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19.04.2024
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Price Elasticity of Demand: Formula and Definition
How can you set a price for a product that attracts buyers while ensuring expected profit levels? Establishing an optimal selling price is challenging, as it requires category managers to have a clear understanding of market demand and supply dynamics. It’s a constant balancing act: set the price too high, and sales volumes will decline; set it too low, and you’ll lose profit.
How can you maintain balance and achieve set KPIs? To begin with, analyze price elasticity and its impact on consumer demand.
In this article, we discuss what price elasticity of demand is, which products are elastic (and which are not), and how e-commerce retailers can use this information to maximize profits.
Price elasticity of demand measures how changes in the price of a product affect changes in its demand.
Elasticity is one of the fundamental concepts in economics. Broadly speaking, elasticity indicates the extent to which a measured cause results in a given effect. This concept is universal and is used in various industries.
In e-commerce, price elasticity of demand helps retailers understand how the market reacts to price changes and determine optimal pricing strategies to maximize profit.
Price elasticity of demand offers insights into the following questions:
How will demand be affected by increases or decreases in the product’s price?
What level of discount would be optimal to stimulate demand?
At what price threshold will demand for the product cease?
How Can You Determine the Price Elasticity of Demand for a Product?
Elasticity is typically determined through experimental methods. For example, you can conduct a sale following this algorithm:
Select the product for experimentation and establish a discount or create a special offer.
Gather sales data for this product over a certain period before the promotion begins. This data will serve as a baseline for comparison.
Launch the promotion with a reduced price for the selected product.
Keep track of sales data and monitor changes in the number of units sold during the course of the promotion.
Compare sales during the promotion period with baseline sales to determine how the price change affected the number of units sold, allowing you to calculate the elasticity coefficient (see formulas below).
In addition to price elasticity, analyze the effectiveness of the promotion in terms of profitability and other relevant factors.
Formula for Calculating Price Elasticity of Demand
Price elasticity of demand (E) can be calculated using the formula:
Е = % change in quantity demanded / % change in price
Where:
Percentage change in quantity demanded is a measure of how much the quantity demanded has changed during the promotion period relative to its original value (considering data for equivalent time intervals).
Percentage change in price is a measure of how much the promotion price differs from the original price.
This formula provides a numerical value E indicating how the quantity demanded responds to changes in prices. If the elasticity value is greater than 1, it indicates elastic demand; if it is less than 1, it indicates inelastic demand. (A value of precisely 1 indicates unitary elasticity.)
Example of Calculating Price Elasticity of Demand
Let’s calculate the price elasticity of demand for refrigerators of a certain model.
The price before the promotion (P1) is $800.
The quantity demanded before the price change (Q1) is 100 units in 30 days.
The price after the change (P2) is $700.
The quantity demanded after the change (Q2) is 120 units in 30 days.
Let’s now determine the percentage change in demand using these formulas:
Percentage change in price = (New price − Previous price) / Previous price * 100%
Therefore, the percentage change in demand is 20%, indicating an increase in demand of 20% compared to the previous level.
Using this data, let’s calculate the price elasticity of demand for refrigerators of a certain model.
We have already determined that the price change is -12.5% and the change in demand is 20%.
Е = % change in quantity demanded / % change in price
Е = 20 % / -12.5%
Е = -1.6
Therefore, the price elasticity of demand for refrigerators is -1.6. This indicates that a 1% decrease in price will lead to an approximately 1.6% increase in demand.
Since the obtained value of price elasticity of demand (E) is less than zero (-1.6), it indicates that the product is price elastic.
In this case, reducing the price of the product will result in increased demand for it.
When a Product Is Price Elastic
Demand for a product is considered price elastic when even slight changes in the price result in significant changes in sales volumes. This indicates that consumers are highly responsive to price fluctuations and can significantly alter their consumption of the product in response to price decreases or increases.
Products with a price elasticity coefficient greater than 1 are typically considered price elastic.
For price elastic products, retailers often implement pricing strategies aimed at lowering prices to stimulate demand, which in turn leads to increased sales volumes.
For example, demand for Coca-Cola is highly elastic, meaning that even a small change in price can lead to a significant change in demand. This elasticity is driven by the competition between Coca-Cola and its main rival, Pepsi, in the beverage market. When Coca-Cola lowers its price, buyers may switch from Pepsi to Coca-Cola due to the relatively lower price, resulting in increased sales for Coca-Cola. Conversely, if Coca-Cola increases its price, consumers may switch back to Pepsi, leading to a decrease in demand and revenue for Coca-Cola as consumers seek alternatives.
A high price elasticity of demand is characteristic of luxury items, electronics and appliances, certain food items, fashionable clothing and footwear, as well as new cars.
When a Product Is Price Inelastic
When significant price changes result in insignificant changes in sales volumes, demand for a product is considered inelastic.
Such products typically have a price elasticity coefficient of less than 1.
The best pricing strategy for such products is to raise prices to maintain sales levels and maximize profit.
For example, demand for gasoline for trips of both short and long distances is inelastic. This means that significant price changes will not lead to significant changes in demand. Even if fuel prices rise, demand will remain relatively unchanged. People are generally unwilling to change their driving habits, relinquish their cars, or switch to public transportation. Other examples of inelastic products related to people’s lifestyles include cigarettes, alcohol, and coffee. Smokers continue to buy cigarettes, and coffee enthusiasts maintain their consumption despite price increases.
FMCG and essential items that lack substitutes are also considered inelastic, such as salt, sugar, grains, and bread. These are so-called Giffen goods: people buy them despite significant changes in cost. Other examples of products with low price elasticity include monopolized goods, items with limited availability, and pharmaceuticals. If a person’s life and health depend on a daily insulin injection, they will buy the medication, even if the price doubles.
Certain technology products also have inelastic demand. For example, despite the yearly increase in the cost of new iPhone models, people continue to queue up eagerly to acquire the latest model. This price paradox, known as the Veblen effect, illustrates how demand for prestigious goods actually rises alongside price increases.
Classification of products by demand elasticity
In addition to the strict classification of goods as elastic or inelastic, another approach considers a wider range of options.
Perfectly elastic goods experience a significant change in demand even with the slightest change in price. These are typically basic consumer items.
Relatively elastic goods see significant changes in demand with relatively minor price adjustments. Examples include mass-consumption items like milk or eggs, where small price changes prompt buyers to switch between brands or stores.
Linearly elastic goods exhibit a proportional change in demand with any change in price, resulting in a price elasticity equal to 1. Household items like soap and toothpaste fall into this category. With linearly elastic goods, price changes lead to proportional adjustments in demand while overall expenditures on the goods are roughly constant.
Relatively inelastic goods are less responsive to price changes; even significant adjustments in price are unlikely to cause a strong change in demand. This applies to items such as gasoline and medicines. While customers may show some price sensitivity, significant changes in demand in response to price increases are improbable.
Perfectly inelastic goods experience no change in demand with changes in price. While perfectly inelastic goods are rare in practice, examples include artworks and collectibles, where price plays no role in the purchase decision.
What Factors Influence Elasticity of Demand and Supply?
Demand elasticity can be influenced by various factors. Here are some of the most important:
Necessity of the product: Essential goods, spare parts, medical services, etc. typically exhibit lower demand elasticity because consumers cannot easily do without them, even when faced with price changes.
Number of substitute goods/number of sellers in the market: The more alternatives are available, the more demand depends on prices. This phenomenon is most noticeable in the electronics segment; popular smartphones are often priced uniformly across all platforms.
Share of expenditures on goods in the overall budget: If the cost of a product doubles but its share in the overall budget is insignificant, consumers may not notice the price change.
Time required to select a product: The longer it takes for a customer to make a decision, the greater the likelihood they will find alternatives or postpone the purchase.
Brand loyalty: Loyal customers are less likely to switch to alternatives, even when prices change, especially if a brand is associated with high quality or prestige.
Income level of the target audience: The income level and perceptions of buyers regarding product value influence their willingness to react to price changes. If customers are sensitive to price changes or have a limited budget, demand for a product will be more elastic.
How to Determine Price Elasticity of Demand for a Product
To quickly forecast a product’s demand elasticity, consider the following questions:
Is the product a necessity or a luxury item?
Essential goods typically exhibit less elasticity because consumers cannot easily reduce their purchase of them even when prices rise. For example, consumers are unlikely to forgo purchasing medicines or fuel, whereas they may postpone buying a designer handbag until it goes on sale.
How long will the price change last?
Temporary price changes may elicit a different response from consumers compared to permanent ones. For instance, a limited-time electronics sale, such as for smartphones or laptops, may prompt consumers to make more impulsive purchases, resulting in more elastic demand during the promotional period. Conversely, continuous price increases for utilities like electricity or water may affect demand elasticity differently. Consumers may gradually adjust their habits in response to higher prices, leading to less elastic demand over time.
How available are alternative products?
The availability of close substitutes affects demand elasticity. Products with numerous substitutes typically have more elastic demand because consumers can easily switch to alternatives if prices change. If a person is accustomed to buying Brand X milk and its price significantly increases, they are likely to switch to Brand Y or Brand W milk without much difficulty. If a product has many analogs, price increases are more likely to deter consumers.
What is the actual cost of the product for your consumer?
The actual cost of the product relative to consumers’ incomes can affect demand elasticity. Items like fast food often have elastic demand because small price changes can significantly impact purchase decisions. In response to a slight price increase, consumers are likely to choose a cheaper alternative or reduce their fast food consumption. In contrast, customers at Michelin-starred restaurants may be less sensitive to price changes due to the quality of the dishes and the emotional experiences associated with dining at such establishments.
Factors influencing demand elasticity almost always interact dynamically and require comprehensive analysis.
How Do Businesses Use Price Elasticity in 2024?
Understanding price elasticity of demand allows for making informed pricing decisions. Here’s how it can be applied in practice:
Differentiated pricing: Use knowledge of the price sensitivity of different audience segments to establish differentiated pricing.
A/B testing: Experiment with price changes to identify optimal pricing points. This approach allows you to study how customers respond to different price ranges and establish optimal price points.
Seasonal discounts and promotions: Understanding the price elasticity of products and categories helps you launch discounts and promotions when demand is more sensitive to price changes.
Dynamic pricing: Use modern automated solutions and analytics for dynamically adjusting prices in real time depending on demand, inventory levels, competition, and other factors.
Offering additional services or products: If a product has high price elasticity, you can offer additional services or products with higher margins to increase overall profitability.
The Importance of Price Elasticity in E-Commerce
Price elasticity of demand is an important parameter for pricing. However, to establish the optimal price for a product, elasticity should be considered in conjunction with competitive pricing analysis.
Here’s a simple example. If you significantly lower the price of a product compared to the market price, customers may doubt its authenticity and quality, leading to a decrease in demand (for instance, when a brand-new MacBook priced at $2000 is sold for $1750).
Here are a few more examples illustrating this concept:
Reducing Prices: Let’s say you’re selling electronics online. After analyzing your main competitor, you notice they’ve reduced prices on smartphones. Based on sales analysis, you understand that your competitor’s prices affect demand, but you also know that the demand is not highly elastic. In other words, reducing smartphone prices will increase sales, but not significantly enough to incur substantial profit losses. Therefore, you also decide to lower smartphone prices to attract more customers and remain competitive.
Reacting to Competitors’ Changes: If your competitors start setting higher prices for similar products, you can use competitor pricing analysis and information about price elasticity of demand to determine whether you can also raise prices.
Thus, competitor pricing analysis and price elasticity of demand help you comprehend market conditions and establish the optimal pricing strategy for your e-commerce business.
Conclusion
Price elasticity of demand plays a crucial role in optimizing profit and refining pricing strategies. By understanding how demand reacts to price changes, businesses can adapt their pricing strategies to strike a balance between maximizing profit and maintaining competitiveness.
FAQ
What is price elasticity in e-commerce?
Price elasticity in e-commerce measures how changes in the price of a product or service will affect demand. It helps businesses understand how price changes impact sales volumes and overall company profit.
What are the types of price elasticity?
There are three types of price elasticity of demand: elastic, inelastic, and unitary. Each indicates a different level of change in demand when the price changes.
How does price elasticity of demand impact a business’s pricing decisions?
Price elasticity of demand determines how much a business can change prices without a significant loss in sales or profit. Understanding this dynamic helps companies optimize their pricing strategy.
How can I calculate e-commerce price elasticity?
To calculate price elasticity in e-commerce, it’s necessary to analyze customers’ responses to changes in product price, comparing sales and price data before and after launching a promotion or discount.
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