Setting the ideal selling price for your product or service can turn out to be a real problem, and it is certainly one of the most difficult things for marketing teams in companies around the world to tackle because price has a problem. significant impact on the results of companies and in particular their turnover. Understanding what economists call “price elasticity of demand” is a critical part of pricing.
In this article, we will first define this term, and then we will see how companies should interpret and use this data.
What is the price elasticity of demand?
Most customers in all markets are sensitive to the price of the products or services they wish to purchase. It can be said that in general, more people will buy a product or service if its price drops, and conversely, fewer people will be interested if the offer is more expensive. But the reality is more complicated in practice, and the price elasticity phenomenon of demand shows exactly how responsive customer demand can be for a product according to its price and evolve. Thus, marketers must understand how their products are “elastic” (that is to say, sensitive to price fluctuations) or “inelastic” (whose sales will not be significantly impacted by an increase in the selling price) when think about how to set or change their prices.
Some products generate immediate and dramatic reactions to price changes, for example when they are considered non-essential, or because there are many substitutes available. When the price of beef is on the rise, demand may fall, as people can easily substitute it for chicken or pork.
Calculation method for measuring the price elasticity of demand
The calculation method for measuring the price elasticity of demand is relatively simple: just divide the rate of change in demand by the rate of change in price, as in the following formula:
Elasticity = (rate of change in demand) / (rate of price change)
These rates of change are expressed as a percentage.
How to interpret the result of the calculation of the price elasticity of demand with the rate of change?
The price elasticity of demand is generally negative. This means that in principle the sales volume naturally decreases when the selling price increases.
But in reality there are five distinct domains of price elasticity of demand, as follows:
In this situation, any price change, however small, greatly influences the quantity demanded. The products that fall into this category are mostly products for which customers have no significant attachment, and where the concept of brand is irrelevant.
In this case, small changes in price lead to large changes in quantity demanded. Beef is an example of a relatively elastic product.
In this situation, any change in price corresponds to an equivalent change in quantity sold.
This happens when large changes in price lead to small changes in demand. Gasoline is a good example of this, because most people need it, so even when prices go up, demand doesn’t change much. Products with strong brands and luxury items also tend to be more inelastic.
In this case, the quantity demanded does not change when the price changes. The products in this category are goods that consumers absolutely need and there are no other options to obtain them. We generally observe this case among companies that have a monopoly. Even if they change their price, you will still need to source from them.
Thus, specialists must know where their products fall within this broad spectrum.
Factors that affect the price elasticity of demand
A number of factors can affect the elasticity of demand for a good:
Availability of substitute products
The more and closer the available substitutes, the higher the price elasticity of demand is likely to be, as consumers can easily switch from one good to another if even a small price change is made. If no equivalent substitute is available, the substitution effect will be small and demand inelastic.
Percentage of income
The higher the price of a product is a percentage of a given consumer’s income, the higher the elasticity tends to be, as people will be more careful when buying the good because of its cost. For goods which represent only a negligible part of the budget, the income effect will be insignificant and demand inelastic.
The more a good is needed, the lower the elasticity, as people will try to buy it regardless of the price, as is the case with insulin and many other basic necessities.
For most goods, the longer a price change lasts, the higher the elasticity is likely to be, as consumers have the time and inclination to look for substitutes. For example, when fuel prices remain high for several years, consumers will tend to reduce their fuel purchases by switching to carpooling or public transport. However, this does not apply to durable consumer goods such as cars, for example, because eventually it becomes necessary for consumers to replace them anyway.
An attachment to a certain brand can outweigh the sensitivity that a price change can generate, and lead to more inelastic demand.
When the buyer does not pay directly for the good they consume, as with business expense accounts, demand is likely to be more inelastic.
Concept of addiction
Goods that are more addictive in nature tend to exhibit a rather inelastic level of price elasticity of demand. Cigarettes and alcohol are examples. Indeed, consumers consider these products as necessities and are therefore obliged to buy them, despite sometimes significant price changes.
How can companies use this indicator?
The price elasticity of demand is one of the key metrics for marketers. Companies must therefore create products and services that have unique and lasting value for customers compared to other options available in the market. Price elasticity of demand is one way for them to measure their performance in this regard. If your product is very elastic, it is seen as a simple commodity by consumers.
The goal of marketing teams should be to move their products from “relatively elastic” to “relatively inelastic”, creating a differentiated offering that has meaning for customers.
When, through branding work or other marketing initiatives, a company increases the consumers’ desire for its products and entices them to acquire it, regardless of the price, it improves its position by compared to its competitors.
But it can go the other way, because your product can become more elastic if a competitor starts to offer attractive substitutes or if consumers’ incomes decline, making them more price sensitive.
Finally, keep in mind that the price elasticity of demand is not only dependent on the quality of your marketing action. It is also affected by the type of products you sell, the income of your target consumers, the health of the economy, and what your competition is doing.