Understanding Price Elasticity of Demand

Understanding price elasticity of demand (PED) is crucial for a business when pricing a new product or re-pricing an existing product because it informs how its customers will react to certain price points. When increasing the price of a good with elastic demand, you will see a proportionally larger drop in demand. In contrast, an inelastic good will see a proportionally lower drop in demand. PED also enables a business to effectively forecast sales as it displays how sales volumes are impacted by changes in price. Conjointly uses PED in preference simulations for conjoint and in Gabor-Granger studies.

Definition and formula

Price elasticity of demand (PED) is a measurement of how quantity demanded is affected by changes in price, i.e. it shows how demand for a product increases or decreases as its price increases or decreases. PED is calculated by comparing two values:

and

The full formula is:

This is called the midpoint method to calculate elasticity because it uses the average percent-change in both quantity and price. It is more useful than calculating elasticity with simple percentage changes as elasticity will hold the same between two price points regardless of if price increases or decreases.

Values of elasticity

The PED of a product is determined by the responsiveness of quantity demanded in relation to changes in price, and can be described as:

• Elastic (when elasticity of demand is less than -1; for example, -2 or even just -1.1): In this case, an increase in price by 1% leads to more than 1% drop in volume. It often means you should “price low”.

• Unit-elastic (when elasticity of demand is very close to -1): In this case, an increase in price by 1% leads to exactly 1% drop in volume. In this case, it is necessary to consider your margins before making a pricing decision.

• Inelastic: (if elasticity coefficient is between -1 and 0): In this case, an increase in price by 1% leads to less than 1% drop in volume. It usually means you should “price high”.

• Positive: (if elasticity coefficient is greater than 0): It is a common misconception that price and quantity demanded are almost always inversely related as customers prefer lower prices. This is not always the case as price-quality inference can strongly influence certain audiences’ purchasing decisions. In the case of positive elasticity, an increase in price leads to an increase in volume. A real-world example of this could be luxury goods, where a high price can signal both quality and scarcity, driving up demand.

Elasticity calculator

Interpreting PED

When interpreting a price elasticity chart, the price elasticity of demand curve shows customers’ willingness to pay for your product at different price points. The steeper the demand curve, the more price-sensitive customers are in relation to your product.

For example, the below chart shows that the optimal price for the product is $25 and the demand curve suggests that customers are price sensitive.

Factors impacting PED

There are several common factors which often influence whether a product is likely to have elastic or inelastic PED, such as:

• Uniqueness: Products with few or no alternatives have a greater likelihood of being inelastic. For example, new products are more likely to be inelastic and can be priced higher. Once competitors enter the market and demand becomes more elastic, prices will need to be lowered.

• Essentialness: Products which consumers deem as necessary are more likely to be inelastic as they are willing to pay more to obtain them. For example, bread and milk are considered essential by many consumers but products such as soft drink and chocolate are considered more ‘optional’ and with elastic demand.

• Loyalty: Products which are driven by brand loyalty are more likely to have inelastic demand as loyal consumers are usually not as price sensitive.

PED for price change vs. promotion

There are several ways to look at price elasticity of demand:

• Elasticity for a price change: This type of elasticity is the most straightforward: it explains consumer behaviour when a brand or retailer wants to increase or decrease price. Because price changes are not frequent, it is often hard to find direct evidence to measure this view of elasticity based on retail sales.

• Promotion elasticity shows how consumers react to promotions. This view of elasticity can be easily observed from supermarket scan data. In weeks with promotions, volume sold for discounted SKUs tends to go up:

NB: Promotion elasticity should not be confused with “volume uplift” for promo. For example, consider a case when with the full price P1 = $5.00, the promo mechanic is “33% off”. In a typical undiscounted week, 20,000 units of this SKU is sold. When on promo, volume tends to go up to 27,000 (+35% increase). Thus, by sacrificing 33% of the price, retailer gets 35% extra in volume. This may sound like a good deal for the retailer, but consider elasticity:

Elasticity suggests that their sales will be lower in weeks with promo (~$90K) than in undiscounted weeks (~$100K). For this reason, it is not uncommon to see elasticity coefficients in the range of -4 to -2.

Other views of PED

• Price elasticity on specific ranges of price vs. the whole range may differ substantially. For example, it is not uncommon to see a flattening of the elasticity curve after a certain high point because only a smaller group of brand loyalists or high-income earners (especially in countries with uneven income distributions) are willing to buy the product after a certain point.

• Long-term vs. short-term elasticity can be quite different. In the short term, strong brands often can get away with a price increase due to loyalty and habit. In the long run, a price increase may open up space for competitors to move in as the newly vacated lower price point. Thus, in the case of price increases, short-term inelastic demand can become elastic in the long-term.

• SKU vs. range vs. brand elasticity can also vary. Generally, for a brand that offers multiple SKUs, each specific SKU may serve as a substitute for another one. Thus, an increase in price for one SKU/range will see consumers switch to another SKU/range of the same brand. Hence elasticity coefficient will be steeply negative. When it comes to price increases for the whole brand, demand will tend to be less elastic.

• Cross-price elasticity of demand (XED) shows the responsiveness of demand for one SKU as a result of a change in price for another SKU. If two goods are substitutes for each other, then they typically have a positive cross-price elasticity. However, if two goods are typically purchased together, they will have a negative XED, as an increase in price for one of the goods may reduce the demand for both.

Find your product’s PED today:

• Generic Conjoint - Feature and claim selection and measuring willingness to pay for features for a single product.

• Brand-Specific Conjoint - Feature and claim selection and pricing in markets where product characteristics vary across brands, SKUs, or price tiers.

• Gabor-Granger - Determine price elasticity for a single product and identify revenue-maximising price level.