What is price elasticity, and how does it work?

When you change the price of your product or service, can you tell how that’ll impact its demand? 

You can’t know for sure what outcome it would have. It’s much easier to predict if you understand price elasticity.

It can help you estimate demand movement before you change the price, which helps you prepare. For example, you can preempt the supply you need.

This guide answers “what is price elasticity?”, including:

• Definition
• Inelastic or elastic
• Substitutes
• Urgency
• Sales

Price elasticity of demand is an economic principle to measure the change in consumption in relation to price.

You can witness the reaction to one price change, then calculate the likely outcome of the next. The equation of this is:

Percentage change of quantity demanded / percentage change of price = price elasticity of demand

Essentially you divide the change in demand by the difference in price, which calculates your price elasticity.

The number you get will tell you the elasticity of your product:

• Inelastic — demand change is less than its price change. Its ratio is below 1 (e.g. 0.75).
• Unitary — demand change is equal to the price change. Its ratio is 1 exactly.
• Elastic — demand change is more than its price change. Its ratio is above 1 (e.g. 2.5).

Inelastic products are either necessities, addictive or luxury. 

For example, petrol is a necessity for many people’s transport. If the price increased they’d still buy it, so it’s unlikely to impact demand.

If you have an inelastic product, though, that doesn’t mean you’re able to charge as high a price as you’d like. Customers will still have a breaking point where they decide the cost is far beyond its necessity.

Again with the petrol example, if the cost rose too high, you might see people switching over to electric vehicles.

Elastic products have many acceptable substitutes that customers decide to purchase instead. If there’s high competition in a market, it’s easier to find an alternative.

For example, there are many cereal brands. If you raised the price of yours, people would buy a slightly cheaper alternative.

The critical point, though, is it also works in the opposite direction. A slight price reduction could mean a high increase in demand as you take customers away from competitors.

When you consider substitutes for your product, it’s not just similar things to acknowledge. If someone could purchase anything else instead of what you sell, that counts as a substitute in price elasticity.

For example, if customers found Netflix too expensive, even a book could substitute for it. Those consumers would move their attention (and their spending) from one form of entertainment to another.

Some brands hold enough value to be less elastic than competitors with similar products. For example, Heinz Beans has a strong identity of ‘it has to be Heinz’, which makes customers loyal and more likely to tolerate a price increase.

A version of beans without brand value wouldn’t benefit and see demand fall more sharply. Supermarket own-brands would lose demand to competitors quickly after a price increase, because there are a lot of other beans available.

For addictive goods, there are no substitutes for many consumers. For example, people continue to buy cigarettes despite price increases because they’re addicted to them.

When asking “what is price elasticity?” another part to consider is the reason behind it. Urgency is a factor that can change the level of price elasticity that a product has.

If customers are in desperate need of a product quickly, they are less likely to remove their demand. 

For example, if your cooker was old but still worked, you’d be able to wait for a sale to buy a new one. Although, if it broke suddenly, urgency would mean you buy one at the current cost. 

The sense of urgency takes away customers’ ability to shop around.

A broader example of this effect on demand is when heavy snow is predicted, fearing shortages, customers flock to supermarkets to buy essentials. 

If the prices increased beforehand, it wouldn’t impact demand because of the immediacy of the situation.

When you consider price elasticity, keep in mind the longevity of the price change. There are certain times of the year when many prices change, so customer demand might respond differently to price movement.

Black Friday sales mean many stores reduce the prices of products for one day. That causes a spike in demand for certain products, which wouldn’t align with the typical increase from a price reduction the rest of the year.

So in that example, if you worked out the price elasticity of demand of the sale, it would give you a misleading figure. If you tried to apply that to a regular day, you’d estimate a more excellent elasticity than there is.

Short-term events and holidays should not come into the calculations, and it’s better to focus on long-term habit changes in your customers. That can help you plan your prices throughout the year, not just when they expect them to change.

Read our guide on how to work out price elasticity of demand.

Now you understand what price elasticity is, think about how you can apply it to what you sell. If you have high elasticity, you know that you can increase demand rapidly with a slight price decrease.

Alternatively, if you have an inelastic product or service, you can raise your price without losing too many sales. That would mean it’s likely that your profits can increase further and you can make the most of the lack of substitutes.

The power to accurately predict demand from price changes is a great asset to your business. But other estimations could benefit you as well.

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For more tips on pricing, see:

• What is a premium pricing strategy?
• What is penetration pricing strategy?
• What is a competitive pricing strategy?