Price elasticity models (also called demand elasticity models) attempt to express the relationship between prices and sales units for a product or products to a smooth curve. More precisely, the models answer this question:
If I raise (or lower) the price of my product by a small amount (say 5%), then how much will my units sales increase or decrease?
The elasticity number epsilon is defines so that, if you raise your price by 5%, then the unit sales increase by epsilon * 5%.
Elasticity models usually assume that
- Transactions are sufficiently numerous that price-units relationships do not depend on a few purchase decisions.
- The number of units sold varies continuously with price over some price range (allowing for some random noise in the data).
- Other non-price conditions of sale are fairly uniform across the market.
If your situation does not match these conditions, then you probably need to do case-by case analysis of each purchase decision, instead of using an analytical price elasticity model.
If your situation does match these conditions, then you can use some standard price elasticity models to estimate the change in unit sales and revenue if you change your price.
Here are three useful extensions of textbook models of price elasticity.
- Non-constant elasticity Textbook models of elasticity usually assume that the relationship between price and sales units a straight line (on a log-log plot). Therefore they cannot predict price(s) that optimized revenue or profit. To detect maxima, you need a model that treats the
relationship between price and sales units a quadratic curve (on a log-logplot). - Interacting products Generally, sales units of one product are affected by prices of interacting products. (For example, if the price of Pepsi goes up, that is likely to increase the sales of close substitutes like Coca Cola.) If this is the case, then you probably want to model these cross effects to get results that are useful for decision-making.
- Estimating profit (in addition to revenue and sale units) If you provide product cost data, then slight extensions of price elasticity models also predict profit margins (as well as revenue and sales units) at any price (or prices for several products).
Below are links to some free and paid spreadsheets that implement elasticity models with some or all of the extras described above. Each one also contains a brief description of the theory and computations.
- Price elasticity model for one product: http://templates.modelsheetsoft.com/modelsheettemplates/product-price-elasticity-templates.aspx
- Price elasticity model for several products: http://templates.modelsheetsoft.com/modelsheettemplates/price-elasticity-templates.aspx
