Price elasticity of demand

What it means

Price elasticity of demand expresses by how many percent the quantity sold changes when the price changes by one percent. If a 10 % price rise cuts sales by 20 %, elasticity is −2 and demand is elastic. If sales fall by only 3 %, elasticity is −0.3 and demand is inelastic.

Elastic demand is typical of products with many substitutes and easy price comparison, such as everyday consumer goods in online stores. Inelastic demand applies to necessities, products without substitutes and services where the customer cares more about trust and convenience than price, such as accounting or machine servicing.

Elasticity is not a fixed property of a product. It changes with the price level, competition, season and customer segment. The same product may have different elasticity for small firms and for corporations, which is why prices are often differentiated by segment.

How it works in practice

In pricing elasticity is decisive: with inelastic demand a price rise increases both revenue and profit, with elastic demand it may reduce revenue. What counts, though, is margin, not just revenue. Even with a slight drop in volume, a higher price can bring more profit if the contribution margin per unit grows.

Measuring elasticity precisely is hard because many things affect sales at once. Smaller companies are best off finding it by experiment: changing the price for a limited time, for one segment or in one channel, or running an A/B test of the price list on the website, and comparing with the period before.

When raising prices because of rising costs, we recommend calculating how far sales could fall before the increase stops paying off. That point can be worked out from the margin and helps decide whether to raise prices at once, gradually, or instead reshape packages and the content of the service.

What to watch out for

A common mistake is estimating elasticity from the gut feeling of salespeople, who naturally overestimate customers’ price sensitivity. Companies then sell more cheaply than they need to for years. Experience shows that with quality services and loyal customers demand is usually less elastic than it seems.

The opposite risk is relying on inelastic demand where competitors can react quickly. A price rise that boosts profit in the short term can drive customers to a competitor for good, and lowering the price again will not bring them back.