What is price elasticity of demand?
The price elasticity of demand is an economic term that measures how a product’s demand changes in response to a change in price. This tool tells economists and producers if a product’s demand increases decreases, or remains unchanged when a price change occurs. It is calculated by dividing the change in quantity by the price setting change.
More precisely, it is the percentage change in quantity demanded when the price increases by 1% while holding all other factors constant (ceteris paribus).
Types of Price Elasticities
There are three significant types of price elasticities. The term is derived from a rubber band’s behavior when stretched.
Elastic price demand occurs when the quantity demanded does not change with a price increase. This type is experienced in goods that consumers cannot do without, such as gas, and food, among other essential goods. However, there may be a significant change in the quantities under extreme price increases.
This response happens when the quantity changes significantly with a price increase. This elasticity is evident in luxury goods, where many individuals opt to reduce the use of the products as they can live without them. This leads to an overall quantity decrease.
It means there are significant shifts in demand when prices change.
Unitary price elasticity of demand is where the quantity changes with the same margin as the change in price. There is no isolated example in this type because the human need is non-linear. Non-linear means that demand by humans does not follow a straight predictive pattern/line.
However, if a seller increases the price of a product by the product manager by $5 and the demand falls by the same margin, then the price responsive rate is unitary.
Application of Price Elasticity of Demand
Price elasticity of demand happens in every business, and it helps companies determine their price change decisions. For SaaS companies, price changes are different and determined by other factors. This means any SaaS company must carefully analyze the situation before instituting price changes.
For such businesses, a price increase may result in both an elastic or inelastic, depending on how clients respond to price changes. If there are cost-effective alternatives in the market, and a company decides to increase the price of its software, the company may or may not notice a change in demand. Some clients may choose to stay depending on the value derived, while others may opt for the competitors.
On the other hand, a start-up company may increase its price majorly to cover increasing overheads and additional costs. For such a company, the price increase may be a standard business procedure but comes with different results, such as changes in demand.
To help mitigate the price increase effects, the company may market itself as offering a unique tool different from other software. However, to make clients stick with you and spend more on your product, you must convince customers your product is worth the additional cost.
Similarly, there are new entrants daily, which leads to an increased supply and altered demand patterns. In this scenario, a business should consider all options before raising prices.
Price elasticity of demand helps businesses determine how consumers respond to price increases. The information further helps a company make informed decisions before increasing a product’s prices.