In the dynamic and competitive landscape of the Consumer Packaged Goods (CPG) and retail industries, pricing and promotions play a pivotal role in driving sales and revenue. To make informed decisions that optimize pricing strategies and promotional activities, professionals in these industries need a solid understanding of consumer behavior. That's where the concept of elasticity of demand comes into play.
This is the first brief post of Kuona 101, a series that aims to review the most crucial and relevant concepts, ideas, and theories related to Pricing, Trade Promotions, and Revenue Management overall. The central idea behind this series is that no concept should be considered basic to the extent that it doesn't deserve our time. On the contrary, all concepts deserve our time and attention, given the evolving world we live in.
In this post, we will explore the definition and types of elasticity of demand, and how it helps businesses anticipate and adapt to market dynamics. By grasping the concept of elasticity, pricing and promotions professionals can effectively determine optimal pricing levels and design promotions that resonate with their target customers.
Let's embark on a journey to uncover the essence of elasticity of demand and discover how it empowers pricing and promotions in the CPG and retail industries.
What is Elasticity of Demand?
First, we need to understand what elasticity means in economics. Elasticity is the responsiveness of one economic variable to other factors. How much a change in one factor affects others.
If you came here looking for what is elasticity of demand, here is its definition: Elasticity of demand is the quantification of consumer demand’s sensitivity to fluctuations in market factors, such as price, income, cross-prices, and even advertising expenditure.
What is the formula to calculate elasticity of demand?
As Analytic Steps does well in clarify “the elasticity of demand is the percentage change in quantity demanded divided by the percentage change in another economic variable.” The mathematical formula to calculate elasticity of demand is:
Elasticity of Demand = Percentage Change in Quantity Demanded / Percentage Change in A Market Variable
Surprised? The formula states “Market Variable” but no “Price”. It is crucial to recognize that elasticity of demand extends beyond price alone.
Elasticity of demand extends beyond price alone.
What are the types of elasticity of demand?
As we recognized before, there is not only one type of elasticity of demand. While we could measure it considering the effects of an extensive amount of variables over demand, these are the 3 market variables most commonly considered:
Price of the commodity
Price of related commodities
Income level of consumers
These variables translates in an specific type of elasticity of demand:
Price of the commodity - Price elasticity of demand (PED)
Price of related commodities - Cross elasticity of demand (XED)
Income level of consumers - Income elasticity of demand (IED)
Each one of these elasticity measures can be leveraged by consumer goods brands and retailers to optimize their strategies to attract customers, boost sales, and ultimately maximize profits. Now, we will explore them in detail.
Price elasticity of demand (PED)
Price elasticity of demand is a specific type of elasticity that measures the responsiveness of consumer demand to variations in price levels, providing valuable insights into how customers react to price fluctuations.
The formula to calculate price elasticity of demand is as follows:
Price Elasticity of Demand = Percentage Change in Quantity Demanded / Percentage Change in Price
Interpreting the results is crucial for pricing decisions. If the value is greater than 1, considered an elastic demand: a small change in price leads to a proportionally larger change in quantity demanded.
Products with elastic demand are typically those considered non-essential or discretionary goods. For example, items like smartphones, clothing, or cosmetics often exhibit elastic demand as consumers are more likely to be sensitive to price changes for these consumer goods.
If the elasticity value is less than 1, is considered an inelastic demand: changes in price have a relatively smaller impact on quantity demanded.
Products with inelastic demand are often essential goods or items with limited substitutes. For instance, everyday necessities like food, toiletries, or cleaning products tend to have inelastic demand as consumers prioritize these items regardless of price changes.
When the price elasticity of demand is exactly 1, it represents unitary elasticity: the percentage change in quantity demanded matches the percentage change in price.
Products with unitary elasticity have a proportional response to price changes and are often found in the moderately necessary goods category.
By knowing the elasticity of demand for their products, pricing and promotions professionals can make strategic decisions when determining optimal pricing levels, setting discounts, or conducting promotional campaigns that align with customer preferences and market dynamics. As an example, for elastic goods, price reductions may lead to a substantial increase in sales volume, while price increases for inelastic goods may generate higher revenue despite a potential decrease in quantity demanded.
Cross elasticity of demand (XED)
Cross-price elasticity of demand measures how the quantity demanded for one product responds to changes in the price of another product. It indicates the relationship between the prices of related goods and their impact on consumer demand.
The formula to calculate cross-price elasticity of demand is:
Cross-Price Elasticity of Demand = Percentage Change in Quantity Demanded of Product A / Percentage Change in Price of Product B
A positive cross-price elasticity indicates substitutes, where an increase in the price of one product leads to an increase in the demand for the other. Conversely, a negative cross-price elasticity suggests complementary goods, with an increase in the price of one product leading to a decrease in the demand for the other.
Understanding cross-price elasticity helps pricing and promotions professionals make informed decisions. For example, analyzing the cross-price elasticity between coffee pods and coffee machines can guide bundling promotions.
Income elasticity of demand (IED)
Income elasticity of demand measures how quantity demanded changes in response to variations in consumer income. It provides insights into consumer purchasing behavior based on income levels.
The formula to calculate income elasticity of demand is:
Income Elasticity of Demand = Percentage Change in Quantity Demanded / Percentage Change in Income
A positive income elasticity indicates a normal good, where demand increases with rising income.
If the elasticity value is greater than 1, it signifies a luxury good. Examples of luxury goods include high-end electronics, luxury vacations, or designer clothing.
Conversely, a negative income elasticity indicates an inferior good, with demand decreasing as income rises. Examples of inferior goods include low-priced generic brands, used or second-hand products.
Understanding income elasticity is crucial for pricing and promotions professionals, as they can gain valuable insights into consumer behavior and make informed decisions about pricing strategies, product positioning, and promotional activities based on income segments.
For normal goods, targeting higher-income consumers can guide pricing and promotional strategies. Inferior goods require considering the impact of changing income levels on demand, potentially adjusting pricing and targeting lower-income segments.
Take advantage of elasticity with AI
While price remains a significant market factor influencing demand, understanding the broader concept of elasticity allows pricing and promotions professionals to consider and analyze the impact of other factors such as income and cross-prices. By comprehending the multiple dimensions of elasticity of demand, businesses can make more informed decisions in determining optimal pricing levels and designing effective promotions to resonate with their target customers.
In today's dynamic marketplace, having access to real-time elasticity values for each product is invaluable. AI platforms like Kuona's Price & Promotion Optimization can provide businesses with the necessary tools to calculate and analyze elasticity values, enabling them to focus their efforts on effective strategies. Kuona can not only provide real-time elasticity values but it also allows you to create clusters based on elasticity, for a more targeted and segmented pricing and promotions strategy.
By harnessing the power of AI-driven analytics, pricing and promotions professionals can gain a competitive edge, adapt quickly to changing market dynamics, and maximize their revenue potential.
If you're looking to unlock the full potential of elasticity of demand and explore the benefits of Kuona's Price & Promotion Optimization, we invite you to contact us for more information. Our team of experts is ready to assist you in implementing data-driven pricing and promotions strategies that drive growth and success in your business.