Price Elasticity of Demand

The Relationship of Elasticity of Demand
to Pricing Strategy

Price elasticity of demand is a way of looking at sensitivity of price related to product demand. Elasticity of demand is an economic concept also known as demand elasticity or as price elasticity.

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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.

It is hard to write about this subject without sounding like an economics professor but I've tried to make this very important subject as clear as possible.

Setting Price

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? And then, most importantly, do your customers value the differentiation?

Price Sensitivity

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.

Price Elasticity of Demand

The elasticity of demand 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.

Demand Elasticity Values

• 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 > 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.

The Relationship Between Price Elasticity and Pricing Strategy

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.

Why is Price Elasticity of Demand Important?

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)!

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For alternatives to standard pricing policies, consider other Competitive Strategies.

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