Does anybody understand how to work with the price elasticity?
Price elasticity
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Price elasticities being negative means that an increase in price will lead to a decrease in volume and vice versa. Ex. a 1% increase in price leads to a 1% decrease in demand (elasticity of -1)
This is what happens with different elasticity values:
- 0 mens its inelastic (a change in price does not change demand)
- Between -1 and 0, the impact in demand is smaller than the change in price → increase in price leads to higher revenues
- -1 means you have similar effects (of opposite direction) in price and demand
- Lower than -1 (e.g. -2) means it will lead to a even bigger change in demand → decrease in price leads to higher revenues
Elasticities in the case are of -0.5 and -2:
- As the frequent travellers are slightly inelastic (-0.5), demand changes slowly with changes in price. To raise demand to 990 you will have to reduce significantly the price. You'll have max demand at 120 price but lower revenue (42.76 million). It's not a good decision.
- Explorers have -2 elasticity, so it's of larger magnitude, so a small change in price allows for a great gain in clients. So you get less per client, but much more revenue.
(edited)
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Hi there,
I highly recommend you do a bit of googling here as it's a bit of a tricky concept to grasp.
Essentially, price elasticity is saying “If I charge $1 more, how many fewer people will buy” (And vice-versa).
I like this exhibit from socratic:
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Hello!
To add on top of the great answers by the previous coaches, elasticity is a quite niche concept to find in consulting interviews. Apart from SK interviews, given their focus in Pricing, I am sure you won´t use it in 99% of the cases.
Cheers,
Clara
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Hi there,
the theory is well explained below by Ian and Pedro, if you would like to understand how elasticity works it in practice, feel free to reach out, I am BCG expert in Pricing competence center.
Lucie
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Hi Pedro, thanks for your explanation. Does it mean that at an elasticity of -1% we are at the optimal price? i.e. that we could not improve it any further by trading demand for price or another way around?
You would be right... if the objetive was to maximize REVENUE. But probably the objetive is to maximize profit. So your optimal elasticity is actually more negative than -1. For example if your profit margin is 50% and you increase prices by 1%, your demand may decrease approximately 2% and you'll be able to keep the same profit (PE of -2 is the sweet spot). But if your margin is 20%, you can increase prices by 1% and have a demand drop of 5% and still keep the same profit overall (PE of -5 is the sweet spot).
Hi Pedro, thanks for your explanation. Could you please provide me the formula you used to compute the sweetspot?
Optimal Price elasticity = 1 / % Margin.