Price elasticity of demand [The extensive guide]

Price elasticity of demand [The extensive guide]

Getting your pricing right is essential in any business. In a SaaS context, where a change in price can trigger cancellations of subscriptions or push potential customers in the arms of your competition, it can make or break your business.

By utilizing price elasticity in your business, not only will you adapt to changing customer behavior, but in the long-term will find an optimized pricing "sweet spot" for your SaaS product.

What is Price Elasticity?

Price elasticity is a phrase you’ll see used more in economic commentary than in your SaaS business. Analysts or business owners usually express this as PED, which is short for Price Elasticity of Demand. While you will want to keep your prices as stable as much as possible, being aware of how you can use it will bring benefits to your strategy.

Price elasticity measures the relationship between the demand for a product and its price, specifically when these variables change.

If you increase the price of your SaaS product by a small amount and see a substantial change in demand, your product will be elastic, or sensitive to price changes.

On the flip side of this, if a substantial price increase saw an insignificant change in demand, you would say your product is inelastic, or insensitive to price changes.

Why is Price Elasticity Important for Your Business?

Knowing how elastic your product is can play a crucial part in setting your pricing strategy. If you know your product is inelastic, for example, you can forecast sales and revenue in advance while also factoring in a planned price change.

Understanding your PED can also allow you to adopt specific pricing strategies for your business. Many SaaS companies increase prices for new subscribers only. However, if your data tells you that current users will accept a price change of X%, why would you leave the additional revenue on the table?

PED can work in the context of a price reduction, too.

Let’s say an annual subscription to your SaaS plan costs $1,000, with an average of 100 subscribers at any one time. You’re making $100,000 a year from those subscribers.

Reducing your annual plan to a price of $800 might feel like something you don’t want to do. However, if that price would increase your average subscriber base to 200, suddenly you’re making $160,000 per year.

You would need to consider specific things like profit margin when working out your optimal pricing. Still, this example highlights what you could do to increase revenue if you have an elastic product.

Price Elasticity Formula

Calculating the elasticity of your product is simple.

Remember you can model PED on example numbers, or run trial pricing and promotions over specific periods to get real-life data to use in future projections.

The PED formula of price elasticity is as follows:

Price Elasticity of Demand (PED) = % Change in Demand / % Change in Price

The below working example shows an elastic product based on the example we gave above in the context of applying a price reduction:

PED = 100% / 20%

PED = 5

This example shows an inelastic product based on a price increase and customers not unsubscribing:

PED = 1% / 10%

PED = 0.1

The outcomes at which you will act will depend on the specific goals of your business. However, as a rule, you would consider 1 as neutral, with numbers below 1 highlighting your product is inelastic, and above 1 that your product is elastic.

You would then apply the relevant context depending on whether you have increased or decreased the price of your SaaS service.

Which Factors Determine Your Price Elasticity?

The main factor in your PED calculation is the reaction of your customers. However, several factors will influence how your customers react and thus determine the elasticity of your product.

Your Competition

Your competitors' products and their pricing will be a considerable influence on the price elasticity of your SaaS platform.

If you're by far the best SaaS product in your niche or have a strong brand presence, you will be less elastic than if you have many competitors that offer similar products. In contrast, if a competitor is offering a similar service to you, a reduction or increase in price could see a big reaction either way as you attract customers or push them away.

Think about smartphones.

Apple can increase the price of an iPhone each time it releases a new model. Yes, a new iPhone has exciting new features, but in terms of competition, Apple only really has Samsung. Besides, Apple users tend to be loyal. Apple knows its customers will pay for the latest model.

In contrast, let’s look at cars.

While some people have loyalty to specific manufacturers, this isn't as anywhere near as strong as it is for smartphones. Let's say Volkswagen suddenly increased the price of a particular model of car by €5,000. People looking to buy a new vehicle would choose another manufacturer offering a similar car at a lower price.

The elasticity dynamic highlights the benefits of developing unique selling points and having an exceptional product. If you have things that will keep your customers paying, you can afford to increase your pricing a little more and see only a slight change in subscriber numbers.

How Much Is Your Product Needed?

There's a fine line between maximizing your revenue and blatant profiteering. Still, if you know your customers are heavily reliant on your SaaS platform, you can afford to push the envelope a little harder with price increases.

How much your customers need your product will again link back to competition, as well as the value you add to your customers' lives.

How Does Your Product Generate Returns for the Customer?

What does your software do, and how does it generate returns for your customers?

More specifically, what return on investment (ROI) does it generate?

If a price increase still generates a healthy ROI for your customers, they're likely to stick around. You might need to reduce the price of your SaaS to produce a better ROI for customers to attract new business, too.

How Loyal Are Your Customers?

Your SaaS platform is incredible. If that's true, you'll reach a point where your customers have become brand evangelists and are telling anyone who will listen how great you are.

You may also reach a point where your brand loyalty is like Apple's, and people will stick with you no matter the price. That loyalty will give you a lot of power and flexibility in terms of your pricing strategy.

As with assessing how much your customers need your product, there’s a fine line to tread. You want people who feel like they’re paying for your product because they want to, not because they feel like they have no choice.

Remember, too, that your price itself may influence the loyalty of your customers. You might find that a lower price makes customers more loyal. Therefore, you would need to develop your SaaS platform and improve your offer to make a price increase more palatable and keep customers on board.

How do You Market Your SaaS Product?

This point shows how important it is to consider every factor when looking at your PED. There’s an old saying that you can have the best thing in the world, but if you don’t know how to promote it, you won’t succeed. This saying is true when it comes to SaaS and will play a part in your elasticity.

Your marketing will ideally increase demand and reflect the experience of your current customers. If your marketing is exceptional, you’ll increase demand and see your PED higher as a result.

Longer-term, remember to keep a diary of what marketing campaigns you ran alongside specific changes in price or your service. Logging this will help you plan future campaigns or make decisions on price changes. If a previous price increase maintained demand because you backed it with a far-reaching campaign, you need to support future campaigns in the same way.

Read more about price elasticity here. 

Getting Pricing Right for Your Business

Getting your pricing strategy right will be crucial to the success of your business overall.

By modeling potential PED outcomes, you will be able to forecast revenue and plan price increases or decreases accordingly. Also, you will be able to be more explicit around the additional actions you will need to take to support these.

Add Price Elasticity to Your Business

Making changes to your existing pricing strategy shouldn't be limited by technology. With a subscription management- and recurring billing platform (like Upodi) you have the flexibility to apply changes and monitor customer behavior in real life.