June 11th, 2021
11 min read
Price elasticity of demand is one of the most critical metrics for retail businesses. Understanding the correlation between price changes and consumers’ reactions will help you optimize your price strategy and win customers’ loyalty.
“Profit for a company is like oxygen for a person. If you don’t have enough of it, you’re out of the game. But if you think your life is about breathing, you’re really missing something.”Peter Drucker
“Profit for a company is like oxygen for a person. If you don’t have enough of it, you’re out of the game. But if you think your life is about breathing, you’re really missing something.”
Price elasticity is a factor of how customers’ demand for a given product changes in relation to the product’s price. If your product is elastic, it’s sensitive to price changes, whereas if your product is inelastic, it’s not sensitive to price changes.
The most well-known form of price elasticity is demand elasticity, which means that the higher the product’s price, the fewer consumers will buy it. Many economists call this type of price elasticity the most “safe” form of predicting consumer behavior.
The price elasticity differs from product type to product type and can be different for the same product at different consumption levels.
As a rule of thumb, the price elasticity is 1.0 for most products.
Everyday products that typically have few alternatives (here, we do not mean variants of products) have a lower elasticity; it can be basic food products. Products with many alternatives, or which are not essential, have a higher elasticity. Products considered luxury products, or where the purchase can be easily postponed, often have an elastic demand. However, more and more products are becoming more elastic as, over time, more alternatives appear on the market.
A good example of how price affects demand is the streaming service Netflix. Customers appreciate more streaming services right now due to the coronavirus pandemic, where social distance and restrictions have characterized our daily lives. Customers’ perceptions of prices and the value of streaming have changed significantly, which is confirmed in a study by Simon-Kucher.
What customers care most about regarding Netflix is the breadth of content available, access to the latest releases, and the price is in the 4th place of priority. However, this is not enough to give concrete recommendations regarding optimization of prices, as there is a lack of a more representative study. Still, it provides a good starting point for streaming providers, emphasizes Simon Kucher.
Do you want to know if your customers will buy more when prices fall or buy less when prices rise? You can do this by calculating the elasticity of your products.
The basic calculation formula looks like this:
Nielsen, a business analyst organization, has recently calculated the price elasticity for 10,356 products to see where it makes sense to make price changes.
Almost half of the products they investigated had a price elasticity of 2 or more.
To predict consumer behavior, economists use this formula to calculate consumer sensitivity to price changes. The advantage is that it indicates the proportional change in demand and price. If a 1% drop in product price causes a 1% increase in demand for the product, demand elasticity equals 1.
COVID-19 has changed consumption behavior to such an extent that some products have, according to consumers, gained a higher value. A clear example is the increased popularity of streaming services during corona. People have been affected by the restrictions and different everyday lives, resulting in having more time for entertainment services. The price elasticity for Netflix, and other streaming services, has fallen a lot in the last three years, according to a study conducted by the consulting firm Simon-Kucher. More precisely, the price elasticity has fallen from 0.6 to 0.13.
Customers react to price changes. Therefore, it’s alpha and omega that you know the price elasticity of your products and continuously follow up on whether the price elasticity changes to see if your products become more or less price sensitive. In addition, you probably know how difficult it can be to price the products in one’s e-Commerce. With an insight into how elastic or inelastic the goods are, you can strategically start working with pricing, thus increasing your earnings.
To use price elasticity as a helpful metric in your retail business, you need to learn how consumers react to price fluctuations. It’s not easy, and there might be a lot to learn if you are just starting. We have made it easy for you with our market monitoring tool to manage your prices.
With a tool like PriceShape, you can look at your own and your competitors’ sales trends, which can help you review the price elasticity of your products more easily and quickly. This valid data will enable you to make accurate decisions about prices and not rely on gut feelings. In addition, you can set up automatic pricing rules, so you save time on manual work with pricing.
In a price monitoring tool, you will get help for making intelligent decisions when testing the prices of your products and continuously optimizing the prices where you are competitive. It can be challenging to find the most optimal price for products with high elasticity, which means you will have to do more tests on these products. The opposite is true for products with inelastic prices.
Such knowledge can significantly help you to adjust supply and offer the correct prices to increase revenue.
Here are three ground rules about price elasticity that you should be looking out for when working with pricing your products online:
“81% of consumers are willing to pay for a better experience”capgemini.com
“81% of consumers are willing to pay for a better experience”
After all, price elasticity is only one part of the data that helps you make better decisions about your prices.
You can’t look at it isolated as the price is always placed in the context of the industry, its competitive structure, and in the context of consumers’ life.
PriceShape can help you to transform your work with pricing into an accessible and straightforward process as it relies on solid data. Get an insight into what PriceShape can help you with by booking a demo today.