Setting the right price for your product or service is hard. In fact, determining price is one of the toughest things a marketer has to do, in large part because it has such a big impact on the company’s bottom line. One of the critical elements of pricing is understanding what economists call price elasticity.
To better understand this concept and how it impacts marketing, I talked with Jill Avery, a senior lecturer at Harvard Business School and an author of HBR’s Go To Market Tools.
What is price elasticity?
Most customers in most markets are sensitive to the price of a product or service, and the assumption is that more people will buy the product or service if it’s cheaper and less will buy it if it’s more expensive. But the phenomenon is more quantifiable than that, and price elasticity shows exactly how responsive customer demand is for a product based on its price. “Marketers need to understand how elastic, sensitive to fluctuations in price, or inelastic, largely ambivalent about price changes, their products are when contemplating how to set or change a price,” says Avery.
“Some products have a much more immediate and dramatic response to price changes, usually because they’re considered nice-to-have or non-essential, or because there are many substitutes available,” explains Avery. Take for example, beef. When the price dramatically increases, demand may go way down because people can easily substitute chicken or pork.
How is it calculated?
This is the formula for price elasticity of demand:
Let’s look at an example. Say that a clothing company raised the price of one of its coats from $100 to $120. The price increase is $120-$100/$100 or 20%. Now let’s say that the increase caused a decrease in the quantity sold from 1,000 coats to 900 coats. The percentage decrease in demand is -10%. Plugging those numbers into the formula, you’d get a price elasticity of demand of:
Note that the negative is traditionally ignored and the absolute value of the number is used to interpret the price elasticity metric, as it’s the magnitude of distance from zero that matters and not whether it’s positive or negative.
“The higher the absolute value of the number, the more sensitive customers are to price changes,” explains Avery. As she explains in her “Marketing Analysis Toolkit: Pricing and Profitability Analysis,” there are five zones of elasticity. Products and services can be:
- Perfectly elastic where any very small change in price results in a very large change in the quantity demanded. Products that fall in this category are mostly “pure commodities,” says Avery. “There’s no brand, no product differentiation, and customers have no meaningful attachment to the product.”
- Relatively elastic where small changes in price cause large changes in quantity demanded (the result of the formula is greater than 1). Beef, as discussed above, is an example of a product that is relatively elastic.
- Unit elastic where any change in price is matched by an equal change in quantity (where the number is equal to 1).
- Relatively inelastic where large changes in price cause small changes in demand (the number is less than 1). Gasoline is a good example here because most people need it, so even when prices go up, demand doesn’t change greatly. Also, “products with stronger brands tend to be more inelastic, which makes building brand equity a good investment,” says Avery.
- Perfectly inelastic where the quantity demanded does not change when the price changes. Products in this category are things consumers absolutely need and there are no other options from which to obtain them. “We tend to see this only in cases where a firm has a monopoly on the demand. Even if I change my price, you still have to buy from me,” explains Avery.
Marketers should know where their products fall on this spectrum, but “the actual number is less important than knowing which zone your product falls within and what will happen to consumer demand if you change your price,” she says.
How do companies use it?
This is one of the key metrics for marketing managers, says Avery. “Our job is to create products and services that have unique and sustainable value for customers compared with other options available to them in the marketplace. Price elasticity is a way for us to measure how we’re doing in that regard,” she explains. “If my product is highly elastic, it is being perceived as a commodity by consumers.” It tells you how effective you are at marketing your products to consumers.
“A marketer’s goal is to move his or her products from relatively elastic to relatively inelastic,” she continues. “We do that by creating something that is differentiated and meaningful to customers.” When, through branding or other marketing initiatives, a company increases consumers’ desire for the product and their willingness to pay regardless of price, it’s improving the company’s standing compared with competitors. But it can go the other way. “It’s an important metric to watch because your product may become more elastic if a competitor starts offering compelling substitutes or consumers’ incomes go down, making them more sensitive to price,” says Avery.
Keep in mind that price elasticity isn’t just a factor of how well you’re marketing. It is also affected by the type of product you’re selling, the income of your target consumers, the health of the economy, and what your competitors are doing. “You can’t look at it in isolation,” says Avery. “You have to look at it in context of the industry and its competitive structure and in the context of consumers’ lives.”
As you may have figured out, this is a number that you can only calculate for certain after you’ve made an actual price change and seen the resulting impact on demand. And to be truly certain, you’d have to change your price multiple times to see what would happen at each price point. This is not what companies tend to do in practice. Rather, they send out questionnaires, run focus groups, or perform small-scale experiments in certain markets, to give them a sense of what would happen if they changed their price.
While it’s important to understand the price elasticity of your product or service, much more often, in corporate contexts, people talk about price sensitivity in a more qualitative way, explains Avery. You’ll hear managers say, “my product is price sensitive” or “we’re lucky to have a product that’s not sensitive to price.” Elasticity is not the same thing as sensitivity, she warns. “Sensitivity is more of a qualitative concept where elasticity is a quantitative one. But they are closely related.”
What are some of the common mistakes managers make with price elasticity?
Many managers assume they understand the full picture based on their experience pricing their products in the marketplace, that they know how consumers will respond to almost any price change, explains Avery. But rarely have companies tested extreme price changes. More likely, a company has a small sample of consumer responses to certain price changes, such as what happens when price is raised or lowered by 5-20%. More extreme changes in price may elicit significantly different consumer responses. “The math isn’t complicated,” she says, “but it’s tough to pin down 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 is not necessarily what they are willing to pay today or tomorrow.
Therefore, elasticity can often be an inexact calculation. “It’s impossible to know what customers will do at every price point or in the marketplace,” Avery says. Sure, marketers can get a good sense of willingness to pay from survey responses, but “the challenge is that what people say they will do is not what they actually do when they are standing at the shelf.” It’s better, she suggests, to do a in-market A/B test, to put your product out at the new price point and see what the demand is, and compare it to the same product at a different price. That’s how you’ll get the most accurate information. Avery points out that in a digital context, this is easy and inexpensive to do. “You can put your product up at $10 and two minutes later change it to $2, and then sit back and see the resulting consumer response,” she says.
But it’s not just about figuring out the right number; you need to understand consumer behavior as well. “You could run market tests every day,” says Avery, “but you also want to understand why consumers are acting the way they are. Understanding the why behind consumer behavior is critical to predicting how they will respond in the future.” That information will inform your marketing efforts. Therefore, smart marketers supplement any quantitative testing with qualitative research to get at the underlying reasons for consumer behavior.
It’s also important to keep in mind that understanding the price elasticity of demand for your product doesn’t tell you how to manage it. “As a marketer, I want to understand my current price elasticity and the factors that are making it elastic or inelastic, and then to think about how those factors are changing over time,” explains Avery. Ultimately, you want to stay relevant to consumers and differentiated from your competitors. Once you do that, you can adjust price up or down to better represent the level of value you are providing to your customers. Your current price elasticity is just one data point that helps you make those future decisions.
Read refreshers on net present value, breakeven quantity, debt-to-equity ratio, and cost of capital.
