Determining the right price can be one of the most challenging decisions in business because of its direct impact on your bottom line. One critical concept to understand when setting prices is price elasticity.
What is price elasticity?
Price elasticity of demand measures how sensitive customer demand is to changes in price. In other words, it helps answer questions like, “Do customers buy significantly more when prices drop? Do they buy significantly less when prices rise?”
Price Elasticity of Demand (PED) can be calculated using a simple formula:
Price Elasticity of Demand =
% Change in Quantity Demanded / % Change in Price
For example, if demand for a product increases by 15% in response to a 10% reduction in price, the PED would be 1.5 (15% / 10%).
Factors like the availability of substitutes and whether a product is a necessity or a luxury significantly impact elasticity. Substitutable goods (e.g., coffee brands) tend to have higher elasticity, while necessities, such as essential food items, tend to have low elasticity.
What happens when a product is price elastic?
A product is considered elastic if a small change in price results in a large change in quantity demanded. This sensitivity to price changes is often seen in markets with many substitute products. For instance, if the price of a particular coffee brand rises, customers may switch to an alternative without much hesitation, keeping demand highly flexible.
Elasticity example: Products with many readily available substitutes, such as various snacks or bottled water brands, are generally more elastic because customers can easily switch if prices change.
What happens when a product price is not elastic?
In contrast, inelastic products show minimal change in quantity demanded even when prices fluctuate. These products are often necessities or have strong brand loyalty. For example, even if the price of milk or eggs increases, most consumers will continue to buy them because they are essential.
Inelasticity example: Essential goods and strongly branded products (e.g., pharmaceuticals, basic household supplies) often display inelastic demand because consumers don’t change their buying behavior significantly, even as prices shift.
Price unit elasticity: when demand matches price changes
Unit elastic demand is when a change in price leads to a proportional change in quantity demanded. Here, a small price drop or increase results in an equal change in demand, common among household essentials where switching brands is easy.
Unit elasticity example: Products like batteries or light bulbs often exhibit unit elasticity, as consumers can easily switch brands based on price without a strong preference.
How companies use price elasticity in strategy
Price elasticity can reveal how customers will likely respond to different pricing strategies, which is essential for building sustainable value. Several factors influence elasticity, including product type, consumer income, economic conditions, and competitor pricing.
Price elasticity should be evaluated alongside other metrics, as it doesn’t tell you everything about your product’s potential. By understanding how demand changes with price, you can better anticipate customer behavior and refine your marketing strategy.
The connection between price elasticity of demand and supply
Price elasticity of demand and the price elasticity of supply are two sides of the same coin. While elasticity of demand measures how much demand shifts with price changes, elasticity of supply evaluates how easily suppliers can adjust production in response to price fluctuations.
When demand is high, suppliers often have greater flexibility to adjust production. In contrast, low demand elasticity usually correlates with low supply elasticity, as suppliers face limitations in adapting to sudden shifts. The relationship between these two elasticities varies depending on the industry and market conditions, so it’s essential to understand how they interact in your sector.
Using elasticity data to stay relevant
Understanding your product’s elasticity allows you to respond effectively to market conditions and price strategically. Consistently relevant and differentiated businesses can adjust prices up or down to reflect their value. Intelis AI equips you with data-driven insights, helping you set prices that drive profitability without sacrificing customer satisfaction.
If you’re ready to leverage advanced tools and insights, Intelis AI can support data-backed pricing decisions and position you ahead of the competition.
For further reading, explore more on price elasticity from HBR, or dive into these influential books on pricing strategies:
- Pricing with Confidence: 10 Ways to Stop Leaving Money on the Table, Reed K. Holden and Mark Burton, 2014.
- The Art of Pricing: How to Find the Hidden Profits to Grow Your Business, Rafi Mohammed, 2005.
- The Undercover Economist, Tim Harford, 2007.
