New technology tends to come down in price, but almost everything else goes up over time. This creates a dilemma when you're selling a product or service: You know your costs are likely to rise, but it's hard to know if you can pass these costs along to your customers. The decision is much easier when your product or service is something your customers must have, regardless of what it costs.
What is Inelastic Demand?
Elasticity, a term used by economists, is a measure of a product’s price sensitivity. You need to know if demand rises and falls with price, or holds steady when you are pricing your products and services. If demand doesn't flex as the price rises, it's inelastic. The price is immaterial because there is no lower-cost alternative available, or because the customer will make the purchase, no matter what the price is.
Examples of Inelastic Goods
Some specialized pharmaceuticals are an example of a product with inelastic demand. If you have the only effective medication for a specific condition, you can charge any price you like, and your customers will have no choice but to pay it. Table salt is a more common example. Like the medication, there's no substitute for salt. If you need salt and the only place to get it is a convenience store, you'll pay the convenience-store price rather than do without.
The demand for products might also be impervious to price changes if a product is inexpensive and rarely needs replacing, such as table salt. Another example of elasticity is addictive substances that are legal for sale, such as tobacco. Smoking is on the wane, but someone who smokes will pay for cigarettes even if the price increases.
What is Elastic Demand?
Products or services that have available substitutes are usually much more sensitive to price differences. Economists call this elastic demand. You can find examples by looking at weekly sales flyers from your local stores. Everything from furniture and canned soup to tools for your workshop falls into this category. If brand A is on sale for less than brand B, it can sway customers’ buying decisions. A few brands command a premium over their competitors including Heinz ketchup, Snap-on tools and Apple cellphones. These popular brands know exactly how much of a premium they can charge before it starts to drag on their sales.
Calculating Price Elasticity
The elasticity of demand is an important economic concept. You can calculate price elasticity by dividing the change in demand by the change in the price of a product. For example, if a 20 percent increase in price caused sales to drop by 40 percent, divide 0.40 by 0.20. The price elasticity of demand (PED) in this case is 2. A PED of 1 or greater in either direction means the product is elastic. If your price increased by the same 20 percent but sales dropped by only 5 percent, your product is inelastic. The calculation is -0.05 divided by 0.20, resulting in a PED of -0.25.
Applying the Price Elasticity Concept
If you have existing data on your customers’ buying patterns, you can calculate the PED to learn which products are price-sensitive. But, for new products or services without data or competitive product comparisons, you need to do a bit of digging.
While pricing data for high-profile products such as Apple iPhones and Tesla electric cars are well-known, data for everyday products is less accessible. You’ll have to research industry publications, news releases or competitors' financial statements for data. If you estimate their comparable product’s PED, you’ll have a grasp on its price sensitivity. With this information, you can more effectively price your own products.
Fred Decker learned business fundamentals at second hand as an insurance and mutual funds broker, and at firsthand as a retail store manager and the chef/proprietor of his own restaurants. He has written hundreds of business-related articles for sites including Zacks.com, Chron.com, Vitamix.com, Bizfluent and GoBankingRates and many others. He was educated at Memorial University of Newfoundland and the Northern Alberta Institute of Technology.