Your pricing strategy directly impacts your revenue.
This being the case, it’s essential to understand your product’s price elasticity of demand. This is because it can help you determine whether a price change will have a positive or negative impact on your revenue.
Let’s start at the beginning…
What is the Price Elasticity of Demand?
For most goods and services, the higher the price the less people will buy and vice-versa. The price elasticity of demand refers to the effect on the quantity bought at incremental price changes. In other words, it’s a quantitative measure of consumers’ likelihood to buy at various prices in a particular market.
A market or product that is very elastic would mean a slight change in price results in a very large change in demand. Conversely, a market which experiences little quantity changes in response to even a significant change in pricing is classified as inelastic.
Consider the price elasticity of demand for gasoline:
In this example, a price increase from $1.10 per gallon to $2.50 per gallon only results in a decrease of 2 gallons purchased
This clearly tells us that consumers who purchase gasoline are relatively insensitive in their buying habits to price changes.
This relative insensitivity is classified as an inelastic price elasticity of demand.
The other clear takeaway is that an unscrupulous vendor (especially in cases of a monopoly) can hike prices significantly and continue to increase profits.
In our example, if we think about this in terms of a single sale:
- At the original price of $1.10, 5 gallons were sold for a total of $5.50
- At the new price of $2.50, 3 gallons are demanded resulting in an income for the vendor of $7.50
- The gross difference in revenue is an increase of $2.50
If we then apply this to a much larger scale, assuming a market of 1000 customers per day:
- At the original price the income from 1000 customers purchasing 5 gallons each at $1.10 per gallon equals $5,500.00
- At the new price the income from 1000 customers purchasing 3 gallons each at $2.50 per gallon equals $7,500.00
And if we now consider what that means in terms of revenue for a year:
- At the original price over a period of a year, a vendor would earn $2,007,500
- At the new price over a period of a year that same vendor could earn $2,737,500
- The difference in revenue is an additional $730,000
This is why we have antitrust laws. It’s also why understanding the price sensitivity of your customers in a competitive environment should be a part of your ecommerce pricing strategy.
You can rest assured that your competitors are either aware of theirs, or are actively working to understand it. Which leads us to the next question…
Should You Really Care About Your Price Elasticity of Demand?
While your pricing strategy and experiments may be working, you put yourself at risk each time you make a price adjustment without understanding how your consumers are likely to react, and to what degree. Understanding the price elasticity of any given market allows you to predict the revenue outcomes of your price changes before they happen, rather than simply checking to see whether they worked after the fact.
Given that most products have elastic demand (customers have a high sensitivity to price changes), there may be potential for you to grow your income and increase your market share by implementing incremental price decreases.
On the flip side, where price elasticity of demand exists, you need to be extremely careful to avoid larger increases without very clear data and an understanding of how your sales volumes are likely to decrease as a result.
Price elasticity also allows you to keep track of how competitive your product is within your space. Jill Avery, a senior lecturer at Harvard Business School, has said “[price elasticity] is an important metric to watch because your product may become more elastic if a competitor starts offering compelling substitutes or consumers’ incomes go down, making them more sensitive to price.”
How to Calculate Price Elasticity of Demand
There’s nothing complex behind a basic price elasticity calculation.
The calculated price elasticity will always (in absolute value) be greater than 0, and is most often separated into three distinct ranges.
- 0-1: Markets that fall in this range are defined as inelastic, with large changes in price resulting in small changes in the quantity demanded. Customers in these markets are unable, or uninclined, to switch away from a product despite higher prices. Generally, this reluctance is characterized by a strong need for the product (for example, in the case of insulin for a diabetic) or because of strong ties to the brand itself.
- =1: A price elasticity of 1, also called unit elastic, represent the point where a % change in price is directly matched by an equal % change in quantity.
- 1+ : Elasticities greater than 1 are considered elastic, and small changes in price will result in large swings in the quantity demanded. Products characterized by highly elastic markets are generally ones where there are many substitutes, like bottled water, or where brand affiliation isn’t a consideration.
In the gasoline example, the price elasticity of demand (which we clearly already knew BEFORE making the changes) is therefore:
= 0.31 (inelastic)
A more pertinent example could be a software company that wants to understand if it can increase revenue from its mid-tier offering through a price hike. They conduct a small scale test with a minimal price difference:
- They increase their price per license by 5%, from $100 to $105.
- At the original price they sold 3,000 in a month
- At the new price they sell 2,600 licenses
- This amounts to 13% fewer licenses and a indicates a price elasticity of demand of 2.6 – which is relatively elastic.
While the impact on revenue is a decrease of $270, without knowing their profit margin, we cannot tell if this was a smart move or not. What we can tell is that for this company in this market, customers have no trouble switching between competitors. All else being equal, they don’t care which company they choose. Therefore, experimenting with a price decrease would yield additional results.
If you find yourself in this situation, it could be an indicator that it’s time to make your product less elastic. You can do this either through developing a stronger brand image or by becoming an integral part of your customers’ stacks. That way, even if you do increase your prices, you’ll know that you won’t lose as many customers due to either the loyalty of your base or the stickiness of your product.
Clearly, calculating price elasticity first requires finding out how customers will react to a price change. But by using the data that you already have, you can segment customers by their response to price changes and establish price elasticities from that data. Augmenting your existing data with A/B tests will allow you to further develop a clear price elasticity model for each of your customer segments.
Don’t Just Trust Your Gut
Relying on what you’ve done, old reports and hindsight analytics is an easy way to see pricing mistakes. But learning from these mistakes only suggests what not to do in your market going forward, not the right price to offer.
Often, companies assume that measuring price elasticities is too difficult and rely on their sales people to offer the right price to their clients. But measuring price elasticity isn’t hard and it allows you to predict the impact of your new price on your revenues. As a result, you’ll be able to optimize and come out ahead, instead of trusting your best instincts. Relying on facts and analytics means you are less likely to be leaving money on the table.