Price Elasticity of Demand

Elasticity is a measure of responsiveness or sensitivity. It is the most commonly used measure

of the responsiveness of quantity demanded to changes in any of the variables that influence
the demand functions.Price elasticity of demand is the ratio of the percentage change in
quantity demanded to the percentage change in price, assuming that all other factors
influencing demand remain unchanged. Also called own price elasticity. 
Price Elasticity = % change in Quantity / % change in Price
Examples: A percentage change from 100 to 150  is 50%; A percentage change from 150 to 100
is -33%
When demand is unit elastic, a percentage change in price P is matched by an equal
percentage change in quantity demanded QD. When demand is elastic, a percentage change
in P is exceeded by the percentage change in QD. For inelastic demand, a percentage change
in P results in a smaller percentage change in QD.

 
PRICE ELASTICITY OF DEMAND:
ELASTIC PRICING MODEL AND
STRATEGY
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 a considerable amount of 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 an economic measurement of how quantity demanded of a

good will be affected by changes in its price. In other words, it’s 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).. I know equations are negative

amounts of fun, but this one is super simple. 

 
How to Calculate Price Elasticity of Demand
Price Elasticity of Demand = (% Change in Quantity Demanded)/(% Change in Price)

Since 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. It’s important to

note, however, 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, revenue will be

maximized when the price elasticity of a good equals 1, or in other words, when demand is unit

elastic.

Let's break it down with some 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. 

Price and demand typically head in the opposite direction, but the demand curve varies greatly
based on product (and, in particular, 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 $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. The pizza, and food
in general, tends to be elastic, where even slightly higher prices may cause a change
in demand. 
How can you increase demand and prices 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. Are you selling 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 percents, 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 through 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 income was halved (B2C), what about our offering makes us the last
thing they cut out of their lives? 

2. Availability of 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
vaccuum 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 of money. 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 cost, 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),
then you’re sure to notice.
For your products, you can take advantage of the actual number on the sticker 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 price of oil rises in the short run (say, tomorrow), people would grumble
over breakfast for a couple days but still fill their tanks. In the long run, however, people might
buy hybrids or smaller cars that use less gas. 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
though, prices have become more competitive and Rackspace has lost some of their lower end
customers. Carbonite also faces this phenomenon with the number of back up 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 
Total Revenue (TR)  and Elasticity

The price elasticity of demand indicates immediately the effect a change in price will have on
the total revenue (TR) = total consumer expenditure.

TR =  Price (P) x Quantity Demanded (QD)

When demand elasticity (ED) is less than 1 in absolute value (i.e., inelastic), an
increase (decrease) in price will result in an increase (decrease) in (P · QD). This occurs
because an inelastic demand indicates that a given percentage increase in price results in a
smaller percentage decrease in quantity sold, the net effect being an increase in the total
expenditures, P · QD. When demand is inelastic—that is, |ED| < 1—an increase in price from $2
to $3, for example, results in an increase in total revenue from $18 to $24. 

In contrast, when demand is elastic—that is, |ED| > 1—a given percentage increase (decrease)
in price is more than offset by a larger percentage decrease (increase) in quantity sold. An
increase in price from $9 to $10 results in a reduction in total consumer expenditure from $18
to $10 (again, see Table 3.3).
When demand is unit elastic, a given percentage change in price is exactly offset by the same
percentage change in quantity demanded, the net result being a constant total consumer
expenditure. If the price is increased from $5 to $6, total revenue would remain constant at
$30, because the decrease in quantity demanded at the new price just offsets the price
increase. When the price elasticity of demand |ED| is equal to 1, the total revenue function is
maximized. 
Total Revenue and Elasticity of Demand

Studying elasticities is useful for a number of reasons, pricing being the most important.
Imagine that a band on tour is playing in an indoor arena with 15,000 seats. To keep this
example simple, assume that the band keeps all the money from ticket sales. Assume further
that the band pays the costs for its appearance, but that these costs, like travel, setting up the
stage, and so on, are the same regardless of how many people are in the audience. Finally,
assume that all the tickets have the same price. (The same insights apply if ticket prices are
more expensive for some seats than for others, but the calculations become more
complicated.) The band knows that it faces a downward-sloping demand curve; that is, if the
band raises the price of tickets, it will sell fewer tickets. How should the band set the price for
tickets to bring in the most total revenue, which in this example, because costs are fixed, will
also mean the highest profits for the band? Should the band sell more tickets at a lower price or
fewer tickets at a higher price?

The key concept in thinking about collecting the most revenue is the price elasticity of
demand. Total revenue is price times the quantity of tickets sold (TR = P x Qd). Imagine that the
band starts off thinking about a certain price, which will result in the sale of a certain quantity
of tickets. The three possibilities are laid out in Table 1. If demand is elastic at that price level,
then the band should cut the price, because the percentage drop in price will result in an even
larger percentage increase in the quantity sold—thus raising total revenue. However, if demand
is inelastic at that original quantity level, then the band should raise the price of tickets,
because a certain percentage increase in price will result in a smaller percentage decrease in
the quantity sold—and total revenue will rise. If demand has a unitary elasticity at that
quantity, then a moderate percentage change in the price will be offset by an equal percentage
change in quantity—so the band will earn the same revenue whether it (moderately) increases
or decreases the price of tickets.
If demand is . . . Then . . . Therefore . . .
% change in Qd is  A given % rise in P will be more than offset by a larger % fall
in Q so that total revenue (P times Q) falls.
Elastic greater than % change  A given % fall in P will be more than offset by a larger rise in
in P Q so that total revenue (P times Q) rises.
% change in Qd is  A given % rise or fall in P will be exactly offset by an equal %
Unitary
equal to % change in P fall in Q so that total revenue (P times Q) is unchanged.
 A given % rise in P will cause a smaller % fall in Q so that total
% change in Qd is less revenue (P times Q) rises.
Inelastic  A given % fall in P will cause a smaller % rise in Q so that total
than % change in P
revenue (P times Q) falls.

If demand is elastic at a given price level, then should a company cut its price, the
percentage drop in price will result in an even larger percentage increase in the quantity
sold—thus raising total revenue. However, if demand is inelastic at the original quantity
level, then should the company raise its prices, the percentage increase in price will
result in a smaller percentage decrease in the quantity sold—and total revenue will rise.

Let’s explore some specific examples. In both cases we will answer the following
questions:

1. How much of an impact do we think a price change will have on demand?

2. How would we calculate the elasticity, and does it confirm our assumption?
3. What impact does the elasticity have on total revenue?

Have you been at the counter of a convenience store and seen cookies for sale on the
counter? In this example we are going to consider a baker, Helen, who bakes these
cookies and sells them for $2 each. The cookies are sold in a convenience store, which
has several options on the counter that customers can choose as a last-minute impulse
buy. All of the impulse items range between $1 and $2 in price. In order to raise
revenue, Helen decides to raise her price to $2.20.
If Helen increases the cookie price from $2.00 to $2.20—a 10% increase—will fewer
customers buy cookies?
If you think that the change in price will cause many buyers to forego a cookie, then you
are suggesting that the demand is elastic, or that the buyers are sensitive to price
changes. If you think that the change in price will not impact sales much, then you are
suggesting that the demand for cookies is inelastic, or insensitive to price changes.
Let’s assume that this price change does impact customer behavior. Many customers
choose a $1 chocolate bar or a $1.50 doughnut over the cookie, or they simply resist
the temptation of the cookie at the higher price. Before we do any math, this assumption
suggests that the demand for cookies is elastic.
Adding in the numbers, we find that Helen’s weekly sales drop from 200 cookies to 150
cookies. This is a 25% change in demand on account of a 10% price increase. We
immediately see that the change in demand is greater than the change in price. That
means that demand is elastic. Let’s do the math.