Setting the right price for your product or service is a hard-working process, and besides all, it is a continuous process if business goals are high.
Price elasticity can provide insights necessary to set the best price for your products and services in accordance with the market price and your business goals. Even though price elasticity is an economic term, we will break it down for you, and filter out information crucial for eCommerce businesses.
What is price elasticity?
Price elasticity is one of the pivotal concepts in economics that measures the responsiveness of demand or supply to changes in product or service prices.
Price elasticity helps to determine the sensitivity of consumers or manufacturers to price changes and provides insights into how certain changes can impact the quantity bought or sold. It also can be utilized to determine the potential impact of price changes on revenue and profitability. For example, if demand is elastic, a price decrease may lead to a significant increase in quantity demanded, resulting in higher total revenue. Conversely, if demand is inelastic, a price increase may result in a smaller decrease in the quantity demanded, potentially leading to higher revenue.
Additionally, price elasticity can provide insights into market dynamics, consumer behavior, and the competitiveness of a product or industry, which all can benefit businesses and allow them to make informed decisions regarding defining pricing strategies, product differentiation, and market positioning.
Price Elasticity of Demand
The price elasticity of demand (PED) is a measure of the responsiveness of the quantity demanded of a product or service to changes in its price. It quantifies the percentage change in quantity demanded in response to a percentage change in price.
The formula to calculate the price elasticity of demand is as follows:
PED = (% Change in Quantity Demanded) / (% Change in Price)The resulting PED value can be positive or negative. However, in most cases, the absolute value (ignoring the negative sign) is considered to determine the elasticity.
Price elasticity can fall into one of the following groups:
Elastic Demand (PED > 1): If the absolute value of PED is greater than 1, demand is considered elastic. This means that a percentage change in price will result in a proportionally larger percentage change in quantity demanded. For example, if the PED is -2, a 10% increase in price would lead to a 20% decrease in the quantity demanded.
Inelastic Demand (PED < 1): If the absolute value of PED is less than 1, demand is considered inelastic. In this case, a percentage change in price will lead to a proportionally smaller percentage change in quantity demanded. For example, if the PED is -0.5, a 10% increase in price would result in a 5% decrease in quantity demanded.
Unitary Elastic Demand (PED = 1): If the absolute value of PED is exactly 1, demand is said to be unitary elastic. This means that a percentage change in price leads to an equal percentage change in quantity demanded. For example, if the PED is -1, a 10% increase in price would result in a 10% decrease in the quantity demanded.
The magnitude of the PED value indicates the degree of responsiveness of quantity demanded to price changes. The more elastic the demand, the more sensitive consumers are to price fluctuations, and vice versa.
Price Elasticity of Supply
On the other hand, the price elasticity of supply (PES) measures the percentage change in quantity supplied divided by the percentage change in price. It shows the responsiveness of quantity supplied to changes in price. If the PES is greater than 1, supply is considered elastic, meaning that a change in price will have a proportionally larger effect on the quantity supplied. If the PES is less than 1, supply is considered inelastic, indicating that a change in price will have a proportionally smaller effect on the quantity supplied.
Factors Influence the Elasticity of Demand & Supply
- Availability of Substitutes: The availability of substitutes is a key determinant of price elasticity. If there are many substitutes for a product, consumers can easily switch to alternatives when the price changes, making demand more elastic. On the other hand, if there are few or no substitutes, demand tends to be inelastic.
- Necessity vs. Luxury: Necessities, such as basic food items or medications, tend to have inelastic demand because consumers are less responsive to price changes. Luxury goods, on the other hand, often have more elastic demand as consumers can delay or forgo purchases when prices rise.
- Time Horizon: The time available for consumers to adjust their behavior in response to price changes also influences elasticity. In the short run, demand may be inelastic as consumers may not have enough time to find substitutes or change their consumption patterns. In the long run, however, demand becomes more elastic as consumers have more flexibility to adjust their behavior.
- The Proportion of Income Spent: Goods that represent a large proportion of a consumer’s income tend to have more elastic demand. A small change in price for these goods can have a significant impact on a consumer’s budget, leading to greater responsiveness to price changes.
- Brand Loyalty and Product Differentiation: If consumers are highly loyal to a particular brand or perceive a product as unique, demand tends to be less elastic as they are less likely to switch to alternatives even if prices change.
- Market Definition: Narrowly defined markets may have more elastic demand, as consumers can easily switch to substitute products within that market. Broader market definitions may result in more inelastic demand as consumers have fewer alternative options.
- Income Level: Higher-income consumers may have more elastic demand as they have more disposable income and can easily adjust their purchasing decisions in response to price changes.
Note: These factors can interact and influence elasticity in combination rather than in isolation. Understanding these factors can help businesses assess the potential impact of price changes on demand and make informed pricing decisions.
Price Elasticity Real-Life Examples
- Gasoline is often considered to have inelastic demand in the short run because it is a necessity for many people who rely on cars for transportation. Even if the price of gasoline increases, consumers may have limited alternatives and still need to purchase it. However, in the long run, demand becomes more elastic as consumers may choose to switch to more fuel-efficient vehicles, use public transportation, or carpool.
- Bottled water is a good example of a product with elastic demand. Consumers have numerous substitutes, such as tap water or other beverages. If the price of bottled water increases significantly, consumers may opt for these alternatives, reducing their demand for bottled water.
- The demand for air travel tends to be elastic. When airlines increase ticket prices, consumers often look for alternatives, such as driving, taking trains, or opting for other modes of transportation. Additionally, consumers have the flexibility to adjust their travel plans or delay non-essential trips in response to price changes.
- Fast food items, such as hamburgers or french fries, often have inelastic demand. Despite price increases, consumers may continue to purchase these items due to factors like convenience, habit, or brand loyalty. However, if prices rise too much, some consumers may choose to eat at home or switch to lower-priced fast food options.
- Luxury goods, such as designer clothing or high-end electronics, typically have elastic demand. These products are often non-essential and have many substitutes available at different price points. As a result, consumers are more responsive to changes in price, and an increase in price may lead to a significant decrease in the quantity demanded.
- Prescription medications tend to have inelastic demand because they are often necessary for treating medical conditions. Even if the prices of medications increase, consumers may have limited alternatives and will likely continue purchasing them.
Impact on eCommerce Businesses
Price elasticity is a crucial consideration for eCommerce businesses as it influences pricing decisions, customer acquisition, revenue optimization, and competition within the online marketplace. By understanding and leveraging it effectively, eCommerce businesses can gain a competitive edge and enhance their profitability by implementing customized repricing strategies.
- Increased Price Sensitivity: Online shoppers tend to be more price-sensitive compared to traditional brick-and-mortar shoppers. The ease of comparing prices across different online retailers and the abundance of options available make it convenient for consumers to find the best deals. As a result, eCommerce businesses often face more elastic demand, where consumers are more likely to switch to alternative online stores offering lower prices.
- Competitive Market Environment: The eCommerce landscape is highly competitive, with numerous online retailers vying for customers’ attention and business. Price elasticity plays a crucial role in this competitive environment. If a particular eCommerce business raises its prices significantly, it may lose customers to competitors who offer the same or similar products at lower prices.
- Dynamic Pricing Strategies: eCommerce businesses have the advantage of employing dynamic pricing strategies more easily compared to traditional retailers. Dynamic pricing involves adjusting prices based on factors like demand, competitor prices, or consumer behavior. By understanding price elasticity, eCommerce businesses can optimize their prices to capture maximum revenue. For instance, they can lower prices during periods of low demand or adjust prices to undercut competitors and attract more customers.
- Promotions and Discounts: eCommerce businesses often use promotions, discounts, and special offers to attract customers and drive sales. Understanding price elasticity helps in designing effective discount strategies. For example, if demand is inelastic, offering a discount may not significantly impact the quantity demanded, resulting in reduced profitability. On the other hand, if demand is elastic, a well-planned discount campaign can lead to a substantial increase in sales and customer acquisition.
- A/B Testing and Price Experiments: eCommerce businesses can leverage price elasticity to conduct A/B testing or price experiments. By testing different price points for a product or service, they can gather data on customer responsiveness and identify the optimal price that maximizes revenue. These experiments allow businesses to gauge the price elasticity of their offerings and fine-tune their pricing strategies accordingly.
Do you sell inelastic or elastic products?
Businesses must know how elastic, sensitive to fluctuations in price, or inelastic, largely ambivalent about price changes, their products are when pricing products.
When a product is elastic, prices should be cautiously adjusted if needed, as potential increments can greatly influence demand and supply. On the other hand, if a product is inelastic, meaning products have inelastic demand, typically necessities or goods with limited substitutes, price adjustments can be performed more freely.
Especially eCommerce businesses belonging to industries that are changing prices several times a day should utilize repricing software to gain a competitive advantage and boost revenue.
