It shouldn’t come as a surprise that your business’s prices can have a major effect on demand for your products. However, exactly how much impact can depend on various factors. If there are many substitutes for your product, a small change in price can result in a plunge or surge in demand. On the flip side, if you control a significant market share—or make an essential product—consumers might continue buying your goods even if you raise the price.
You can understand this relationship better by measuring how much a change in price changesdemand. This is known as the product’s price elasticity of demand, and it is crucial in helping you determine your business’s pricing strategy.
What is price elasticity?
Price elasticity is how a change in a product’s price changes the supply or demand for that product. A product may be either price elastic (meaning price changes have a major impact on supply or demand) or price inelastic (meaning price changes have minimal effect on supply or demand).
What is price elasticity of demand?
Price elasticity of demand (PED) is the specific measure of how much a change in a product’s price changes the demand.
For example, a price increase for a life-saving patented medication will have little impact on market demand. Customers with no other options for treatment will pay the higher price, indicating that demand is inelastic.
On the other hand, if the price of canned sparkling water increases, there’s a high chance that consumers will switch to a different brand, choose other beverages, or simply drink still water. Demand for sparkling water would then fall, meaning that it is elastic.
How to calculate price elasticity of demand
You can calculate price elasticity of demand using the following formula:
PED = (percentage change in quantity / percentage change in price)
If the result is less than one, you know that demand for your product is relatively inelastic. As the price rises and falls, the impact on the quantity demanded is minimal. If the result is one or more, demand for your product is elastic. As price changes, so does demand.
Let’s say you sell subscriptions to business accounting software for $15 per month, and demand hovers around two million users. After raising prices to $18 per month (a 20% increase), you notice that demand falls to 1.9 million users (a 5% decrease). You can determine price elasticity by plugging the numbers into the formula:
PED = 0.05 / 0.2 = 0.25
Because your price elasticity of demand of 0.25 is less than one, your software has relatively inelastic demand.
Types of price elasticity of demand
Demand for any product falls into one of five categories, although the two at either end of the spectrum are theoretical, as you’ll see:
Perfectly elastic
Perfectly elastic demand occurs when price increases—no matter how small—cause demand for the product to drop to zero. Conversely, any price decreases—no matter how small—causes the quantity demanded to surge infinitely. In real life, this never happens, but the concept of perfectly elastic demand serves as an endpoint for the full spectrum of relationships between price and demand.
Relatively elastic
Relatively elastic demand means that a change in price has an outsize impact on demand. This is typical of goods that are easy to live without and goods that have many potential substitutes. For instance, a modest increase in the price of down pillows might cause a disproportionate number of consumers to switch to pillows with polyester or bamboo fill, or to a different brand.
Unit elastic
Demand for a product is unit elastic if the percent change in price results in an equivalent percent change in demand. Let’s say you sell running shoes for $120 and decide to increase your price by 15%. If demand falls by exactly 15%, your running shoes are unit elastic.
Relatively inelastic
Relatively inelastic demand occurs when a price change results in a smaller change in demand; consumer desire for your product might shift, but not to a significant degree. An example of a relatively inelastic product would be gasoline. A price increase might cause some consumers to drive less, but most consumers would likely continue purchasing the same amount of gas, because they still need to drive to work or go grocery shopping.
Perfectly inelastic
Perfectly inelastic demand occurs when demand for a product remains constant, regardless of changes in price. Like perfectly elastic demand, this type only exists in theory, bookending the opposite end of the spectrum. Goods that approach perfectly inelastic would be those that are essential to life and for which there are no substitutes.
Why does price elasticity of demand matter?
Price elasticity of demand can have a significant effect on your business’s pricing strategy. If you operate in an industry where demand for your product is elastic, you’ll have to find the sweet spot that balances price and demand to maximize your bottom line. Finding this balance may take some trial and error.
For instance, you may discover you can raise your prices without having a major impact on demand, but only up to a point. Once you reach a price where demand for your product starts to dip, you have to assess whether the additional revenue from higher prices outpaces the drop in sales. Eventually, you’ll settle on a comfortable price where any further increase results in lower revenue.
Of course, there are many other factors to consider when setting your price—and if you’re considering the long game, you may not want to start with a price that maximizes profit. In a penetration pricing strategy, you would try to increase demand as much as possible by lowering your prices to undercut the competition. If demand is elastic, considerably more customers will purchase from you in response to the low prices. Once you’ve established market share, you might experiment with raising your prices—and you might find that demand now is relatively inelastic. As consumers become reliant on a specific product, they grow more willing to pay higher prices for it.
If you run a store on Shopify, you can use a variety of price monitoring tools to gauge price elasticity of demand—and you’ll be able to see clearly whether consumers’ willingness to buy your product is elastic or inelastic.
Reverse elasticity of demand
The demand curve, which graphs how demand reacts in response to changes in price, can sometimes move in surprising ways. For example, an increase in the price of a staple good like rice might actually lead to an increase in demand. If a family pays more for rice, cutting into the budget for meat, they might end up buying even more rice to ensure they have enough food for the week. Demand would thus be elastic, but in the opposite direction from the one you might expect. In other words, the demand curve will show that the amount consumers seek increases as the price increases.
In another example, if you sell high-end wine and raise your prices, demand may increase as customers perceive your product as more prestigious and desirable, even though there is no change in the product’s absolute value.
Price elasticity of demand FAQ
How do you know if demand is elastic or inelastic?
You can know whether demand is elastic or inelastic by how it changes in response to changes in price. If you raise your price and demand falls (or if you cut your price and demand rises), you’ll know that demand is elastic. If price changes have minimal effect on demand, then demand is inelastic.
What factors affect price elasticity of demand?
Price elasticity of demand is affected by two significant factors: How essential is the product? And do readily available substitutes exist? If a product is essential and there are few or no substitutes available, demand will likely be relatively inelastic.
What is cross-price elasticity?
Cross-price elasticity of demand measures how much demand for one product changes in response to an increase or decrease in the price of a different product. It’s easy to imagine how an increase in the price of lemons could lead to a higher demand for limes.
