Price elasticity is the degree to which changes in price impact the unit sales of a product or service. The level of this elasticity controls the degree to which a business can alter its prices. The possible outcomes are:
- Inelastic demand. The demand for a product is considered to be inelastic if changes in price have minimal impact on unit sales volume.
- Elastic demand. The demand for a product is considered to be elastic if changes in price have a large impact on unit sales volume.
A product is more likely to have inelastic demand if customers buy it for reasons other than price. This typically involves high-end luxury goods, or the "latest and greatest" products that are impacted by style considerations, where there are no obvious substitutes for the product. Thus, altering the price of a custom-made watch may not appreciably alter the amount of unit sales volume, since roughly the same number of potential customers are interested in buying it, irrespective of the price (within limits).
A product is more likely to have elastic demand when it is a commodity offered by many suppliers. In this situation, there is no way to differentiate the product, so customers only buy it based on price. Thus, if you were to raise prices on a product that has elastic demand, unit volume would likely plummet as customers go elsewhere to find a better deal. Examples of products having elastic demand are gasoline and many of its byproducts, as well as corn, wheat, and cement.
The key considerations in whether a product will have elastic or inelastic demand are:
- Uniqueness. If there is no ready substitute for the product, it will be more price inelastic. This is particularly true where intensive marketing is used to make the product appear indispensable in the minds of consumers.
- Percent of income. If something involves a significant proportion of the income of the consumer, the consumer is more likely to look for substitute products, which makes a product more price elastic.
- Necessity. If something must be purchased (such as a drug for a specific medical condition), then the consumer will buy it, irrespective of price.
- Duration. Over time, consumers will alter their behavior to avoid excessively expensive goods. This means that the price for a product may be inelastic in the short term and increasingly elastic over the long term. For example, the owner of a fuel-inefficient vehicle will be forced to pay for higher gasoline prices in the short term, but may switch to a more fuel-efficient vehicle over the long term in order to buy less fuel.
- Payer. People who can have their purchases reimbursed by someone else (such as the company they work for) are more likely to exhibit price inelastic behavior. For example, an employee is more likely to stay at an expensive hotel if his or her company is paying for it.
Clearly, inelastic demand gives a great deal of room in price setting, whereas elastic demand means that the appropriate price is very well defined by the market. However, products having inelastic demand tend to have smaller markets, whereas products with elastic demand can involve much larger sales volume. Thus, a company pursuing a strategy of only selling products with inelastic demand is also limiting its potential sales growth.
From a practical perspective, companies are most likely to set prices based on what competitors are charging for their products, modified by the perceived value of certain product features. Price elasticity can also be used to fine-tune prices, but it is still more of a theoretical concept than one that has practical applicability.
The Price Elasticity of Demand Formula
The formula for the price elasticity of demand is the percent change in unit demand as a result of a one percent change in price. The calculation is:
% Change in unit demand ÷ % Change in price
A product is said to be price inelastic if this ratio is less than 1, and price elastic if the ratio is greater than 1. Revenue should be maximized when you can set the price to have an elasticity of exactly 1.
For example, ABC International wants to test the price elasticity of demand for two of its products. It alters the price of its blue widget by 3%, which generates a reduction in unit volume of 2%. This indicates some inelasticity of demand, since the company can raise prices while experiencing a smaller offsetting reduction in sales.
ABC then tests the price inelasticity of its purple widget by altering its price by 2%. This results in a reduction in unit volume of 4%. This indicates considerable elasticity of demand, since unit sales drop twice as fast as the increase in price. In this case, the company clearly has little ability to raise prices.