What elements do we consider when selecting a product’s price? Is it entirely dependent on customer demand? Firms & marketers are constantly striving to unfold the relationship between sales demand and price fluctuation to find a pricing point that is best for their products. Let us look at price elasticity to reveal the facts behind this relationship.
Price elasticity of demand (PED) is an economic measure representing the responsiveness, or elasticity, of the quantity demanded to the change in the price of a product or service. To simplify, it is the ratio of percentage change in quantity demanded of a product in response to the percent change in its price.
Most markets are sensitive to the price of a product or service, the cheaper the product higher the demand, and vice versa. While this need not be true for all products and services, price elasticity as a quantifiable phenomenon shows precisely how sensitive customer demand can be for a product price. For starters, let us look at questions professionals in marketing try to answer when determining the elasticity of their products:
Let’s look at Coca-Cola to try and understand these concepts. Assuming that a bottle of Coca-Cola regularly costs $1, if the price surges to $2, it will likely result in a dip in demand as most people would consider it expensive. On the other hand, if you drop its price to 10¢, you will notice a significant rise in its demand.
Price elasticity springs from the fundamental economic law of supply and demand:
Price elasticities are usually negative; when our price decreases, our sales demand increases. It makes sense, doesn’t it? However, positive price elasticities are found in rare cases where products do not conform to the law of demand.
Yes, these case scenarios happen when we have Veblen goods. Veblen goods are typically high-quality, exclusive, and a status symbol. Example – Louis Vuitton
The chart above shows that a 33% increase in price point decreases consumer demand by a million, whereas demand doubles if we drop it by 50%.
Price elasticity (E) is the percentage change of an economic outcome (which is generally the number of units sold) in response to a 1% change in its price:
Where:
% Change in Quantity Demanded = (New Quantity – Old Quantity)/Average Quantity,
% Change in Price (P) = (New Price – Old Price)/Average Price
For example, let’s say that a clothing company raised the price of a coat from $100 to $120, and the 20% increase in price caused a 10 % decrease in the quantity sold from 1,000 coats to 900 coats. Formulating these numbers gives you a price elasticity of demand which is 0.5, as mentioned below:
-.10 / -20 = -0.5 or 0.5
We understand the business context of price elasticity and how important it is for every business to maintain a healthy financial sheet. The following operational question is how to solve / implement it. We have used Linear regression, either the Ordinary Least Square (OLS) or Recursive Least Squares (RLS) method, to predict quantity from the price change over time for any specific product.
Where,
β is the beta coefficient (slope). Generally, beta is negative with respect to quantity sold, except for few exceptions where it can be positive.
If additional supporting factors are directly linked with sales, we may utilize them in multivariate linear regression alongside the price variable.
To get the elasticity value of a product, we need to use equation #1 from above:
As price & unit have a linear relationship, beta (dy/dx) will remain constant. Hence, we can use the average value of price & units to get the elasticity score.
Once ready with the price elasticity model, the next step is to apply the business learning to reveal a product’s sensitivity in the market
The above chart shows that the Samsung-65 Class LED TV with a negative price elasticity of -17.68 will have 170.6% more demand with a 10% drop in its price or lose 170.6% of its sales demand with a 10% rise in price.
Whereas the Sony XBR-X850E-Series 75-Class TV with a positive price elasticity of 7.19 will notice a 71.2% drop in its sales demand with a 10% price reduction and a 71.2% boost in sales demand with a 10% increase in its price.
New problems arise the moment you solve a business problem. For instance, what is next? Or is there a better approach? What can we do additionally to improve the implemented solution? The case is the same for price elasticity models. We see that changing the price of a product affects its sales. But what happens with a change in the price of a competitor’s products? The phenomenon that causes a shift in demand for one product from a change in the price of competing products is known as Cross-Price Elasticity. But more on that in the next blog!
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