Price Elasticity of Demand Guide: Strategy & Examples

When retailers develop a pricing strategy, they take into account a multitude of factors, one of which is price elasticity of demand. This is an important metric that can help you find out whether customers’ buying ability will change after price corrections and to what extent it may be impacted.

In this guide, you will find out exactly how knowledge of price elasticity can be useful for your marketing strategy, plus learn the formula to calculate it and the factors that impact it. We will review examples of elastic and inelastic products for you to define the category of your items, as well as the ways of price elasticity management.

Price elasticity of demand shows the correlation between price changes and customers’ demand (the quantity they are ready to buy). Practice shows that higher prices make consumers buy less, and lower prices motivate them to buy more. The demanded quantity cannot stay unchanged after price corrections, especially considerable ones.

Market research shows 46% of people are ready to pay more for the brands they trust. That means there are both pricing and non-pricing factors that motivate consumers to spend more money on products, even with a large number of cheaper alternatives around. Price elasticity of demand is made up of all these factors. A correctly calculated price elasticity allows retailers to boost their profit while maintaining customer loyalty.

Let’s observe it by means of an example. Your brand sells ice cream for $6: at this price level, the demand keeps around 80 items per day. Once you lowered the price to $4, your sales volume increased to 100 items per day. To calculate the price elasticity of demand, use the following formula:

Price elasticity of demand = % change in quantity % change in price

First, you need to calculate the percentage of the changes. Let us observe equations with examples:

Where:

Q1 - The initial sales volume (quantity) - 80 items
Q2 - Sales volume after price change (quantity) - 100 items
P1 - The initial price - $6
P2 - The new price - $4

Now, we can calculate the price elasticity of demand:

22.2 / -40 = -0.55

We get a negative number between 0 and -1. That means you do not have enough price elasticity to decrease or increase prices. If the price changes by 1%, the demand will alter by only 0.55%, and a 10% change in price will shift the demand by 5.5%.

Note that in most cases, price elasticity is negative (it is below zero). However, for the purpose of convenience, only positive numbers are used to denote the elasticity. While elasticity keeps below 1 (or above -1), the product is considered to be inelastic.

A positive price elasticity (higher than 1) means that a product is elastic, i.e., a higher price will result in a growth in demand. This is a rare situation that usually happens in particular markets, such as luxury goods.

Depending on the market and choice of analog products, we can talk about elasticity or inelasticity of demand. For example, the Apple brand is so popular and trustworthy that consumers are ready to pay extra for their iPhones and MacBooks. If the price of an iPhone rises, the majority will still want to buy a smartphone. For less known brands like Lenovo, you would expect the demand to be elastic — customers will not buy their electronic devices if they are priced on par with Apple.

However, when it comes to the retail sphere with its huge variety of analog offers, price elasticity of demand is evident. For example, one store sells wooden chairs for $40, and the second store offers analog chairs for $50. If the entire market starts buying at $40, it would mean that the demand totally depends on the price, and the product’s quality or material are of no importance. This is a perfectly elastic product, i.e., the demand is defined by a price only.

Price elasticity of demand can be defined by a large multitude of factors. Although brand perception and attractiveness of promotional campaigns play an important role, there are many other aspects motivating customers to make a purchase or search for alternatives.

Here is what should be taken into account when forecasting and defining price elasticity of demand:

• If the price of a product is equal to or higher than the price offered by a market leader for the analog, the elasticity is high. In this case, relative price availability matters most, and it evolves around the market leader (customers are likely to compare the leader’s prices with other offers).
• To maintain optimal demand, retailers should assess customers’ brand awareness and analyze their competitive strengths. If your brand is not very popular, you will build your strategy on price adjustments, so you should always calculate the cost of items in regard to the market leader.
• Price elasticity also depends on the quality of the product, or to be more precise, its market value. When items have more or less the same properties and quality — for example, dishwashing sponges have barely any differences — brands cannot sharpen their competitive edge by emphasizing the advantages of their commodity. In this case, consumers will buy a cheaper or better-advertised product.
• Significant price increases can repel customers, so retailers practice a single-digit price increase and do not raise the price of a product by more than 9.9%. Otherwise, customers may get dissatisfied and will buy less.
• The highest price elasticity is observed in mass-market products where the selection is huge, and products have pretty much the same quality. On the other hand, minimum price elasticity is typical for luxury items and the economy.
• Price elasticity of demand can be different for various categories of buyers. Loyal customers will keep buying the product even after price changes, which contributes to higher price elasticity.

As mentioned above, different segments of products demonstrate different levels of elasticity. Let’s take a closer look at these categories.

In case of a minor price change, the demand for these products will shift significantly. These products are also called “pure commodities.”

Elasticity is typical for products that are discretionary and have many substitutes. For example, cereal is a type of food that is optional in anyone’s diet. If a cereal brand raises the price, buyers may stop purchasing the product entirely: they will find cheaper alternatives.

Thus, perfect elasticity is typical of markets where products have similar quality, so price becomes the major differentiation point.

In this case, relatively small changes in price cause serious changes in the product demand. This is a common situation for luxury goods like TVs and designer brands. They cost a lot, and a small shift in availability can make a significant difference. At the same time, it depends on the customer segment. Buyers with an average salary make their choice depending on the price, while some premium retailers (for instance, the most acknowledged fashion houses) serve only deep-pocketed clients, which means demand will barely change.

For such products, any change in price leads to an equal shift in demanded quantity. In this case, the price elasticity equals 1. A good example of unit elastic products is fruits. For instance, John sells mangoes for $3 per pound. If the price of mangoes rises by 10%, John’s sales will decrease by 10% because people will start buying bananas, apples and other sorts of fruits.

Unit elasticity is observed when the demand depends mostly on the price because there are many substitutes on the market (even if they are not identical), and those products are not of primary importance.

For such products, a significant change in price is not likely to affect the quantity of items sold. Basic foods are a good example: if the price of eggs changes by 5%, people will still continue buying them. The demand will barely change because there are practically no substitutes, and the quality of eggs of different brands is pretty much the same.

For this group of goods, any change in price does not impact demand. In reality, perfectly inelastic products are theoretical concepts because consumption level can change even for life-essential goods, such as water or gas. For example, when tap water is potable and cheap, it is consumed in large amounts, but when it is expensive, it will be used more judiciously. People need gas to drive cars and have access to transportation, so they are forced to purchase it at any price before alternatives appear in the long run.

By using the above-mentioned formula, you can calculate an exact price elasticity of demand. But what if you do not have sales volume statistics at your fingertips? There are several criteria that will help you define how elastic the product is.

Necessities like water or gas are usually inelastic because people cannot stop buying them, so they have to accept whatever price the seller sets. Luxury items, on the contrary, are very elastic because they are easy to go without. Those include entertainment, delicious foods, expensive brand clothing, etc. Thus, you should understand how indispensable your products are.

If your product has many analogs on the market and the competition is fierce, rising prices are most likely to repel customers. This is relevant for such categories of products as clothes, foods, homeware, and so on.

In the software and SaaS sphere, product differentiation is also important and easier to achieve. You can introduce essential functions plus some features that customers cannot find in competitors’ solutions - that will make your product irreplaceable. Besides that, users are less likely to switch to another solution when the procedure is too complicated, inconvenient or time-consuming (for example, in the website hosting sphere).

For cheaper items, price changes are hardly noticed by customers. No one minds paying 5-10% extra for a pencil, but when you want to buy a car, a 10% discount is a considerable difference that will influence your decision.

Price changes have an impact on demand in the long run — people learn to manage without certain items, or find alternatives within weeks or months. Hence, changing prices for a few days won’t make a difference in demand. If gas prices rise for a week or two, people will complain but will still continue filling their vehicles with fuel.

However, when gas becomes too expensive in the long run, they may decide to switch to smaller cars or electric hybrids. So, even if your product is inelastic, think of the lasting impact of price changes.

By considering all the factors mentioned in this guide, you can define an approximate price elasticity of demand for your products and decide whether changing their prices makes any sense. Get a full market insight: study which product analogs are available, find out how essential your product is, and build your pricing strategy accordingly.

If you want to calculate an exact price elasticity of demand, you need to know how your sales volume alters with price corrections. With hundreds or thousands of products, manual calculations become too challenging. What is the way out? Consider using Priceva’s price optimization solution. It collects and presents relevant data and offers pricing recommendations based on price elasticity. This is a must-have tool in your marketing inventory that will help you achieve balance between lead conversion and profit margin.

The price elasticity of demand should not be overlooked, because it will let you know how price changes impact the quantity of items sold. Use the simple calculation formula to discover the elasticity of your products, and remember that even for essential inelastic commodities, price shifts can cause demand change in the long term. Knowing about the importance of your products and customers’ behavior will also help you evaluate elasticity.

Perfect elasticity is when demand shifts dramatically after a price change. Relative elasticity is when price corrections cause tangible changes in demand. Unit elasticity (equals 1) is when the percent of price change is equal to the percent of demand change. Relative inelasticity is when demand barely alters after a price correction. Perfect inelasticity is when demand does not depend on the price at all.

Luxury items and some foods are not life-essential, so price corrections influence consumption of a product. Also, any goods with a large number of alternatives have a price-sensitive demand.

Any commodities essential for life, such as electricity and water. People cannot stop buying them because those products help us live and meet our basic requirements (food, shelter, safety).

This metric shows whether and how price fluctuations can impact demand for a product. With so many competitive markets around, it is important to plan your pricing strategy ahead of time in order not to experiment with customers. Price elasticity can be used to develop optimal pricing strategies and allows you to stay among the strongest competitors.