Understanding Price Elasticity and Its Use in Companies

Determining the right price for your product or service is a difficult thing. This is one of the crucial things that must be done by marketers because it has an impact on company profits. An important element of pricing is understanding price elasticity.

What is Price Elasticity?

In general, most customers in many markets are sensitive to the price of a product or service. The assumption is that more people will buy a product or service if it is cheaper and fewer people will buy it if the product is more expensive.

However, the phenomenon can be measured more than a theory because the price elasticity shows exactly how responsive customer demand is to a product based on price. Price elasticity or price elasticity is the ratio of the percentage change in the quantity of an item demanded to the percentage change in the price of the good itself. Marketers need to understand their product when thinking about setting or changing prices.

You need to understand how elastic a product is, its sensitivity to price fluctuations, or inelasticity, as well as how much ambivalent about price changes. Some products have a much quicker and more dramatic response to price changes, because they are usually considered good to have or unimportant, or because many substitutes are available.

How to calculate it?

Here is the formula for the price elasticity of demand:

Price elasticity of demand = Percentage change in quality demanded

Percentage change in price

For example, a business that sells clothing increases the price of one of its jackets, from Rp. 100,000 to Rp. 120,000, so the price increase is 20%. Then the price increase caused a decrease in the number of jackets sold, from 1,000 jackets to 900, so the decrease in demand decreased to -10%. If you put it into the formula for the price elasticity of demand it becomes:

-10% = - 5 or 5

20%

Note that negative numbers are usually ignored and the absolute value of the number is used to interpret the price elasticity metric. The magnitude of the distance from zero is important and not positive or negative. The higher the absolute value of the number, the more sensitive the customer is to price changes.

There are five zones of elasticity for products and services:

Perfectly elastic or perfectly elastic where every very small change in price results in a very large change in quantity demanded. Most of the products that fall into the ono category are pure commodities. There is no brand, no product differentiation, and the customer has no meaningful attachment to the product.

Relatively elastic or relatively elastic where a small change in price causes a large change in the quantity demanded (the result of the formula is greater than 1). Beef is an example of a relatively elastic product (because it can be replaced with chicken or mutton).

An elastic unit in which every change in price is offset by an equal change in quantity (the sum equals 1).

Relatively inelastic where a large price change causes a small change in demand (the sum is less than 1). Gasoline is a good example here because most people need it, so even if prices go up, demand doesn't change much. Products with stronger brands also tend to be more inelastic, suggesting that building brand equity is a good investment.

Perfectly inelastic or perfectly inelastic, namely when the quantity demanded does not change, our price changes. Products in this category are the things that consumers really need and there is no other choice to get them. This can be seen from the case where the company has a monopoly on demand.

Marketers need to know where their product/service is on this spectrum, but the actual number is less important than knowing where your product/service is and what will happen if the price changes.

How do companies use it?

It is one of the key metrics for marketing managers to create products and services that have unique and sustainable value for customers compared to other options available to them in the market. Price elasticity is a way to measure performance. Highly elastic products are considered commodities by consumers.

The goal of marketers is to move their products/services from relatively elastic to relatively inelastic. It does this by creating something different and meaningful to the customer. Through branding or other marketing initiatives, companies increase consumer demand for products and their availability to pay regardless of price.

Keep in mind that price elasticity is not the only factor in how well you market. It is also affected by the types of products you sell, the incomes of your target consumers, the health of the economy, and what your competitors are doing.

What are some common mistakes managers make with price elasticity?

Many businesses assume that they understand the full picture based on their experience pricing their products in the market. More extreme price changes can lead to significantly different consumer responses.

However, it is difficult to determine how it will play out in the market because price elasticity is a dynamic concept. What consumers have historically been willing to pay for a particular product may not necessarily be what they are willing to pay on the same terms today or in the future.

Therefore, elasticity is often an imprecise calculation. One way that can be done is with A/B testing in the market. Release your product at a new price point and see what demand arises, then compare it to the same product at different prices.

To get the most accurate pricing, it is important to consider market competition, consumers, and cost elements. It also gives weight to the challenges in pricing that can be learned through the Marketing Pricing Strategy for stakeholders.