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What is Price Elasticity of Demand?

Price elasticity is an economic concept that you should get to know. It is instrumental in understanding demand for your product and the price you can set for it.

A price elastic product is one that experiences changes in demand as the price rises or falls. Some products are staples, and their price is inelastic. (Think things like bread or milk).

People will buy these regardless of price fluctuations. When your product is price elastic, a price rise might prompt people to buy an alternative product or wait until the price is cheaper. Products that are affected in this way are often non-essential or luxury goods.

Working out price elasticity of demand

You can determine price elasticity of demand, using an equation. The equation takes the percentage change in demand and divides it by the percentage change of price.

For a product that increases 10% in price and sees a 10% drop in demand, their price elasticity of demand is negative 1.

Most products range between negative one and zero.

The pricing factors you need to understand

Here are the factors you should consider before increasing the price of your product:

  • Are there substitutes to your product? - If people can easily switch to another product they may be price sensitive.

  • Your customer’s budget - If the cost of your product represents a small percentage of your customer's budget, they may pay less attention to the cost.

  • Need or a want? - If your product is a necessity, your customer will buy it no matter the price. But they may not feel very good about the price increase!

  • Loyalty to your brand - The goal is to have people choose your product over your competitors on factors other than features and price. Boosting brand loyalty can help to reduce price sensitivity.

  • Your buyer - If your product is usually purchased through an expense account, your demand may more inelastic, because the purchaser is not paying the final bill.

Let's look at an example.

Suppose a coffee shop owner wants to determine the impact of a price increase on their sales. They currently sell a cup of coffee for $2.50 and sell an average of 200 cups per day. The owner decides to increase the price to $3.00 per cup and wants to assess the potential change in demand.

To calculate the price elasticity of demand, the owner collects data over a certain period and finds that the quantity demanded decreases to 180 cups per day after the price increase.

Using the formula for price elasticity of demand, we can calculate the percentage change in quantity demanded and the percentage change in price:

Percentage Change in Quantity Demanded = [(New Quantity Demanded - Initial Quantity Demanded) / Initial Quantity Demanded] * 100

= [(180 - 200) / 200] * 100 = -10%

Percentage Change in Price = [(New Price - Initial Price) / Initial Price] * 100

= [(3.00 - 2.50) / 2.50] * 100 = 20%

Now, we can calculate the price elasticity of demand:

Price Elasticity of Demand = Percentage Change in Quantity Demanded / Percentage Change in Price

= (-10% / 20%) = -0.5

In this example, the price elasticity of demand is -0.5. Since the elasticity is less than 1 in absolute value, demand can be considered inelastic. This means that a 1% increase in price leads to a less than 0.5% decrease in quantity demanded.

Based on this information, the coffee shop owner can conclude that increasing the price from $2.50 to $3.00 per cup will likely result in a small decrease in demand. However, since the demand is relatively inelastic, the decrease in quantity demanded will be proportionally smaller than the increase in price, resulting in a potential revenue increase for the coffee shop.

The owner can further analyze different scenarios by adjusting prices and examining the corresponding changes in demand to identify the optimal pricing strategy that maximizes overall revenue and profitability.

With competition increasing in most sectors, understanding your price elasticity can give you the tools to pitch your product competitively.

In summary, a good understanding of price elasticity of demand empowers businesses to make informed pricing decisions, effectively respond to market dynamics, optimize revenue, and gain a competitive advantage.



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