Price elasticity of demand is a way of looking at sensitivity of price related to product demand. Demand elasticity is an economic concept also known as price elasticity.
Often price elasticity is not well understood.
But as a business owner, you need to understand price and demand elasticity when building pricing strategies for your products or services.
Pricing your product or service is a key element in the success of your business.
Many business owners do not treat pricing as a strategy; but it is.
And it is important to recognize that price needs to be a part of your marketing mix program.
Note: It is hard to write about this subject without sounding like an economics professor but I've tried to make this subject as clear as possible as it is important to your business.
Understanding how to set prices is a key element to your pricing strategy.
To set a price for your product or service you need to know your market and your competition, know what the demand, and understand the price elasticity of demand for your product or service.
Setting prices is also affected by how unique or differentiated your product is; in other words, is it a commodity item or a specialty or niche item?
Have you segmented your market (by demographic, psychographic, geographic, and other factors)?
And then, most importantly, do your customers value the differentiation?
Part of your strategy in building price must be to consider price sensitivity. This is particularly important when you are introducing new products or services to the market; and, when you are changing price (that is, increasing or decreasing price).
The market is less sensitive when the product is unique or differentiated and has high value; price increases in this scenario do not affect demand.
The market is more sensitive when the product or service is easily substituted for a more economically priced alternative; price increases in this scenario would affect demand negatively.
The market is less sensitive when products have quite different qualities and are therefore hard to compare to each other; price increases in this scenario often do not affect demand.
The market is less sensitive, and relatively inelastic, when the cost of switching from one product to another involves significant cost (penalties for moving to another supplier - such as breaking a lease).
The market is less sensitive to price when the product is a necessity, as compared to a discretionary item.
The demand elasticity formula calculates the impact of a change in price for a given product on demand:
The percentage change in demand divided by the percentage change in price.
For example, the demand for hotel rooms decreased by 10% when hotel room taxes increased by 8%: 10% divided by 8% = 1.25 (demand is elastic in this example; it is affected by an increase in price).
Note: While the result is a negative, economists typically don't show it that way in the formula.
If Price Elasticity of Demand = 0, then demand is perfectly inelastic. This means that demand is not affected by price changes (the demand curve in this instance is vertical).
If Price Elasticity of Demand = between 0 and 1, then demand is inelastic. This means that the demand change will be proportionately smaller than the price change.
If Price Elasticity of Demand = 1, then demand is unit elastic. This means that the increase in price would result in the same decrease percentage in demand.
If Price Elasticity of Demand is greater than 1, then demand is elastic and it is more than proportionately affected by a change in price.
What is the demand elasticity of your product in your market? Understand that price elasticity of demand is closely tied to the amount, direction (up or down), and frequency of price change.
If possible, try to test pricing through surveys, or focus groups, or by talking to your customers. Define the product or service in the test, set various levels of price for that product (going up in specific increments), and ask at what level of price does your customer consider the price to be 'fair'; at what level of price would your customer consider an alternative; and, finally, at what level of price would your customer would stop buying.
The relationship between rising price and falling demand is the price elasticity of demand.
Using a spreadsheet analysis, you can develop demand curves that show you at what price point demand will start falling. As you might expect, the higher the price, the lower the demand; unless you are selling luxury or prestige products or services. This is important data when determining pricing method and techniques.
For example, a customer expects to pay a high price for a Lamborghini or for a yacht (it's part of the prestige) and demand in those product categories is not affect by price but by brand identity. For those types of products or services, the demand curve would be considered to be abnormal.
Because you can use elasticity of demand data to predict the potential impact of a price change on your total sales revenues. Pricing helps drive sales revenues; it is not a cost center (unlike other marketing mix elements such as product, promotion, packaging and place/distribution)!
Find four alternative Pricing Methods that might better fit your strategy.
Penetration Pricing focuses on quick entry and quick results: but at what cost?
Return to Pricing Strategy.
Pricing is the foundation of your business success.
Interestingly many businesses focus on either building their price structure by using costs as the basis OR by using market information (that is, what the market will pay).
The reality is that the price needs to be constructed with both costs and market forces as part of the consideration. Additionally, the product or service value (ranging from commodity to luxury) plays a role in price strategy.
Building a strong pricing program is part of your marketing mix activities (product or service; promotion; place or location; and price). Many businesses focus most of the marketing attention on developing the product or service program and then promoting it; make sure you give price the time and attention it needs.
Businesses need to be more aware of the power of competitive and comparative markets than ever before.
Because technology and the internet makes pricing information available 24 hours a day, 7 days a week.
Customers use their mobile phones, laptops and even desktops to price check and compare.
The speed of pricing changes makes this an urgent action item for all businesses.