In economics, elasticity is the responsiveness of one variable to changes in another. In marketing, elasticity is a measure of how sensitive demand for a product is to changes in its price. If a product’s demand increases significantly when its price decreases and then falls again when its price rises, it has high elasticity.
In other words, if your customers respond dramatically to changes in your prices, that’s good news—because you can increase revenue by lowering your prices or raising them. In general terms, price elasticity of demand measures how much the quantity purchased of a product will change based on a change in its price. Each market has different levels of price elasticity because of differences in the type of goods being sold and the income level of consumers.
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| Price Elasticity |
What Does Price Elasticity Mean?
Price elasticity of demand refers to the change in the volume of a product that results from a change in its price. This can be calculated a number of ways, but the result will always show the percentage increase or decrease in the quantity of the product that was sold given a percentage increase or decrease in its price.
The first part of this equation is the change in price, which is negative when you’re talking about a decrease in price. The second part is the change in quantity, which will always be a positive number. The result is the elasticity of demand, which is the percentage change in quantity divided by the percentage change in price.
If the result is greater than one, the demand is elastic. This means that demand is particularly sensitive to changes in price. If it’s less than one, the demand is inelastic and changes in price have little effect on the quantity purchased.
How to Calculate Price Elasticity
The formula for calculating price elasticity is:
Percentage change in quantity demanded / percentage change in price
For example, if you’re selling apples and your price drops by 50%, you expect a 20% increase in sales. When you plug these values into the formula, you get: 0.2 / -0.5 = 0.4
Here’s the thing though: calculating the price elasticity of demand for a product isn’t as straightforward as it looks. That’s because there are a few different methods for calculating elasticity. The most common method, which is used in the example above, is the one-sided method, which calculates the percentage change in quantity demanded divided by the percentage change in price. There’s also the two-sided method, which calculates the percentage change in quantity demanded divided by the percentage change in both price and quantity demanded.
Why You Should Care About Your Product’s Elasticity
The price elasticity of demand for a product is, in one sense, the most important thing you can know about your business. It’s the basic data point that tells you whether you should raise or lower your prices, and by how much. What’s more, the price elasticity of your product can vary a great deal over time.
Why does the elasticity change and what can you do about it?
Because businesses often buy their raw materials on long-term contracts, their prices are generally fixed for long periods of time. When that happens, you’ll have to raise your prices to adjust for normal inflation. That’s bad news because in most industries, your customers know that prices go up. If they’re already stretched financially, they may decide to buy less of your product or switch to a competitor’s brand. On the other hand, if you’re able to decrease your prices because your suppliers give you a better price due to market conditions, you can increase your sales. Or you might be able to give your customers a break by lowering your prices with no negative consequences in terms of quantity.
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| What Is Price Elasticity |
When You Shouldn’t Care About Elasticity
As important as price elasticity is, not every company has a product with a price elasticity of demand that’s easy to predict. Many products are necessities, and people will buy them regardless of price. Gasoline and diapers, for example, are necessities that consumers buy even when prices rise dramatically.
And there are some products, such as luxury items, for which you can change your price as often as you like without affecting sales. There’s another way to look at elasticity, however. You can also ask yourself how much you have to increase sales to make up for a drop in price. In other words, if your price elasticity is high, that’s good news. It means you can reduce your price and increase sales by a significant amount before they drop off again.
Bottom Line
Price elasticity of demand isn’t something that most business owners think about on a daily basis. But the more you know about elasticity, the more likely you are to keep your prices high and increase your profits. That’s why it’s important to understand what drives price elasticityand how you can use it to your advantage.
For example, you might find that you can reduce your price by 10% without seeing a significant drop in sales. If so, you can use that information to drive down your costs.
If, on the other hand, you find that even a 5% drop in price will result in a significant loss in sales, you have to ask yourself if it’s worth it.