Entrepreneurs, This is the 1 Pricing Principle You Need to Beat the Competition

Businesswomen calculating price elasticity

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Laura Berlinsky-Schine2.3k
May 28, 2024 at 7:33AM UTC

Price elasticity of demand is a measure of how the demand for a product increases or decreases in relation to a change in price. A large change in demand as the result of a small change in a price is deemed perfectly elastic, while a price change that yields no meaningful change in demand is considered perfectly inelastic. 

Meanwhile, as a result of calculating the price elasticity of demand for a product, a company might alter its production accordingly. Price elasticity of supply is the change in production as it relates to the change in the price of a product and is affected by factors such as competitor products and substitutes available, the business’s ability to increase production, stock availability and others.

Examples of price elasticity 

Products that are considered essentials and staples with few or no alternatives, such as subway passes, are typically inelastic. For example, if the price of a New York City Metrocard rises by 10%, the demand is unlikely to fall, because people have no alternative but to use the system to go to work, run errands, come home and so on.

Gasoline is another good example of an item that is typically inelastic. While consumers hate it when the price of gas rises, that’s not going to stop them from buying it, because they need it to drive their cars. Moreover, the rates don’t vary among Shell, Exxon Mobil, Chevron and their competitors, so customers can’t turn to a different gas company to avoid paying steeper prices.

Meanwhile, goods that are non-essential and having plenty of alternatives, such as products with many competing brands, luxury items and other products we don’t actually need, tend to be more price-elastic. If the price of Coke rises by even a small margin, it’s likely that the demand will fall, since consumers can turn to Pepsi or another choice of beverage. This makes it price elastic. Likewise, if a car with similar features as its competitor suddenly decreased in price, demand could increase, making it price elastic as well.

Ultimately, product makers have less control over the price if there are many substitutes on the market, while they have more control if there are few alternatives.

How is price elasticity calculated?

Price elasticity is calculated by dividing the percentage in the change of product use by the percentage of change in the price of the product. In other words:

Price elasticity of demand = percentage change in quantity demanded / percentage change in price of goods

Alternatively, you might want to calculate the price elasticity of supply to change your production strategy. This can be calculated as the percentage change in quantity delivered divided by the percentage change in price of the goods, or:

Price elasticity of supply = percentage change in quantity produced / percentage change in price

Different formulas

Commonly, the Midpoint Method is used to calculate price elasticity. This formula uses average percentage changes for the price and quantity. P1 and P2 are the current and new prices respectively, while Q1 and Q2 are the current and new quantities respectively. The equations are as follows:

Percentage change in quantity = ([Q2-Q1]) / [{Q2+Q1} / 2]) x 100

Percentage change in price = ([P2-P1]) / [{P2+P1} / 2]) x 100

What is a high price elasticity?

Remember, a minimal or very small price change resulting in a large change in the demand indicates perfect elasticity — or high price elasticity — while a price change that results in no change in demand is known as perfect inelasticity. Another type of price elasticity, called unit elasticity, occurs when price and demand change proportionately to one another. For instance, if the price increased by 10%, the demand would then decrease by 10%.

Most economists and others who use these terms and measures describe a price elasticity of higher than 1 as being highly elastic, while a score of less than 1 is considered inelastic. A score of 1 indicates unit elasticity. 

Let’s say, for example, that the price of a certain brand of dishwasher increases by 15%. Meanwhile, the demand drops by 25%. So the formula to calculate price elasticity would be:

0.25 / 0.15 = 1.67

This indicates that the dishwasher has high price elasticity, since it has a score of greater than 1. 

On the other hand, if the price of gasoline rises by 20% and the demand falls by 5%, as per the calculation below, it would have low price elasticity, with a score of 0.25.

0.05 / 0.2 = 0.25

When is it used?

Economists use price elasticity to study how price and price changes affect the supply and demand of given products.

Businesses, particularly the professionals on the marketing side, consider price elasticity when determining how they will price or alter the prices of given products. If they consider how the cost of a product affects the demand, they’ll have a better sense of its value and be able to adjust the price accordingly. Of course, this is just one of many factors the marketing team and entire organization will use when making these decisions, but it can be a highly influential one — after all, they need find ways to increase profit while still remain competitive in the market. 

Product developers can also consider their market research regarding the price elasticity of a given product. They can factor it in when thinking about how to create an or improve an item that consumers will deem worth the price. If they find, for instance, that a competitor’s product saw a considerable fall in demand when they raised the price, they should think about how they can design something that doesn’t see a similar trend.

Finally, the government often considers price elasticity when setting a statutory price control for a given product or service. Public utilities, for example, fall under this umbrella.

Ultimately, price elasticity can be a valuable tool in both studying and predicting market trends and creating pricing strategy. It’s also helpful for estimating the quantity of a given item companies need to produce and can offer valuable insights to organizations across nearly every industry.

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