January 30th, 2013 How price sensitive is my product?
How much will demand change if I raise the price of my product by a dollar?
We get this question. It’s something every business owner has asked and we love answering it! So here we go.
This is called “price sensitivity” or in economics the fancier description is “price elasticity of demand,” which is the name of a formula that economists use to answer this question.
Price Elasticity of Demand (“PED”) is the percentage change in quantity demanded relative to one percent change in price.
PED is almost always negative, which is to say that the higher the price the more demand goes down.
There are only a few items where this is not the case, where when the price goes up people actually want it more (strange, huh?) items like diamonds and luxury cars would be in this category; they are called Veblen goods.
For everyone else though, Price Elasticity is almost always negative. The smaller this number is the more price sensitive your product is. The closer your number is to zero the less price sensitive your product is.
In fact, if PED were zero then it would mean that people want your product no matter how much it cost.
For example, the price elasticity of pediatric visits is about -0.04. That is very close to zero and rightfully so, if our kids are sick we really don’t care how much it cost to make them better. If your product’s number is very close to zero like pediatric visits we call it “Inelastic” — your demand is pretty much constant — people need it. Gas for cars is also very inelastic (-0.09) because when the price of gas goes up, we still buy it because we have to get to work in the morning.
On the other end, items that are “elastic” are items that we really don’t consider a necessity but we still want. Coca-Cola is a great example of this, the PED of coke is about -4.00 which is very far away from zero relative to gasoline or pediatric visits. If people can’t easily afford Coca-cola, they won’t buy it.
So how do I calculate MY price elasticity?
Let’s step through an example.
While there are many ways of determining price elasticity, we will take the easiest route here. Ventata uses a more sophisticated method for evaluating PED, changes in PED, changes in the change of PED and so forth but since we are not machines sitting in a data center somewhere doing math 24 hours a day, we’ll just keep to the basic formulas.
If you aren’t interested in the math, we built Ventata so that you don’t have to worry about any of this. But in case you are curious, let’s dive in:
Price Elasticity of Demand = ((Q2-Q1)/((Q1+Q2)/2))/((P2-P1)/((P1+P2)/2))
Q1 = the number of items sold before the price change.
Q2 = the number of items sold after the price change.
P1 = the first price
P2 = the second price (the price you changed it to)
So if your were selling 100 items at $20/piece and you changed your price to $24 and only sold 50 items then your PED would be -3.67, which is really close to Coke’s -4.00
But lets say that after that same price change, instead of dropping to 50 items sold you only went from 100 to 99 then your PED would be -0.06, which is closer to pediatric visits and gasoline.
Now that you can calculate your own PED you can use this to make more intelligent pricing decisions for all of your products.
Or for about $25 a month we’ll do this analysis and more in real-time on all of your products and change the price to maximize your profit.