Choosing the right price for each product can be a difficult task. Following our last post on dynamic pricing, it seems important to cover price elasticity, which plays a huge role in price optimization in e-Commerce. If you’ve ever taken an Econ 101 course in college, you have probably calculated price elasticity. Determining the price elasticity for your products allows you to run better tests and make informed pricing optimization decisions.
What is Price Elasticity?
It’s assumed that more customers will buy a product when it’s cheaper, and less will buy it when it is expensive. This follows the basic principles of supply and demand and nearly always holds true. But how many more people will buy when you lower the price? How many fewer people would buy that same product if you raised the price? The price elasticity of demand is a concept that answers this question.
Price elasticity attempts to show exactly how responsive demand is for a product, based on how it is priced. When contemplating a pricing change, understanding how elastic or inelastic your products are is critical. Elastic products are sensitive to changes in price. Inelastic products are not sensitive to changes in price and demand. Knowing the elasticity of products can help you to improve pricing tests and find your optimized price quickly.
Some products are clearly elastic, and show immediate and sometimes dramatic responses to changes in price. There are many reasons why a product may sell well at one price, but not so well at even a slightly higher price. Some of the common reasons why a product may be price elastic include:
- The pricing change has placed the product above average market value. If you increase the price of an item above that of your competition, sales may decline. With some very elastic products, that decline may be substantial for even a modest price increase.
- The item is non-essential. Non-essential items are typically elastic and sensitive to changes in price. With non-essential products, there may be a price point where consumers refuse to buy.
- There are other substitutes readily available. If the price of the PlayStation 4 were to rise by $250, more consumers would opt to purchase the XBox One. When substitutes are available at lower prices, elastic products will see huge fluctuations in sales figures.
Now, all products are elastic to some extent. You’d be hard-pressed to find a product that doesn’t see its sales figures shift when prices rise or fall dramatically, but certain products are necessary to consumers regardless of price. Gasoline, for instance, is a popular example of a product with inelastic demand. When gasoline prices rise, the demand for the product may decrease slightly, but not by much.
How is Price Elasticity Calculated?
Here is the most common formula for calculating price elasticity of demand:
Price elasticity of demand = Percentage change in quantity demanded / percentage change in price.
Let’s use this formula in an example. Let’s say that a furniture company increased the price of a table from $300 to $360. This is a price increase of 20%. You would expect this substantial hike to result in fewer sales.
Now let’s pretend that this price change resulted in a change in quantity sold from 100 units to 70 units. The percentage of demand decrease is -30%. Now, using the formula let’s solve for the price elasticity of demand:
-.30 / .20 = -1.5.
In this example, the price elasticity of the table is 1.5. The negative is ignored and the absolute value is used to represent price elasticity. It is the distance from zero that we are interested in measuring. When a product has a higher price elasticity value, customers are more sensitive to changes in price for that product.
Testing Price Elasticity with Product Advertising
Product advertising is an excellent way to run price elasticity tests. Experienced eCommerce companies likely have a good idea which of their products are elastic and which are inelastic, but running tests can return some surprising results.
In fact, search engine product advertisements may be the best way to test elasticity. With an understanding of price elasticity, you can use that data to inform more tests to determine optimal pricing for your products. There are a few reasons why product advertising makes an excellent testing ground:
- Fast results. Product advertising generates results much more quickly than waiting for customers to organically find your products and purchase them. You can quickly generate elasticity data by increasing your advertising spend on specific items.
- Easily controlled variables. You can set specific ads to run at certain times during the day, week, or month. You can ensure that outside influences play as little role in the sales process as possible.
- Automation. With tools, you can automate the testing of price elasticity and even price optimization among hundreds or thousands of products at a time. This data can provide huge returns and with automation, cost very little.
Discounting a product helps you to acquire more customers, but the question is where the optimal return lies. Let’s take a look at an example. Let’s assume that the product in this example has a per-unit cost of $50.
After testing a product’s pricing, you generated the sales figures outlined in the graph. At your highest price of $120, you generated 10 sales. At your lowest price of $80, you generated 60 sales. This is a 600% increase in sales. This example shows us that this product is price elastic, in that its sales are sensitive to changes in pricing. But which price point generated the most profits?
While discounts will certainly help you to acquire more customers or get rid of excess inventory, it also greatly decreases your margins, affecting your profits. So, based on the tests run in this example, which pricing level would be optimal? To figure this out, we have to look at the profit generated at each price point.
The test showed that the product generated the most profit at a $90 pricing. Of course, there are many variables that have to be considered before you can accept this as the true optimized price for the item, but it does provide you with an excellent starting point for further testing.
Factors such as the time of year, time of day, and traffic source all play a critical role in how products sell. eCommerce companies should do their best to control these variables. Product advertising allows you to control these variables and limit outside influences. Ideally, you should test items at different prices until you reach statistical significance to determine optimal pricing.
You can also factor in your Advertising Cost when you calculate Price Elasticity. Our tests have shown that as you raise your prices, you will need to spend more advertising budget to achieve the same impression volume. This additional budget should be another factor in your profit analysis.
Using Price Elasticity to Inform Optimization Testing
The real value in understanding the price elasticity of products in eCommerce is the data that it provides. Understanding how elastic your products are allows you to make better testing decisions for each product. Items with a higher elasticity will have to undergo a wider range of tests to determine optimized price, while inelastic (or less elastic) products have a much smaller potential pricing window.