Price Elasticity - Relationship between Price and Demand

Price Elasticity or Price Elasticity of Demand is measure of relationship between demand of products/services and their prices.  For example, how price of tomato will impact its demand?

 

Price Elasticity Curve

 

In a mathematics formulation

Price Elasticity of a Product = % Chance in Demand /% Change in Price

Since, typically change in demand and price in inversely linked, Price Elasticity Coefficient has a negative sign. But the sign of coefficient is not considered only level of coefficient is important.

Meaning of key level of Price Elasticity Coefficient

Price Elasticity Coefficient =0: No change in demand or Price does not influence demand of a product. It is an example of perfect Inelastic Demand.

Price Elasticity Coefficient <1:  Low change in Demand given a change in Price. Again this is a case of inelastic demand. For example, tomato prices has gone up by 50% but demand is reduced only by 20%. This could be a scenario for essential goods and impact of price fluctuations on the demand is very low.

Price Elasticity Coefficient >1: Significant higher change in demand for a given change in Price. This indicates that Price has impact on Demand and level of impact will be measure by Price Elasticity Coefficient.

Type of relationship between Price and Demand may not be a linear relationship. For a given scenario, Price Elasticity curves have to be plotted to understand the relationship.

Applications of Price Elasticity

Concept of Price Elasticity is used across industry and functional areas.

  • Price Elasticity of Marketing: Price is one of the key Market Mix Elements which could be used by the Marketers to influence demand. Examples of Price Elasticity in Marketing for Banking and Retail
    • Banking -% Interest Rate on Mortgage Product: Most of the banks and mortgage lenders use interest rate (Price) on new home loans as a lever to create demand and acquire customers.
    • Retailer - % discount on MRP: Most of the retailers and especially e-retailers (such as Amazon, Flipkart and Myntra in India) are increasing demand/sales by giving discounts (Price) on the list of products.
  • Price Elasticity by Regulation: Regulators across globe use Price (Interest Rate) as a lever to control demand of products and services. For example, Reserve Bank of India use interest rate (base rate and reverse repo rate) to control credit growth and inflation (which is also linked to demand of the products).
  • Price Elasticity for Optimal Pricing: Price impacts demand/sales and margin. Organizations wants to price at a point which balances between sales volume and margin. For example, in Forex or Currency Exchange – if an organization gives better rate, it will create more sales but it will take a hit on margin. So, Price Elasticity Modeling is used to find an optimal value of price for Forex products.

Other important aspects in Price Elasticity is “Time Gap”, how much time it takes to impact the Demand and this especially important in regulatory scenario.  And next one is at what level of Price, for example after a reduction of prices a further reduction may not result in any additional demand.

Any of the analytics tools can be used for building Price Elasticity Models and a list of regression models can be used for building Price Elasticity Model.

Price elasticity model using excel: An example of Price Elasticity simulation using excel 

Price elasticity model using SAS: Auto regression modeling example for Price Elasticity Modeling 

Price elasticity model using R: A retail example of how Price is impacting Sales for difference products and regression using R is used for building Price Elasticity Model.

4 thoughts on “Price Elasticity - Relationship between Price and Demand”

  1. The above Link using R is not working.If u have other links regarding Price Elasticity model,Please share it.

    Thanks.

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