Price Elasticity

What is Price Elasticity?

Price elasticity describes how much the demand for a product or service changes when its price is altered.

It can be either elastic (responsive to price changes) or inelastic (unresponsive to price changes).

In other words, it measures how sensitive consumers are to price increases and decreases—the basics of which can be explained using a supply and demand curve.

Several factors impact how elastic or inelastic the demand for a product is:

• Availability of substitutes (i.e., the number of competing products or services on the market)
• Proportion of income spent on a product or service by consumers
• Necessity of the product (i.e., whether it is a “want” or a “need”)
• Urgency in the moment of purchase
• Length of time since the price change (i.e., whether consumers have had enough time to adjust to the new price)

Price elasticity plays a significant role in price optimization and discount management for all businesses. Demand may drop drastically when prices are too high, decreasing revenue and profits. When prices are too low, there is no incentive to buy more products or services, and sales remain stagnant.

Synonyms

• Price Elasticity of Demand
• Price Elasticity of Supply
• Price Sensitivity

Understanding Price Elasticity of Demand

Price elasticity of demand is the economic concept that measures how consumers respond to price changes.

Economists and businesses have discovered that some goods and services are inelastic—a price increase doesn’t hurt demand, and a price reduction or sales discount won’t boost demand much.

Other products are the opposite—even small changes in pricing can dramatically impact sales and revenue.

The potential to drive revenue growth through pricing means this concept is an integral part of a successful business strategy.

In a sense, a business’s main goal is demand inelasticity. And they can achieve that through brand loyalty, product differentiation, and creating customer value through meaningful services.

The Importance of Price Elasticity of Demand

Understanding and considering price inelasticity of demand is crucial when creating a pricing strategy, as it can affect a business’s sales, revenue, and profits.

The more elastic the demand for a product or service is (i.e., the more sensitive consumers are to changes in price), the more likely it is that businesses will adjust their pricing strategies in order to optimize their profits.

On the other hand, when demand is inelastic (i.e., consumers are not sensitive to changes in price), businesses won’t need to adjust their pricing strategies as drastically to keep up with market demand.

Regardless of the level of elasticity, understanding how demand for a product responds to changing prices is crucial for businesses to maximize profits.

Types of Price Elasticity of Demand

There are five types of price inelasticity of demand. They are categorized based on the number calculated from the price elasticity equation.

• Perfectly Inelastic: The demand does not change regardless of the price—the elasticity is 0.
• Inelastic: The demand is slightly but insignificantly affected by changes in price—the coefficient lies between 0 and 1.
• Unit Elasticity: The demand is affected in the same proportion as the price—the coefficient is 1.
• Elastic: The demand is significantly affected by price changes—the coefficient is greater than 1.
• Perfectly Elastic: Price changes result in demand dropping to zero—the elasticity coefficient is infinite/unlimited.

Perfect elasticity and inelasticity are theoretical concepts. In reality, every good or service is somewhat elastic or inelastic, and some are closer to one side of the spectrum than the other.

How to Calculate Price Elasticity of Demand

The basic elasticity formula for price elasticity of demand is as follows:

For example, if the demand for a product falls by 20% and the price increases by 10%, the calculation would be:

The result is -2, which means that the demand for this product is elastic. There will a decrease in quantity demanded equal to two times the rise in price.

Example of Price Elasticity of Demand

The airline industry is a prime example of fluctuating price elasticity of demand.

Depending on the time of year and destination of the flight, demand could be either elastic or inelastic.

For example:

• During holidays, airline pricing increases, as does the demand for travel. Since travel is more of a necessity during these times, the demand is inelastic and consumers will pay more for a flight.
• On weekdays, airline pricing decreases, and demand also tends to be lower. Since travel is less common on weekdays, raising prices would result in fewer people booking flights, meaning the demand is elastic.

Airlines determine their pricing using pricing engines, which are sophisticated computer systems that factor in supply and demand to optimize the price and maximize profits.

Pricing engines adjust prices multiple times a day based on numerous variables, such as the number of seats available, flight dates/times, market competition, etc.

Understanding Price Elasticity of Supply

Price elasticity of supply describes the responsiveness of a good or service’s supply to a change in its price.

According to the Law of Supply, more people will make or sell a product when its price goes up. This means that there will be more of the product available, and people can buy it.

When product pricing goes down, fewer people make or sell it, so there is less of it available to buy.

When the supply of a product is elastic, an increase in price will cause a significant increase in supply.

If the supply of that product is inelastic, that same increase in price will not result in much of an increase in supply.

In short, price elasticity of supply shows how quickly a producer can shift its production levels to meet consumer demand.

If a producer can’t keep up with increasing demand, prices will continue to rise with demand in perpetuity as the product becomes more scarce.

The Importance of Price Elasticity of Supply

Price elasticity of supply is important for different reasons than price elasticity of demand.

While the latter affects how much consumers are willing to pay for a product, the former affects how quickly and efficiently producers can meet that demand.

If producers can’t adjust their production levels quickly enough, there could be a shortage of products in one area or an oversupply in another.

The relationship between elasticity of supply and demand is a delicate balance that can help businesses maximize profits while ensuring they meet customer needs. 

This is why it’s important for producers to understand their price elasticity of supply—it helps them make better decisions about production plans and pricing strategies to achieve revenue optimization.

Types of Price Elasticity of Supply

Price elasticity of supply can be broken into five main categories described by its respective price elasticity formula.

• Perfectly Inelastic: When the supply doesn’t change, no matter how much the price fluctuates (e.g., precious metals, bitcoin, and other finite resources), the coefficient is zero.
• Relatively Inelastic: When the supply changes slightly with a dramatic change in price, the coefficient is between 0 and 1. Goods that are relatively inelastic in this sense include nuclear power, natural gas, and electricity, which require a high degree of know-how to set up.
• Unit Elastic: When the percentage change in supply equals the percentage increase or decrease in price, the coefficient is 1. This type of elasticity applies to most manufactured goods, from cars and electronics to furniture and clothing.
• Relatively Elastic: When the supply changes more than proportionally with a change in price, the coefficient is greater than 1. When a product is in this category, it means that producers can ramp up their production levels to meet demand. Many food items fall into this category since they can be manufactured quickly and on a large scale.
• Perfectly Elastic: When the supply is endless, it isn’t responsive to price changes. In these cases, the coefficient is infinite. As such, you will never find an example of perfect elasticity in the real world. However, some digital goods, such as software and music downloads, come close.

How to Calculate Price Elasticity of Supply

The formula for calculating this is similar to that of price elasticity of demand.

For example, let’s say the price of a product goes up by 10%, and the supply increases by 15%. The price elasticity of supply for that product is 1.5 (15 / 10).

This number indicates that the supply is relatively elastic—it has increased more than proportionally with the price increase.

Examples of Price Elasticity of Supply

• Diamonds are an interesting example of price elasticity of supply.
• Diamonds are not rare, but their supply is closely controlled by a few large companies.
• These companies have used their market power to keep diamond prices artificially high.
• But diamonds have poor resale value. And with a worldwide increase in wealth levels and reductions in poverty levels, more and more people are buying them.
• In normal cases, this would cause an increase in quantity supplied, but because of the tight control of diamond producers, the supply does not match demand.
• The tight market control has resulted in a relatively inelastic supply curve for diamonds—the manufacturers cannot increase production to meet the increased demand.
• This helps explain why diamond prices have stayed high despite the increase in demand, and why their value on the secondary market is so low.

Elasticity in Practice: Step-by-Step Workflow

Price elasticity guides real business decisions. The following workflow shows how companies use elasticity to set prices strategically:

Total Revenue Test

The Total Revenue Test is a practical method for interpreting price elasticity and understanding how changes in price affect a company’s revenue. It links the concept of elasticity directly to revenue outcomes, helping businesses make informed pricing decisions.

What It Is

The Total Revenue Test examines whether total revenue rises or falls when the price of a product changes. Total revenue is calculated as:

Total Revenue=Price×Quantity Sold\text{Total Revenue} = \text{Price} \times \text{Quantity Sold}Total Revenue=Price×Quantity Sold

By observing how revenue responds to a price change, businesses can determine whether demand for a product is elastic or inelastic.

How It Relates to Elasticity

• If demand is elastic (elasticity > 1), a price increase leads to a proportionally larger drop in quantity sold, causing total revenue to decrease.
• If demand is inelastic (elasticity < 1), a price increase results in a smaller drop in quantity sold, so total revenue rises.
• If demand is unitary elastic (elasticity = 1), a price change does not affect total revenue.

Example

Imagine a software subscription priced at $100 per month with 1,000 subscribers:

If the company raises the price to $120 and the number of subscribers drops to 900:

In this case, total revenue increased, indicating that demand is relatively inelastic. This insight can guide future pricing strategies, helping the business maximize revenue without losing too many customers.

Price Elasticity in Practice

Understanding price elasticity isn’t just an academic exercise; it has real, strategic implications for businesses. By analyzing how sensitive customers are to price changes, companies can make more informed decisions about pricing, revenue, and growth strategies.

Using Elasticity for Pricing Strategy

Businesses can tailor their pricing based on the elasticity of their products or services. For highly elastic products, small price increases may lead to significant drops in demand, so companies often focus on competitive pricing or promotional strategies. For inelastic products, price changes have a smaller impact on demand, allowing businesses more flexibility to adjust prices without losing customers.

Implications for Revenue Optimization and Forecasting

Price elasticity informs revenue projections and helps anticipate how price adjustments affect overall sales. By understanding elasticity, companies can optimize revenue by identifying the price points that maximize total revenue and avoid pricing decisions that inadvertently reduce income. This is especially valuable for subscription-based or recurring-revenue models, where small price changes can compound over time.

When to Raise or Lower Prices

Elasticity analysis helps determine the optimal timing for price changes. For products with inelastic demand, businesses may consider raising prices to boost revenue without a significant drop in sales. Conversely, for products with elastic demand, lowering prices or offering discounts may increase sales volume and market share. The key is aligning pricing decisions with customer sensitivity and broader business objectives.

Industry Examples of Price Elasticity

Price elasticity varies widely across industries, depending on factors like necessity, availability of substitutes, and customer sensitivity to price changes. Understanding these differences helps businesses make smarter pricing decisions.

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