Although consumer behavior is uncertain, the primary objective of the marketing and product teams in an organization is to increase usage, conversion, and positive brand outlook. Price optimization is important to ensure the company’s long-term stability.
One of the important aspects of price optimization is determining its elasticity. This blog discusses how businesses can increase the demand by making their products more inelastic via marketing and product development.
What is the price elasticity of demand?
Price elasticity of demand (PED) is an economic indicator of changes in consumer behavior when product pricing changes. Economists use this measure to explain the effects of price changes on demand and supply and the working of the real economies.
Some products like fuel are inelastic. It means that even if the oil prices increase, the demand will not be significantly impacted as people still need fuel to travel for work and other purposes.
When the demand for a product is significantly impacted by changes in its prices, it is known as ‘elastic’. On the other hand, if the demand is only marginally impacted, the product is called ‘inelastic’.
Formula to calculate the price elasticity of demand
The formula for calculating this economic indicator is
PED = % change in the quantity demanded / % change in price
The equation can be further expanded to:
PED = [(Q1 – Q0) / (Q1 + Q0)]/ [(P1 – P0) / (P1 + P0)]
Q0 is the initial quantity
Q1 is the final quantity
P0 is the initial price
P1 is the final price
Calculation of price elasticity of demand
Generally, demand for a product reduces when the price increases, and therefore, most often the price elasticity coefficient is negative.
However, it is important to note that a decrease in demand does not necessarily mean a reduction in revenues. The higher profit margin may compensate for the decrease in demand.
Here is the step-by-step calculation of PED.
- Determine the initial price and quantity (P0 and Q0, respectively) and then decide the target quantity based on the final price (Q1 and P1, respectively).
- Calculate the numerator by dividing the quantity difference by the initial and final quantities [(Q1 – Q0) / (Q1 + Q0)].
- Calculate the denominator by dividing the quantity difference by the initial and final prices [(P1 – P0) / (P1 + P0)].
- PED is calculated by dividing the result of step 2 by the result of step 3.
Examples of price elasticity of demand
Here are some price elasticity of demand examples.
Assume that the petrol price was INR 50 per liter, which increased to INR 60 per liter. As a result, the demand for petrol at a fuel station reduced from 100 liters per day to 80 liters per day. The PED is calculated as below:
Percentage change in quantity = (80 – 100) / (80+100) = -11.11%
Percentage change in price = (60 – 50) / (60 + 50) = 9.09%
PED = -11.11% / 9.09% = -1.22
Here is another example to understand the price elasticity of demand formula.
A small bakery sells 180 loaves of bread every week for INR 20 per loaf. It increases the price to INR 25 per loaf, which results in sales dropping to 140 loaves per week. The PED in this example is:
Percentage change in quantity = (140 – 180) / (140+180) = -12.50%
Percentage change in price = (25 – 20) / (25 + 20) = 11.11%
PED = -12.50%/11.11% = -1.13
What are the four factors that determine price elasticity?
Companies aim to make their products inelastic as much as possible, which means the demand is not significantly affected even if they increase the price.
Here are four factors that affect PED:
Nature of product
Necessary products like water, electricity, gas, and the like are generally inelastic as these are consumed even if the prices increase.
On the other hand, luxuries like entertainment, vacations, and much more are price-sensitive, and consumers may stop spending on these in case of difficult situations.
Availability of substitutes
If the company's products have several competitors and are easily replaceable, a price increase can significantly reduce its demand because consumers will switch to a competitor's product.
The company needs to provide unique features that help to retain their customers even if the price increases.
Actual cost of the products
As a result of psychological pricing, the higher the price of a product, the more is the elasticity.
For example, if the cost of a packet of pens increases, most customers won’t even notice it.
However, if the price of a car decreases, it can result in saving a significant amount thereby impacting the demand.
Duration of the price change
Most products become elastic in the long term. Over a period, it is easier for customers to find substitutes or to learn a living without these products making these elastic.
For example, when petrol prices increase, customers still buy fuel. However, in the long-term, they may switch to hybrid or smaller vehicles that reduce fuel consumption.
What are the five types of price elasticity of demand?
There are five types of price elasticity of demand, which are as follows:
Customers are very responsive to price changes for elastic goods and services. Users are not willing to spend more and opt for an alternative.
Consumers put greater emphasis on the prices of the goods and services and other factors like quality may be overlooked.
For example, while buying term insurance, most buyers choose the least expensive policy since the coverage available is more or less standard for all insurers.
Inelastic demand is when the PED is less than 1, which means that users are not very responsive to changes in the pricing.
One of the reasons that make a particular product or service inelastic is the limited availability of substitutes.
For example, the local grocery sells a particular type of bread, which is not available at other nearby outlets. Consumers will have to travel far to get the same bread, which makes them less responsive to an increase in its price by the local grocery.
According to this theory, the decrease in demand for a product is the same as the increase in its price.
For example, the price of a television is INR 20,000 and the manufacturer sells 100 TVs at this cost. If the company increases the price by 10% to INR 22,000, the demand reduces by 10% to 90 TVs.
Because human demand is non-linear, unitary demand does not exist in real life.
Perfectly inelastic demand
It means the quantity and prices are fixed and are not affected by the other variable. In other words, the increase in the price of a product has no impact on its demand.
In real life, there are no perfectly inelastic products since it would mean that companies can price these at any amount and consumers would still need to buy them.
One example of a product that is close to perfect inelasticity is gasoline. Even when the price rises, people need to drive to work and other places, which does not significantly impact the demand
Perfectly elastic demand
A sharp increase or decrease in the demand due to price changes is known as the perfect elasticity of demand.
A small increase in price can reduce the demand to almost zero and vice versa for perfectly elastic goods and services.
There are no perfectly elastic demand examples in reality as the market is not perfectly competitive and the products aren’t homogenous.
Frequently Asked Questions (FAQs)
What is the price elasticity of demand?
PED measures the change in consumer demand in relation to price. It identifies the relationship between price and demand for goods and services.
What are the types of price elasticity?
PED can either be elastic or inelastic. The former occurs when demand is highly sensitive to changes in pricing.
The latter is when price changes do not significantly impact the demand. Often, necessities are inelastic while common goods and services are elastic.
What is the importance of price elasticity of demand?
Knowing PED can help companies to understand the market reaction to any price change. It plays an important role in price optimization to ensure long-term sustainability for the business.
What is inelastic demand?
Inelasticity is when the price fluctuations of goods and services do not change their demand.
For example, any individual who owns a vehicle will continue buying fuel even if the price increases as substitutes are not easily available.
What is elastic demand?
Elastic demand describes situations when demand is highly sensitive to even a small price fluctuation.
An example is if Pepsi increases the price of its beverage, customers may opt for other alternatives like Coca-Cola. Goods and services that can be substituted without difficulty have elastic demand.
This is a companion discussion topic for the original entry at https://jupiter.money/resources/understanding-price-elasticity-of-demand/