Price is the most important profit lever. Being able to increase price without a loss in demand is more profitable than increasing units or decreasing variable or fixed costs. Unfortunately, demand reacts to price changes, and a price increase – in general – leads to a decrease in demand. Therefore, measuring how customers react to price changes is crucial. This is done using the price elasticity of demand – in short: price elasticity.
In this, and two follow-up blogs, we take a closer look at key facets of price elasticity:
The Good: How in simple cases, price elasticity can be used to maximize revenue or profit.
The Bad: How in most cases, price elasticity cannot be estimated with the necessary precision to be useful for pricing.
And the Ugly: How pricing on price elasticity completely falls apart in a market with multiple products and competition.
Price elasticity describes the relationship between price and demand. It is defined as the ratio between the percentage change in demand and the percentage change in price*. For example, if the price is increased by 1% and consequently demand decreases by 2%, the price elasticity is -2% / 1% = -2.
Let’s see if we can bring these equations to life using a simple example. Assume we operate a lemonade stand and we want to find the ideal price. We offer only one product, a cup of lemonade, and we are the only supplier in town.
We have costs of $0.50 per cup (for lemons, sugar, ice, water and the cup) and from a “Free Trial”, we know the market size is 1,000 cups per day.