What is price elasticity?

Price elasticity is a valuable measure that reveals how the changing price of your product affects consumer demand. Products that are elastic see the biggest shift in demand when prices change. Products that are inelastic are typically unaffected by changes in cost.

Price elasticity is calculated using a formula that compares the change in demand for a product at different prices.

Why is price elasticity important for small businesses?

All businesses want to drive sales. Once you know the elasticity of your product, you can:

• Determine how the market is likely to respond to a price increase or decrease
• Adjust prices to maximize revenue
• Forecast sales

Price elasticity helps you make informed decisions. If your product is elastic, for example, you know that a price increase can reduce your sales. If your product is inelastic, you may be able to increase your price and still maintain stable sales. This may make it possible to pass a tax or shipping costs to your customers without affecting revenue.

Factors that affect elasticity

The elasticity of a product depends on a number of factors and can change over time. You need to consider why a product is elastic or inelastic and plan your strategies accordingly.

• Competition: People have little choice but to purchase from a company with a monopoly, so products with less competition tend to be inelastic. A price increase doesn’t change demand significantly.
• Availability of similar products: When the price is raised on a common item like a candy bar or soft drink, demand can drop dramatically. It’s easy for consumers to opt for another brand they see as equivalent. If your product is highly elastic, you may need to differentiate your product.
• Brand loyalty: Popular brands such as Adidas can withstand price increases compared to lesser known brands. Businesses can try to change the elasticity of a product through marketing strategies that build brand affinity.

How is price elasticity calculated?

Price elasticity is the percentage change in demand divided by the percentage change in price. Most products have a price elasticity between 0.5 and 1.5.

Products with a price elasticity higher than 1 have elastic demand and tend to be affected by price changes. The higher the number, the more elastic a product is. Products with an elasticity of less than 1 are relatively inelastic.

Types of price elasticity

Relatively elastic

When price elasticity is greater than 1, a change in price results in a higher than proportional change in demand. These products have elastic demand.

Examples:

• Products that are desired but not necessary, such as high-end cars
• Items whose purchases can be delayed, like big-screen TVs
• Products for which there are many substitutes, such as clothing, candy bars and soft drinks

Relatively inelastic

When price elasticity is less than 1, a change in price results in little change in demand. These products have inelastic demand.

Examples:

• Necessities like medicine, grocery staples, fuel, rental housing
• Products that are limited in supply, such as diamonds or real estate in expensive cities
• Products that are habit forming, like cigarettes
• Brands that inspire loyalty, such as Apple

Unitary elasticity

When price elasticity is equal to 1, a change in price has a proportional change in demand. For example, a product with unitary elasticity typically has a 1% change in sales corresponding to a 1% change in price.

Perfectly inelastic and perfectly elastic

There are two theoretical extremes: perfectly inelastic and perfectly elastic demand.

• A product with an elasticity of 0 is perfectly inelastic, because a price increase has no effect on demand. These are products that are essential or have no competition, so businesses can set any price for them.
• A product with infinite elasticity is a perfectly elastic product. These products experience an infinite change in demand when the price changes.

Formula for calculating price elasticity

To calculate the price elasticity of your product, you need to know:

• Quantity of the product sold at the original price
• Quantity of the product sold at the new price

1. Determine the percentage change in demand

Subtract the demand for the product at the new price from the demand for the product at the original price. Divide this figure by the demand for the product at the original price.

Written as a formula, the change in demand is:

• (Quantity sold at original price) – (Quantity sold at new price) / Quantity sold at original price

2. Determine the percentage change in price

Subtract the new price of the product from the original price of the product. Divide this figure by the original price.

Written as a formula, the change in price is:

• (Original price) – (New price) / (Original price)

3. Calculate the price elasticity of demand

Divide the percentage change in demand by the percentage change in price.

• (Change in demand) / (Change in price)

Don’t worry about positive or negative signs. The absolute value is the price elasticity.

Sample calculations of price elasticity

Example #1

A business that sells organic pies drops the price of its product from $10 to $9. Because of the discount, sales increase from 80 to 92 pies.

• The percentage change in demand is: (80 – 92) / 80 = -0.15
• The percentage change in price is: ($10 – $9) / $10 = 0.10
• The price elasticity is: -0.15/0.10 = -1.5

The pies have a price elasticity of 1.5, which means this product is highly elastic or affected by price changes.

Example #2

A popular toy company increases the price of its product from $40 to $44. This results in a slight drop in sales from 100 to 95 toys.

• The percentage change in demand is: (100 – 95)/100 = 0.05
• The percentage change in price is: ($40 – $44)/$40 = -0.10
• The price elasticity is (0.05/-0.10) = -0.5

The toys have an elasticity of 0.5, which means this product is relatively inelastic and not dramatically affected by price changes.

Frequently asked questions about price elasticity of demand

What does high price elasticity mean?

A product that has high price elasticity is easily affected by changes in price. An increase in price can result in a dramatic drop in demand, and a decrease in price can result in a dramatic increase in demand.

What products have high price elasticity?

Two types of items have high price elasticity.

• Commonly available goods such as pencils, cereal, pizza, t-shirts and electronics. A company that raises its prices on these products is likely to see a drop in demand because there are many similar brands available.
• Non-essential items that are highly desired but not a necessity, such as jewelry or high-end name brands. A price drop for a coveted brand such as Nike or Apple is likely to create a demand among consumers who may now find these products more affordable.

Is milk elastic or inelastic?

Milk is considered inelastic. Most consumers consider it a necessity and buy it regardless of price fluctuations. The average price elasticity of milk is 0.59, according one study.