Price elasticity: A short primer

In various blog posts, I have asked the readers to base their pricing decisions on elasticity. In this post, lets try to understand the term better.

Lets start with a mental exercise. Imagine you increase the price of your product by 1%. What happens next?

If the sales volume decrease by 2%, then the price elasticity of your product is 2. Such a product would be called an elastic product. If the volume decrease is less than 1%, then the product would be called inelastic. A company finds it easy to increase prices if its products are inelastic.

#1 Definition:

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Some times, there may be a volume increase even after a price increase. This is especially true for prestige goods. For now, lets stay away from these exceptions. Coming back to our example, lets assume that we have done some study and arrived at a price-volume formula that looks like this.

                        Volume = 10,000 – 60*Price

Currently if the price is $100, then we are selling 4,000 units of the product. If we increase the price to $101, then the volume will change to 3940. This is a volume change of 60 units which is 1.5% of the 4,000. So the price elasticity of this product is 1.5.

#2. Types of Elasticity: The sales volume may change not just because of your price changes. It may also change due to other factors such as change in the price of competitor’s product or change in your advertising spend. Specificalyt, the price change of competitor’s product is an important consideration. It is called cross price elasticity. 

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#3. Is elasticity symmetric? Elasticity is not symmetric. The volume increase due to price reduction need not be equal to volume decrease due to equivalent price increase. However, in a narrow range a symmetric price elasticity is a reasonable assumption.

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With cross price elasticity, we should not make the same assumption. The volume decrease of your product due to price decrease of competitor’s product would not be equal to the volume decrease of competitor’s product if you were to decrease your prices by equivalent amount. Every product has different value perception owing to their brand image. So the number of customers who switch will not be symmetric.

#4. Where do you get the data from? Now the million dollar question.  While all the formula makes sense, how do we gather the data to build the equation? The data can come from three sources.

  • Past transactions: Some industries such as travel, retail, hotels have rich data of past transactions. With adequate care you can normalise the data for all other factors and build a demand model that helps you calculate the price elasticity.

  • Market Study: In the absence of internal data, you can conduct a market study. It could be as simple as a survey on price preference or a bit more ambitious one like a conjoint analysis.

  • Test: If the purchase is done primarily online, then one can conduct an A/B test. Some buyers can be shown higher prices while others see lower prices. Their purchase and click behaviour can give insights to build the demand model. However, you have to be cautious while conducting such tests. In a few instances which involved large retailers like Amazon, it has ballooned into a controversy where the buyers felt that they were being discriminated against.  

#5. Should I change my price if price elasticity is not equal to 1? : Not really. Elasticity is only the beginning. Any price change needs some further analysis and alignment to over all strategy. I will cover them in another blog post.

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