Make more money (by understanding price elasticity)

The best price to charge is the one where you make the most money (profit). There is a simple formula for this. To calculate the price elasticity, you simply have to have two data points.

How much product was sold at P1 and how much product is sold at Price 2?

Price elasticity (PE) is basically the relationship between the change in quantity and change in price. If you imagine that as a straight line between two points, it is the slope of the line.

 (PE) PE = [(Q2-Q1) / ((Q1+Q2) / 2 )] / [(P2-P1) / ((P1+P2) / 2]

Where Q1 = initial quantity; Q2 = final quantity; P1 = initial price; P2 = final price

 

  • If the PE > 1 (i.e. positive) the product is said to be relatively elastic. An increase in price would result in a decrease in revenue, and a decrease in price would result in an increase in revenue.
  • If the PE < 1 (i.e. negative) the product is relatively inelastic. An increase in price would result in an increase in revenue, and a decrease in price would result in a decrease in revenue. (Think products like petrol.) 

 

To illustrate, assume that:

(a) The product costs $50.

(b) You have calculated the elasticity of a product to be -2.4005.  (This would be a product that is very inelastic – meaning that this product can tolerate price increases without sacrificing quantity.)

 

The simple formula for the optimum price is this:

 

Profit maximizing RSP

 

price elasticity x cost

price elasticity +1

 

-2.4005 x $50

-2.4005 +1

 

$85.70 

This means that the price at which you would sell your product to make the most profit is $85.70.

(There is one technical assumption that is unlikely to make a difference, but for the sake of completenes: This calcualtion assumes that the conditions that applied (competitors, discounts, etc) when you collected your price sensitivity data continues to apply after you have set your price.)