Price Elasticity of Demand with a Simple Linear Regression (Part I)
“How sensitive is Sales Demand, if product Price changes?” “How much my sales will increase, if I lower my price?”
One of the major questioning of a marketer or business is to know the art behind setting the price of a product. Many of us have wondered, what are the external and internal influences that needs to be considered in order to set a price and how we can measure the consumer demand impact towards the price settled? Do the product price changes affect my consumer demand?
This article would answer all these questions by getting to know one of the main important measurements of price using econometrics, which it is Price Elasticity.
In the first part of the article, it would give you an easy explanation of what is price elasticity and how to interpret the data for your further price analysis.
In the second part, I created a price elasticity model using linear regression in python; coding and the explanation process is included.
If you are not sure how to interpret price elasticities, I would hugely recommend to read this article below.
In case you nailed the topic and want to know how to do it in Python using Linear Regression, please click this link to see Part 2 :)
Part.1
What is price elasticity and how to interpret price elasticity?
Price elasticities help the marketer to know how the demand would be likely to react or change when the product price changes by increasing or decreasing the price.
It answers following questions:
1. Does sales demand changes, when the price changes?
When the price changes have no effect on the sales demand, this is called inelastic price. In other words, the demand is likely to not change in proportion to price changes, even when the price increases or decreases.
How is that happening?
Price inelasticity happens due that the product is likely to not have competitors and as a result it has the advantage to set their own prices without having the consumers juggling between price comparison of one similar product against the other.
Another of the common reasons is brand loyalty, no matter the price, the consumer would keep buying the product due to the brand reputation.
2. How likely sales demand change when price changes?
Price elasticities are usually negative, this means that when our price decrease our sales demand increase. It makes sense isn’t it?
However, positive price elasticities are found on rare cases, where products do not conform the law of demand.
In simple words, positive price elasticities have the following effect:
When product prices decrease, sales demand decreases. Or the opposite, when product prices increase, sales demand increases.
What are you saying, is that even possible?
Yes, these case scenarios happen when we have Veblen goods. Veblen goods are typically high-quality goods , are exclusive, and are a status symbol, perceived as luxury goods.
In summary, what differs an elastic from an inelastic price is the following:
Demand is said to be elastic when demand has a higher proportionate response to a smaller change in price. On the other hand, demand is inelastic when there is little movement in demand with a significant difference in price.
Let’s get to the point, how to measure price elasticity and how to interpret price elasticities?
Price Elasticity of Demand : % change in quantity / % change in Price
(Percentage change in quantity sold divided by percentage change in price)
How can we interpret price elasticities?
Price elasticities differ from product to product, some products might have a greater price elasticity than others.
One example it is the chart below:
If we analyze several laptops in an e-commerce platform, an Apple Mac Book Pro laptop highlighted below have a greater negative price elasticity (-15.34) than a Lenovo laptop (-2.52).
Apple Mac Book Pro with a negative price elasticity of -15.34, it is described as follows:
A 10% price decrease in Apple MacBook Pro-13, it increases sales demand by 153.5% or a 10% price increase in Apple MacBook Pro-13, it decreases sales demand by 153.5%
Lenovo Laptop with a negative price elasticity of -2.52, it is described as follows:
A 10% price decrease in Lenovo Laptop, it increases sales demand by 25.2% or a 10% price increase in Lenovo Laptop, it decreases sales demand by 25.2%
Now you got it! , you can analyze and observe how sensitive it is the consumer sales demand of different products towards price changes in a sole marketplace.
In the introduction above, I used the classic demand that is sales demand. However, this same process can be implemented in ad impression demand for instance.
Thank you very much!
Keep up with me in the Part 2, where I shared with you my price elasticity model using linear regression in Python.
All inclusive: Explanation and coding included
References:
Cost and Economics in Pricing Strategy, University of Virginia
