Is your business setting realistic prices for products and services? Price changes can have an influence in consumer demand, described with the price elasticity of demand concept. Learn more about what this means and how to calculate it below.
Price elasticity of demand definition
Price elasticity is a term used by economists to describe how changes in price influence supply or demand. The price elasticity of demand measures this change. If a product’s price doesn’t have much of an influence on its demand, it’s described as inelastic.
For example, petrol is needed for everyday operations no matter the price. Even when oil prices rise, consumers are still likely to purchase petrol at similar rates which makes it inelastic.
On the other hand, when a change in pricing causes a distinct change in a product’s supply or demand, it’s described as elastic. Many consumer goods, like magazines, gaming consoles, and craft supplies, would all fall under this category.
Factors affecting price elasticity of demand
There are a number of factors affecting price elasticity of demand. Household staples that you cannot live without are more likely to be inelastic. Here’s what influences this elasticity:
Substitutions: Some goods are easily substituted for one another, making them elastic in price. If the price goes up too high, the consumer will look for a cheaper alternative. For example, if you equally enjoy apples and bananas but the price of apples sharply increases, you’re likely to simply switch to bananas.
Discretionary purchases: If a purchase is discretionary, this means it’s something you can probably live without if the price is too high. For example, if your current smartphone works just fine, you might wait for the latest iPhone to drop in price or your phone to break before you buy a new one.
Habit forming purchases: Addictive products like alcohol and tobacco tend to be more inelastic, because consumers are more likely to purchase them no matter the price. This is why taxes are often added to products like cigarettes.
Luxury purchases: Designer clothing is always high in price because consumers will pay for the privilege of the brand name. This also holds true for products that have earned a loyal following, like cult beauty products.
Product life cycle: Price elasticity of demand will depend on which stage the product is within its life cycle. New products tend to have fewer substitutes or competitors, making them more inelastic. With wider choice at a future stage of the cycle, they become elastic.
How to calculate price elasticity of demand
Although there are numerous factors involved with a product’s elasticity, figuring out how to calculate price elasticity of demand is quite simple via a basic price elasticity of demand formula:
Price Elasticity of Demand = Percent Change in Quantity Demanded / Percent Change in Price
Because a product’s demand usually decreases when its price increases, the coefficient is negative most of the time. However, economists will still express this coefficient as a positive number.
If the price elasticity is less than 1, it’s inelastic. An increase in price will not cause much of a drop in demand.
If it’s greater than 1, it’s elastic. An increase in price will cause a drop in demand.
Price elasticity of demand example
So, how can you use this price elasticity of demand formula in your everyday business? Here’s a basic example of how this calculation looks.
Imagine that the price of bananas falls by 4% from $0.86 per kg to $0.83 per kg. As a result of this drop in price, shoppers purchase 15% more bananas than before. You then plug these numbers into the formula:
Price Elasticity of Demand = 0.15 / 0.04 = 3.75
The coefficient is 3.75, which is far higher than 1. This means that the demand for bananas is very elastic.
Ultimately, price and demand will depend on how attached to your products consumers are. If bananas go up in price and consumers equally like apples or grapes, they will be less likely to make a purchase. But when a luxury perfume rises slightly in price, those who consider it their signature scent might be willing to pay more. You must look at additional factors like materials costs, marketing, and processing fees to work out the best pricing model.
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