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The Ultimate Guide to Price Elasticity of Demand

Salesperson calculating price elasticity
Price elasticity of demand is how businesses know where to set the price for what they sell. [Adobe / Skyword]

Learn how to ride the waves of changing consumer behavior and markets to boost profit.

“The price of gas is up. No, wait, it’s down again.”

“I need to get my hands on the newest cell phone. Sure, it costs more than my rent, but check out the new camera.”

“Our electric bill went up. I guess we’ll cut back on takeout this month.”

Do these sound like comments you’ve made or heard — comments that leave you feeling as if you’re riding a rollercoaster? Then you’re already familiar with the price elasticity of demand.

Price elasticity of demand is how businesses know where to set the price for what they sell. It sounds complicated, but it’s a basic economic principle with a simple formula to follow. And once you understand it, you have access to untapped profits and higher customer satisfaction.

Strap in. Buckle up. We’re going to ride the ups and downs of price elasticity and explore how it drives successful pricing strategies and revenue forecasts.

What you’ll learn:

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What is price elasticity?

Price elasticity measures your product or service’s supply-and-demand responsiveness to changes in its price. You use a formula that calculates the percentage change in the quantity demanded or supplied. You finish up by dividing the percentage change in price. The result shows a correlation between your price change and the quantity you sold. If you raised prices, did your customers buy more or less? Did you have to increase supplies because the new low prices spurred massive demand?

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Price elasticity of demand vs. price elasticity of supply

You can measure price elasticity of demand (PED) or price elasticity of supply (PES). We’ll go over the differences between PES and PED in more detail later. In the meantime, here’s a glance at the formula:

PED = [percent change in quantity (of goods or services bought)] / [percent change in price]

PES = [percent change of supply (of goods or services produced)] / [percent change in price]

Price elasticity of supply measures how quickly the production of a product or service can ramp up when there is a price change. Let’s say you really want to buy a new cell phone on the market. The phone manufacturer announces a big sale. You, along with a million other people, rush to order.

The manufacturer can’t keep up with the demand. Supplies run short.

Suddenly, they are out of stock. You find yourself on a waitlist.

That’s price elasticity of supply.

On the flip side, price elasticity of demand predicts if a price increase will affect how many of your customers continue purchasing from you. Imagine you’re selling ice cream on a hot beach. If you raise the price, will your sales plummet — or will sunbathers still line up, cash in hand? The price sensitivity and customer response are what price elasticity for PED and PES seek to understand and quantify.

The idea that something is elastic implies that something can be inelastic or insensitive to price increases. Before we discuss the importance of price elasticity, let’s break down the seller’s options.

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Why is price elasticity of demand important?

Understanding price elasticity is not just about setting prices, it’s about unlocking potential. It guides your pricing strategies to create revenue without alienating your customers. PED helps with sales forecasting. You won’t be caught off guard by a sudden dip in demand because you adjusted your prices. You’ll ride the highs of an accurate financial plan that can boost profitability. PED helps identify who in your target market may respond differently to price changes. You can then decide to change marketing strategies or increase sales efforts. This helps businesses make informed decisions by:

  • Setting optimal prices: Businesses can use elasticity to figure out the price that maximizes their profits. For example, if they know demand is elastic (meaning a small price increase leads to a big drop in sales), they might keep prices lower to attract more customers.
  • Planning for promotions and discounts: Knowing elasticity helps businesses decide if a sale will actually boost sales or reduce their profit margin. If demand is inelastic (meaning price changes don’t affect sales much), a sale might not be worthwhile.
  • Developing product strategies: Elasticity can help businesses understand how much customers value a product’s features. If a key feature has inelastic demand (people will buy it regardless of a price increase for that feature), the business might focus on emphasizing that feature.
  • Understanding customer behavior: Elasticity predicts how customers will react to price changes. This can be crucial for planning marketing campaigns, aligning your sales funnel, and budgeting.

Price elasticity of demand lets you determine how much you can increase prices without losing too many customers. In preparation for the upcoming summer season, your beachfront ice cream shop reviews last year’s sales. The report indicates a consistent demand even though you raised prices by 2%. You decide to run a test and see if your target market is willing to pay an extra 5%. You add the 5% and generate additional revenue without turning away too many customers.

You can create a marketing plan that targets customers who are willing to pay a premium for your desserts during the summer season. This can include targeted advertising, promotions, and other strategies to increase sales and drive growth.

It could be said that the ultimate goal for a business is to achieve inelasticity: No matter the price change, demand stays the same. However, certain factors determine the inelasticity or price elasticity of demand for your product or service.

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3 different types of price elasticity

Using the ice cream example, if you increase the price, you might find that your customers aren’t as eager to buy your treats and sales die down. But if you lower your prices, you have a line of customers stretching down the beach.

Got enough ice cream to support the demand?

1. Elastic price

In this case, your price increase directly affects the demand for your product. You added a dollar to your ice cream prices, and now customers are going elsewhere.

2. Unit elastic price

This is a direct correlation to the supply and demand of your product or service. For example, you raise prices by 25% and then see a 25% decrease in the quantity sold. Non-essential consumer products often witness this event. Let’s think about that ice cream again. You decide to raise the price of vanilla by 25%. Now, the demand for vanilla has fallen by 25%.

What’s the difference between unit elastic and elastic? Unit elasticity is a one-to-one ratio. Increase the price by 25%, and you see a 25% change in demand. In contrast, simple elasticity doesn’t carry as much of a direct correlation.

3. Inelastic price

If you increase your prices, the demand for your product or service stays relatively the same. A good example of this would be certain prescription drugs. If they can, patients will continue to buy their medications for the sake of their health. Additionally, other essential products such as rent and utility bills fall into this category.

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What affects price elasticity of demand?

Let’s take a look at the factors at play.

Essential vs. non-essential purchases

There are some generic options for certain medications that might offer a lower price than the brand-name drugs. However, once a person finds a drug that works well for them, the chances of them switching are relatively low due to things such as side effects and the time it takes for your body to get used to the new drug. Also, there are limited options for competition in the pharmaceutical industry.

If your product or service is non-essential (for example, ice cream and many home electronics), your customers will feel less obligated to buy and may try to find something at the price they want to pay.

Stiff competition

Are there limited substitution options for your product? Or can customers find a variety of sellers that provide similar goods and services? When we think about ice cream, I can go to any number of diners, shops, or even my local grocery store to get my favorite scoop. If something is non-essential, and competition is plentiful, then you need to pay attention to price elasticity.

How long a product or service is priced at a certain amount will impact demand. The longer the price change lasts, the more likely people are to find ways to adapt to it, potentially leading to a bigger impact on demand.

If the price change is short-term, people might not have time to find alternatives. Then they might not be as likely to cut back on buying the item (less elastic demand). If the price change is long term, consumers have time to adjust their habits. They might switch to cheaper options or cut back on buying the item altogether (more elastic demand).

Think about a surprise one-day sale. You might be caught off guard and then adjust. You grab a discounted item you like, but this won’t change your shopping habits. A more permanent price increase gives you more time to prepare. You might find alternatives or adjust your budget.

Consumer income to product cost

If your product’s price takes a large chunk out of your customer’s wallet, then even the slightest increase could have immediate effects on your demand. By the same token, if your prices are a smaller nibble on the customer’s income, then a price change will have less impact.

We see this with high ticket ERP (enterprise resource planning) software. ERP systems that act as a centralized data hub for all the departments within an organization can carry a hefty subscription price tag. So, when the ERP subscription increases, businesses need to have a serious conversation about whether to continue with their current provider or go with a competitor.

Keep all these factors in mind when setting or adjusting the price of a product or service. First, tap into what your target audience needs and what they consider urgent or essential. Then, prepare to adjust accordingly so you meet their demand. After you consider all the possible scenarios that could impact your price elasticity of demand, it’s time to categorize your products or services.

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How to calculate and measure price elasticity (with formula)

As I mentioned earlier, the formula for price elasticity is:

[Percent change in quantity (of goods or services bought)] / [percent change in price]

After you run your calculations, you will be left with either a value greater than one, a value equal to one, or a value less than one.

Greater than one (a positive number): Implies your product or service is elastic. When you change your price, you will see a significant proportional change in your supply or demand.

A value equal to one (the number one): Means you have achieved unit elasticity. When you change your prices, they will be equal to your change in supply and demand.

Less than one (a negative number): Shows that your product or service is inelastic, and any price changes will be relatively small in proportion to the change of your supply or demand.

Let’s plug in real numbers.

PED formula in action

Your ice cream shop sold 150 cones at $1.00 each yesterday. You decide to raise prices by 75% making the new price $1.75 per cone. Today, you only sold 125 cones.

Formula for PED = % change in quantity / % change in price

Step 1: Find the percent change in quantity

(New quantity – original quantity) / (New quantity + original quantity) / 2

(125 – 150) / (125 + 150) / 2 = -.045 (-4.5%)

Step 2: Find the percent change in price

(New price – original price) / (New price + original price) / 2

(1.75 – 1.00) / (1.75 + 1.00) / 2 = .136 (13.6%)

Step 3: Use PED formula

% change in quantity / % change in price = PED

-4.5% / 13.6% = -.33

The negative number indicates that your demand for ice cream is relatively inelastic. Even math and economics can feel like a rollercoaster. Before we move on to price elasticity of demand’s counterpart — price elasticity of supply — let’s go through one more calculation and a slightly new formula: cross-price elasticity.

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What is cross-price elasticity of demand?

Cross-price elasticity is how much consumers switch between products or services depending on price changes. The more your consumers switch, the more elastic the cross-price elasticity.

The formula for cross-price elasticity is:

(% change in quantity demanded for X product or service) / (% change in price for Y product or service)

You’re at the grocery store and see your favorite bag of chips (Product Y) increased its price by 30%. You decide to switch to a competitor chip (Product X) and buy three bags priced at $2.00 each.

Step 1: Calculate percentage changes

Let’s assume you normally buy 1 bag of Product Y chips.

[(New quantity – original quantity) / original quantity] x 100%

[(3 bags – 1 bag) / (1 bag) x 100% = 200% increase

Step 2: Apply the cross-price formula

(200% change in Product X) / (30% change in Product Y) = 6.66

The result from this formula (a positive number) shows that product X is considered a “substitute good.” The term “substitute good” is an economic principle that means consumers view a competitor’s product or service as similar enough to your product or service.

If chip prices across the board increased and the number of bags sold went down, that principle is called “complementary goods.”

Now that the math lesson is over, let’s wrap up with the difference between price elasticity of demand and price elasticity of supply.

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How to manage price elasticity

If you made it this far, congratulations. That was a ton of formulas, definitions, and economic theories to process. Now, how do you apply everything you learned?

Use price elasticity and the formulas to explore strategic pricing models and product differentiation. I recommend A/B testing product and service prices.

Example: A streaming service wants to determine the price elasticity of their monthly subscription fee. They would run an A/B test using a control group.

Group A (the control group) keeps the standard monthly price — $10

Group B (the test group) sets a slightly higher price — $12

The company sets a test period and tracks how many people in each group sign up for their service.

If the signup for Group B is significantly lower compared to Group A, it suggests some degree of elastic demand. Now the subscription service knows their customers might be price-sensitive and could choose other streaming services if the price increases. They can use this information to conduct competitor and market research, or even hold focus groups to figure out the maximum price they can charge.

You can adjust the prices based on the results you are seeing weekly, quarterly, or yearly. Be sure to make accurate calculations and keep track of all metrics.

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Price elasticity: untapped potential awaits

We are rounding the final corner of our economics rollercoaster ride. Is that a dip ahead or a massive drop? Mastering the concept of price elasticity of demand allows businesses not just to react to the market, but to anticipate and shape consumer behavior. The standard formula makes the price elasticity of demand easy to calculate. You are now well-equipped to choose the right pricing strategy and forecast with more accuracy.

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