price-elasticity

What Is Price Elasticity? Price Elasticity In A Nutshell

Price elasticity measures the responsiveness of the quantity demanded or supplied of a good to a change in its price. It can be described as elastic, where consumers are responsive to price changes, or inelastic, where consumers are less responsive to price changes. Price elasticity, therefore, is a measure of how consumers react to the price of products and services.

Understanding price elasticity

Consumers are sensitive to the price of a product or service when deciding whether to make a purchase decision. While most consumers are more likely to purchase a cheap product and less likely to purchase an expensive product, the role of price in the decision-making process is more nuanced.

Gasoline is one example of a product with inelastic demand. Consumer demand for the product is less responsive to price changes because it is considered a vital commodity. Common products with elastic demand include soft drink, cereal, clothing, electronics, and vehicles. Consumers are more responsive to changes in price because these products are not considered necessities and there are readily available substitutes.

Price elasticity data is valuable to a marketing team. The data enables them to determine how the market will react to price changes to existing products and whether such a reaction will impact the company’s bottom line.

The four types of price elasticity

There are four types of price elasticity, with each used to explain the relationship between two economic variables:

Price elasticity of demand (PED)

A measure of the change in consumption of a good or service in relation to a change in its price.

Price elasticity of supply (PES)

A measure of the change in the supply of a good or service in response to a change in its price.

Cross elasticity of demand (XED)

This is a measure of the change in demand for one good in response to a change in demand for another good.

Income elasticity of demand (YED)

A measure of the change in demand for a good in response to a change in the buyer’s income.

Factors that affect elastic and inelastic demand

In the introduction, we touched on some of the factors affecting elastic and inelastic demand. Let’s take a more detailed look at these below.

Factors affecting elastic demand

Available substitutes

When there are many products of a similar type available, those with a lower price are more attractive than those that are more expensive. Chocolate bars are one example. 

Homogenous products

Similarly, the presence of homogenous products gives consumers more choice and freedom. Demand for insurance is not affected by price increases because there is always a provider offering cheaper premiums.

Lower switching costs

If there are no costs associated with switching products, then demand is less likely to be impacted by price. For example, there is no cost to the consumer in switching to Mercedes if they consider BMW sedans to be too expensive.

Factors affecting inelastic demand

Purchase frequency

Consumers tend to spend more money on one-off purchases such as a new car or smartphone.

Lack of substitutes

If there are no suitable alternatives, then demand tends to be elastic. For example, demand for milk does not change if prices rise by 10% because for most people, there is no substitute.

Geographical location

Some goods and services are inelastic because a company has geographical dominance. In most sports stadiums, food and beverage retailers can raise prices without affecting demand because fans have no choice but to purchase from them.

Basic necessities

Some products are necessary to survival, including medication, electricity, water, and some food items. Demand for these goods and services is unresponsive to price changes.

Key takeaways:

  • Price elasticity is a measure of how consumers react to the price of products and services. It can be described as elastic, where consumers are responsive to price changes, or inelastic, where consumers are less responsive to price changes.
  • Price elasticity data is valuable to a marketing team. This data enables them to determine how the market will react to price changes to existing products and whether such a reaction will impact the company’s bottom line.
  • Factors affecting elastic demand include available substitutes, homogenous products, and lower switching costs. Factors affecting inelastic demand, on the other hand, include infrequent purchasing, a lack of substitutes, geographical location, and whether the product is a basic necessity. 

Read Next: Pricing Strategy.

Connected Business Concepts

Revenue Modeling

revenue-model-patterns
Revenue model patterns are a way for companies to monetize their business models. A revenue model pattern is a crucial building block of a business model because it informs how the company will generate short-term financial resources to invest back into the business. Thus, the way a company makes money will also influence its overall business model.

Pricing Strategies

pricing-strategies
A pricing strategy or model helps companies find the pricing formula in fit with their business models. Thus aligning the customer needs with the product type while trying to enable profitability for the company. A good pricing strategy aligns the customer with the company’s long term financial sustainability to build a solid business model.

Dynamic Pricing

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Price Sensitivity

price-sensitivity
Price sensitivity can be explained using the price elasticity of demand, a concept in economics that measures the variation in product demand as the price of the product itself varies. In consumer behavior, price sensitivity describes and measures fluctuations in product demand as the price of that product changes.

Price Elasticity

price-elasticity
Price elasticity measures the responsiveness of the quantity demanded or supplied of a good to a change in its price. It can be described as elastic, where consumers are responsive to price changes, or inelastic, where consumers are less responsive to price changes. Price elasticity, therefore, is a measure of how consumers react to the price of products and services.

Premium Pricing

premium-pricing-strategy
The premium pricing strategy involves a company setting a price for its products that exceeds similar products offered by competitors.

Price Skimming

price-skimming
Price skimming is primarily used to maximize profits when a new product or service is released. Price skimming is a product pricing strategy where a company charges the highest initial price a customer is willing to pay and then lowers the price over time.

Productized Services

productized-services
Productized services are services that are sold with clearly defined parameters and pricing. In short, that is about taking any product and transforming it into a service. This trend has been strong as the subscription-based economy developed.

Menu Costs

menu-costs
Menu costs describe any cost that a business must absorb when it decides to change its prices. The term itself references restaurants that must incur the cost of reprinting their menus every time they want to increase the price of an item. In an economic context, menu costs are expenses that are incurred whenever a business decides to change its prices.

Price Floor

price-floor
A price floor is a control placed on a good, service, or commodity to stop its price from falling below a certain limit. Therefore, a price floor is the lowest legal price a good, service, or commodity can sell for in the market. One of the best-known examples of a price floor is the minimum wage, a control set by the government to ensure employees receive an income that affords them a basic standard of living.

Predatory Pricing

predatory-pricing
Predatory pricing is the act of setting prices low to eliminate competition. Industry dominant firms use predatory pricing to undercut the prices of their competitors to the point where they are making a loss in the short term. Predatory prices help incumbents keep a monopolistic position, by forcing new entrants out of the market.

Price Ceiling

price-ceiling
A price ceiling is a price control or limit on how high a price can be charged for a product, service, or commodity. Price ceilings are limits imposed on the price of a product, service, or commodity to protect consumers from prohibitively expensive items. These limits are usually imposed by the government but can also be set in the resale price maintenance (RPM) agreement between a product manufacturer and its distributors. 

Bye-Now Effect

bye-now-effect
The bye-now effect describes the tendency for consumers to think of the word “buy” when they read the word “bye”. In a study that tracked diners at a name-your-own-price restaurant, each diner was asked to read one of two phrases before ordering their meal. The first phrase, “so long”, resulted in diners paying an average of $32 per meal. But when diners recited the phrase “bye bye” before ordering, the average price per meal rose to $45.

Anchoring Effect

anchoring-effect
The anchoring effect describes the human tendency to rely on an initial piece of information (the “anchor”) to make subsequent judgments or decisions. Price anchoring, then, is the process of establishing a price point that customers can reference when making a buying decision.

Pricing Setter

price-setter
A price maker is a player who sets the price, independently from what the market does. The price setter is the firm with the influence, market power, and differentiation to be able to set the price for the whole market, thus charging more and yet still driving substantial sales without losing market shares.

Economies of Scale

economies-of-scale
In Economics, Economies of Scale is a theory for which, as companies grow, they gain cost advantages. More precisely, companies manage to benefit from these cost advantages as they grow, due to increased efficiency in production. Thus, as companies scale and increase production, a subsequent decrease in the costs associated with it will help the organization scale further.

Diseconomies of Scale

diseconomies-of-scale
In Economics, a Diseconomy of Scale happens when a company has grown so large that its costs per unit will start to increase. Thus, losing the benefits of scale. That can happen due to several factors arising as a company scales. From coordination issues to management inefficiencies and lack of proper communication flows.

Network Effects

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network effect is a phenomenon in which as more people or users join a platform, the more the value of the service offered by the platform improves for those joining afterward.

Negative Network Effects

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In a negative network effect as the network grows in usage or scale, the value of the platform might shrink. In platform business models network effects help the platform become more valuable for the next user joining. In negative network effects (congestion or pollution) reduce the value of the platform for the next user joining. 

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