Thanks to online retail, it’s never been easier to compare prices for goods and services. For businesses, it’s vital to charge the right price to stay competitive, and to understand the relationship between pricing and customer demand (known as price elasticity of demand).
In this article, we’ll provide a definition of price elasticity of demand, and explain how understanding it could help you maximise revenue.
Understanding the price elasticity of demand
When a business changes the price of a commodity and there’s a resulting change in demand, then the commodity is considered to be ‘elastic’, says economist and financial consultant Tom Koesternen, whose practice has supported growing companies since 2013. “Most consumer goods are elastic, and a change in price will change demand for that product or service,” he says. “If a commodity’s price doesn’t significantly affect demand, that would be said to have inelastic demand.”
Understanding price elasticity can be helpful to an SME because it shows how attached customers are to a product, and how likely they are to switch to another product if the price changes. This information can help your business to find the right pricing strategy for a product.
Factors that affect the price elasticity of demand
Availability of substitutes
If your customers have easy access to a number of similar products or services, this will affect the price elasticity of demand. For example, “if the cost of one brand of tea bags increases, people can easily switch to another brand. If the price of tea leaves goes higher, people can easily switch to coffee,” says Koesternen.
Urgency
Some products have more elastic pricing if there's an urgent demand. Simply put, customers are less sensitive to pricing if they need to repair their car today, or they want next-day delivery of a new sofa.
Duration of price change
Customers who are used to buying a particular commodity may not switch suppliers if a price increase lasts for a short period, but over time if lower-price alternatives are available, this could impact the price elasticity of demand.
Nature of the product
“Goods can either be necessities, comfort or luxurious goods,” says Koesternen. “A necessity good such as food will tend to have inelastic demand. Comfort goods like washing machines have an elastic demand because their consumption can be postponed when the price increases. Luxury goods, like diamonds, have high elasticity of demand.”
Income level
Another key factor is the price level in relation to your customers’ income. Low-priced goods will tend to have a lower price elasticity of demand, while something more expensive will not. “Matchboxes tend to be less elastic than mobile phones,” says Koesternen. “A change in the price of a matchbox will not force it into the costly price segment, while a decrease in the price of a mobile phone can make them more affordable.”
Price elasticity of demand example
For a taxi company, petrol is essential for business. Petrol could increase in cost by 20% and have very little impact on how much demand for the product exists from the business. The price elasticity of demand is inelastic. However, it is not perfectly inelastic: at some point, the change in pricing will start to affect demand. Should the price of petrol increase by 100% in a short period of time, demand would likely fall as the taxi company might switch to alternative fuels.
How to calculate the price elasticity of demand (formula included)
Price elasticity of demand is the ratio of the percentage change in quantity demanded relative to the percentage change in price, expressed as a positive or negative figure. The formula is:
Price Elasticity of Demand = % Change in Quantity Demanded/ % Change in Price
For example, a pair of headphones increases in price by £5, from an initial price of £100, and demand quantity falls by 2 million units from an initial 20 million units.
The quantity demanded has fallen by 10% and the price has risen by 5%, so the price elasticity of those headphones is (−10%)/(+5%) = −2. This negative figure of -2 suggests a relatively inelastic demand for the headphones.
This is because a figure of below 0 suggests that demand is relatively inelastic, while the higher a figure is above 0 the more elastic demand is said to be. A lower score indicates that consumers will buy the product or service even if the price changes, and vice versa.
Types of price elasticity of demand
Let’s look at the different categories of price elasticity of demand, and what they mean.
Perfectly inelastic demand
The price of a product or service has no impact on the demand.
Relatively inelastic demand
A shift in pricing leads to a relatively smaller change in demand: a 20% increase in price leads to a 10% decrease in demand.
Unit elastic demand
A shift in pricing is equal and proportional to the shift in demand: a 10% increase in price leads to a 10% decrease in demand.
Relatively elastic demand
A change in price that causes a greater than proportional change in demand.
Perfectly elastic demand
A change in price results in demand declining to zero.
How to define cross price elasticity of demand?
Sometimes changing the price of one product or service can impact demand for another product or service. This can be expressed using cross elasticity of demand, which measures the percentage change in quantity demand after a price change in another product or service. The formula is:
XED (Cross Price Elasticity) = % increase in Cost for Product A / % Increase in Demand for Product B
For example, if there is a 10% increase in the cost of cheddar cheese, and a corresponding increase in demand for blue cheese of 5%, then the cross elasticity of demand would be expressed as:
XED = 10%/ 5% = +2
How does the price elasticity of demand affect the total revenue of a supplier?
Price elasticity of demand can help suppliers to maximise revenue by setting prices effectively.
Wedding cake supplier Little Button Bakery tracks average industry prices for wedding cakes to judge the elasticity of price demand. This is hugely important in a sector like food and drink, where the cost of ingredients has increased in recent years. “The cost of eggs, butter and sugar has increased by 40% in the last two years, and it’s important to understand how much of that increase we can pass on to customers before it starts to have an impact on demand,” says Kate Tynan, the company’s founder. “There isn’t a lot of elasticity in pricing for wedding cakes, and at a certain point, people will look for cheaper alternatives, whether that’s a cheaper baker, having a friend make the cake, or choosing something like doughnuts or cheese instead of a wedding cake.”
In recent years, average order values at Little Button Bakery have hit £850, a 20% increase over pre-pandemic figures, says Tynan. While part of this increase is possible because of price elasticity, Tynan has also made a point of maximising value for customers. “We’ll do things like bundle cake stand hire rather than charging for that, and we also stress that we have more experienced decorators and more industry awards than companies that charge lower prices,” she says.
Another way to cover short-term price increases when selling products with inelastic demand is to use your American Express® Business Gold Card for purchasing supplies. You get up to 54 days¹ to clear your Card balance, so you can keep your money in the account for longer and get more flexibility in your cash flow. Plus, you can earn Membership Rewards® points every time you spend², which you can reinvest back into your business.
1. The maximum payment period on purchases is 54 calendar days and is obtained only if you spend on the first day of the new statement period and repay the balance in full on the due date. If you'd prefer a Card with no annual fee, rewards or other features, an alternative option is available – the Business Basic Card.
2. Membership Rewards points are earned on every full £1 spent and charged, per transaction. Terms and conditions apply.
