# Understanding Price Elasticity of Demand

Understanding PED is crucial for a business when pricing a new product or re-pricing an existing product because it informs how its customers will react to certain price points and what the best price is for revenue maximisation. PED also enables a business to effectively forecast sales as it displays how sales volumes are impacted by changes in price. Conjoint.ly uses PED in preference simulations for conjoint and in Gabor-Granger studies.

## Definition and formula

Price elasticity of demand (PED) is a measurement of how quantity demanded is affected by changes in price, i.e. it shows how demand for a product increases or decreases as its price increases or decreases. PED is calculated by comparing two values:

$$\textrm{Percentage change in quantity} = \frac { Q_2 - Q_1 }{ (Q_2+Q_1)/2 }$$

and

$$\textrm{Percentage change in price} = \frac { P_2 - P_1 }{ (P_2+P_1)/2 }$$

The full formula is:

$$\textrm{PED} = \frac { Q_2 - Q_1 }{ (Q_2+Q_1)/2 } / \frac { P_2 - P_1 }{ (P_2+P_1)/2 }$$

This is called the midpoint method to calculate elasticity because it uses the average percent-change in both quantity and price. It is more useful than calculating elasticity with simple percentage changes as elasticity will hold the same between two price points regardless of if price increases or decreases.

## Values of elasticity

The PED of a product is determined by the responsiveness of quantity demanded in relation to changes in price, and can be described as:

• Elastic (when elasticity of demand is less than -1; for example, -2 or even just -1.1): In this case, an increase in price by 1% leads to more than 1% drop in volume. It often means you should “price low”.

• Unit-elastic (when elasticity of demand is very close to -1): In this case, an increase in price by 1% leads to exactly 1% drop in volume. In this case, it is necessary to consider your margins before making a pricing decision.

• Inelastic: (if elasticity coefficient is between -1 and 0): In this case, an increase in price by 1% leads to less than 1% drop in volume. It usually means you should “price high”.

• Positive: (if elasticity coefficient is greater than 0): It is a common misconception that price and quantity demanded are almost always inversely related as customers prefer lower prices. This is not always the case as price-quality inference can strongly influences certain audiences’ purchasing decisions. IN the case of positive elasticity, an increase in price leads to an increase in volume. It generally means you should “price high”.

## Interpreting PED

When interpreting a price elasticity chart, the price elasticity of demand curve shows customers’ willingness to pay for your product at different price points. The steeper the demand curve, the more price-sensitive customers are in relation to your product.

For example, the below chart shows that the optimal price for the product is \$25 and the demand curve suggests that customers are price sensitive.

### Factors impacting PED

There are several common factors which often influence whether a product is likely to have elastic or inelastic PED, such as:

• Uniqueness: Products with few or no alternatives have a greater likelihood of being inelastic. For example, new products are more likely to be inelastic and can be priced higher. Once competitors enter the market and demand becomes more elastic, prices will need to be lowered.

• Essentialness: Products which consumers deem as necessary are more likely to be inelastic as they are willing to pay more to obtain them. For example, bread and milk are considered essential by many so consumers but products such as soft drink and chocolate are considered more ‘optional’ and with elastic demand.

• Loyalty: Products which are driven by brand loyalty are more likely to have inelastic demand as loyal consumers are usually not as price sensitive.

### Find your product’s PED today:

• Generic Conjoint - Feature and claim selection and measuring willingness to pay for features for a single product.

• Brand-Specific Conjoint - Feature and claim selection and pricing in markets where product characteristics vary across brands, SKUs, or price tiers.

• Gabor-Granger - Determine price elasticity for a single product and identify revenue-maximising price level.