At the core of marketing is predicting how consumers will respond to different forms of stimulus. How much will getting Ryan Gosling (or Patrick's hero Hal Varian) to endorse the product raise sales? How would consumers feel about a teddy bear in the marketing email or on the package? Although businesses can never be 100% sure of the way a consumer will react, the purpose of every marketing and product team is to increase conversion, usage, and positive brand outlook.
Pricing, and more specifically your company's pricing strategy, is the one area applicable to marketing and product that still contains considerable guesswork. Phenomenal marketing and product development can lead to an increase in your prices while maintaining the same level of conversion. The two areas of your business can also tank your conversion if done incorrectly. Yet, setting a price and communicating value shouldn’t be a blind man’s game. Similarly, price optimization and changes shouldn’t be a shot in the dark.
Fortunately, there is a way to guide that process. One of the cornerstones of pricing strategy, microeconomics, and a great marketing/product foundation is the theory of price elasticity of demand, also known more simply as price elasticity. Let's lay out the basics of price elasticity and how you can increase demand by making your product offering more inelastic through marketing and product development.
What is Price Elasticity of Demand?
Price elasticity of demand (PED) is a critical concept in the law of demand. It is a measurement of how demand for a good will be affected by changes in its price. In other words, PED is a way to figure out the responsiveness of consumers to fluctuations in price, as opposed to price elasticity of supply, which determines the responsiveness of supply to price.
While equations can sometimes be complicated, this one is super simple and easy.
How to Calculate Price Elasticity of Demand
Here’s the basic price elasticity of demand formula you can use:
Price Elasticity of Demand = (% Change in Quantity Demanded)/(% Change in Price)
Since the quantity demanded usually decreases with price, the price elasticity coefficient is almost always negative. Economists, being a lazy bunch, usually express the coefficient as a positive number even when its meaning is the opposite. We're a pretty difficult people. However, it’s important to note that a decrease in quantity demanded does not automatically mean that revenue decreases. The additional profit margin could make up for the slight decrease in purchases.
When the price elasticity of a good is less than 1, it’s considered inelastic. That means a one-unit increase in price resulted in a less than one unit decrease in demand. On the other hand, if the coefficient (the absolute value) is more than 1, the good is elastic. That means a unit increase in price will cause an even greater drop in demand. Theoretically, total revenue will be maximized when the price elasticity of a good equals 1, or in other words, when demand is unit elastic.
Price elasticity of demand examples
I just threw out a lot of words like "unit", "elastic", "coefficient", "lazy", etc. Yea, economists like to use fancy words to alienate those political science or communication folks (kidding, of course), so let's break this down a bit with some examples of price elasticity of demand.
Price and demand typically head in the opposite direction, but the demand curve varies greatly based on the product (particularly on how necessary the product is). When you're looking at something like a tank of gas, does a $0.50 increase per gallon affect whether you'll fill up or not? Typically, other than aggravating you, the answer is no, because many commuters rely on gasoline to get them to or from their jobs. In this manner, gasoline is considered inelastic, where it would take a drastic price increase to truly drive down demand. Boston's MBTA saw this recently with their price increase when the price went up, but ridership wasn't really affected.
Conversely, if a slice of pizza you purchased every day for lunch went up by $0.50, would it affect your purchase? As long as you weren't super attached to the pizza and had other options (more on this below), you probably would move to another lunch establishment. Pizza, and food in general, tends to be elastic, where even slightly higher prices may cause a change in demand.
How to determine the price elasticity of demand for your product
Obviously, at least hopefully, you want your business to capture as much cash on the table as possible. As such, you need to make your product as inelastic as possible, increasing demand, regardless of how expensive you make the product. Essentially, you want your customers, whether through particular features, your service, or world-class marketing, to not be able to live without your business. The inputs necessary for this phenomenon to occur will adjust with different customer segments, but the thought process for each segment remains the same. So, how do you determine your product's elasticity for each segment and use this knowledge to your advantage? Here are a few things to think about:
1. Is the product a necessity or a luxury good?
Necessities tend to be inelastic (gasoline, electricity, water, etc.), while luxury ones are the opposite (chocolate, food, entertainment, etc.) because they are easier to cut out when the going gets tough. For example, you probably won’t stop buying light bulbs if the price went up by a few percent, but you might not book that cruise to the Bahamas if the cost rose. In this case, light bulbs could be predicted to be relatively inelastic, while cruises, unfortunately, wouldn’t.
Google has done a swimmingly good job with their AdWords platform in driving demand because a considerable amount of businesses utilize their advertising to sustain their entire businesses. Of course, competitors are creeping up, but your marketing and actual product make your offering a necessity. You must figure out the answer to: if our customers' revenue dried up (B2B) or consumer income was halved (B2C), what about our offering makes us the last thing they cut out of their lives?
2. How available are close substitutes?
I eat a lot of sandwiches (don't judge). If the price of Boar’s Head Deli cuts went up, I could easily switch to Sarah Lee Turkey Breast. There are a ton of other brands of cold cuts available, so unless Boar’s head could convince me its quality was somehow worth the price increase, I will probably stop buying their meat.
If your product has a lot of competition that is pretty similar, raising prices will most likely drive consumers away. I’m just going to make a quick shout-out to product differentiation here. In the SaaS and software space, product differentiation is a lot easier than if you're selling vacuum cleaners. Therefore, build integral features that are essential to the customer and that your competitors don't have in their wheelhouse. Alternatively, become a part of your customer's backstory, where the switching costs from you would be so high, it wouldn't be worth the move. We use Hubspot on a hardcore level. Switching to another platform would be inconvenient from a tactical and procedural standpoint. Of course, a competitor with this in mind could create an easy solution, but it's doubtful (Boston love!).
3. How much does your product actually cost?
I’m not talking about in comparison to your competitor’s goods, but rather how much does your type of good cost. You might sell some of the least expensive cars around, but even a cheap vehicle costs a lot. The higher the price, the more elastic it is, due to psychological pricing. For example, you probably don’t even know how much that pack of Paper Mate pens costs, so when the price rises by 10% (just a few cents) you likely won’t notice. But, if the price decreases by 10% on that new car you want (hundreds or thousands of dollars), you’re sure to notice.
You can take advantage of the actual number on the sticker for your products by providing offers at small, medium, and high levels. You're not going to offer a car at $50 (unless it's a real clunker), but you may offer a car rental program that allows you to have a smaller price point. Zipcar is great at this with their hourly and daily rates. Compete is even better with an ecommerce SKU in addition to their enterprise-level plans.
4. How long will this price change last?
All goods become more elastic in the long run. With time, it is possible to find substitutes or learn to live without something when it wasn’t possible under the pressure of time. The classic example is oil. If the oil price rises in the short-run (say, tomorrow), people would grumble over breakfast for a couple of days but still fill their tanks. However, people might buy hybrids or smaller cars that use less gas in the long run. So even if you determine that your product is inelastic, be careful of what implications a price change (even a small percentage change) could have down the road.
For instance, Rackspace was able to rock premium prices for a long time because premium hosting solutions weren't available, even for small web applications. With the birth of the cloud, prices have become more competitive and Rackspace has lost some of their lower-end customers. Carbonite also faces this phenomenon with the number of backup solutions in the market.
Overall, price elasticity should be an important consideration when developing your product and marketing strategies, in addition to being a basic building block behind your pricing. A huge factor that I'll repeat is that the price elasticity for different customer segments will vary. Thus, your marketing, pricing, and bundling must vary. At the end of the day remember, pricing is a process that you must integrate into your company's trajectory.
For more on pricing strategy, download our Pricing Strategy ebook or check out what we have to say about our price optimization software.
Price elasticity of demand FAQs
What are the types of price elasticity?
There are two types of price elasticity of demand: elastic demand and inelastic demand.. Elastic demand happens when the demand changes for goods is sensitive to price changes. Inelastic demand is when the demand for goods is not affected much by price changes. Common goods typically have elastic demand, while necessities have inelastic demand.
What is an example of elastic demand?
Elastic demand is used to describe the scenario where the change in demand is sensitive to a small change in price. For example, if we see a large change in the price of Lays chips, consumers are more likely to shift to a different brand, driving the demand down and vice versa. This means that chips have elastic demand due to the availability of close substitutes.
What is an example of inelastic demand?
Inelastic demand describes the scenario where fluctuations in price do not change the demand for a good. For example, gas is required for cars to run and there are no substitutes for the gas availability. This means that anyone who has a car will have to pay for gas regardless of how high the prices are, making demand inelastic.
Why is price elasticity of demand important?
Knowing the price elasticity can offer insight into how a market will react to price changes. This is important for businesses that are making pricing decisions as raising or lowering prices will directly impact the number of sales. Factoring price elasticity of demand is a key step for companies to determine the right pricing objectives within their niche.