor, you don't need to consider cross price elasticity because there is no substitute for your offering. However, if a complementary product or service sees a market fluctuation, you might need to prepare for cross price elasticity.
Cross Price Elasticity Formula
Cross Price Elasticity of Demand = % change in quantity demanded for Product A / % change Product B’s price
Your product or service's price elasticity can inform your pricing strategy, help you feel out your competitive advantage, and ultimately dictate how your company plans for the future. Given the massive implications it can have on your business, having a grip on price elasticity — as a concept — is in your best interest.
Editor's note: This post was originally published in April 3, 2019 and has been updated for comprehensiveness.