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# PREDICTIVE ELASTICITIES: HOW TO MEASURE CROSS ELASTICITY OF DEMAND

By: Joanna R.
Date: May 15, 2020

“The price of everything rises and falls from time to time and place to place; and with every such change the purchasing power of money changes so far as that thing goes”

– Alfred Marshall, celebrated English economist

As a CPG company, you will probably agree that improving your pricing strategies and increasing your revenue are generally your two main goals. In addition to striving to meet these goals, as a company, you must also be aware of the demand for one of your products possibly being influenced by consumer preferences, advertising, events, holidays, sales, or promotions. That being said, one important thing to keep in mind as we delve into the world of elasticities, is the definition of the Law of Demand: a principle of economics that states that demand falls when prices rise and demand increases when prices decrease. Keep that information accessible, and now ask yourself this question to open our discussion on Cross Elasticity of Demand: When the quantity demanded of a product is affected by a change in the price of a different product, how is this change measured?

Cross Elasticity of Demand (XED), also known as Cross-Price Elasticity of Demand, is measured by taking the percentage change in the quantity demanded of one good and dividing it by the percentage change in the price of the other good. We will also discuss, Price Elasticity of Demand (PED), also known as elasticity, which is calculated as the ratio between the percentage change in demand and the percentage change in price. While XED measures responsiveness between product A and B, PED measures the responsiveness of the change in quantity of product A, while everything else remains the same.

Firstly, let’s lay the foundation of PED, and take a look at elastic versus inelastic product demand:

Elastic (|PED| >1)
A small price change has a big, unequal change in demand—the higher the value, the more disproportionate change in demand. These products tend to be easily replaceable, or non-essential, such as finding alternatives for various meat products.

Inelastic (|PED| <1)
A big change in price has a small change in demand. These items are not easily replaceable, or essential items, such as insulin.

If we take a look at the price versus demand curve, which is a graphical portrayal of the relationship between price and demand, the steepness of the slope determines the product elasticity.

Here, PED is calculated as the ratio between the percentage change in demand and the percentage change in price. For example: If the price increases by 1%, and as a result, demand decreases by 4%, the PED is -4.

Due to each product having a different PED, products’ elasticity or inelasticity can be determined, which can be very useful to your CPG company in your pricing processes to maximize profits. Wise Athena’s determination also helps to forecast how customer demands will react to specific price changes.

This elasticity matrix (each point acts as a rollover point that depicts a product) considers the relationship between different products, ie., XEDs. Therefore, in a quick glance, you have insight regarding the interactions between your entire portfolio, as well as your competitors.

Secondly, we’re going to switch our sights to discuss XED’s different types of cross elasticities: positive, negative, and unrelated.  Following the Law of Demand, while the sign-in PED doesn’t generally matter, as it is almost always negative, XED’s signs can vary.  This may sound overwhelming, but here is the information is broken down into easily understandable bullet points:

Positive Elasticity: (XED > 0)
Known as substitute products with competitive demand, the quantity demanded of product A has increased due to an increase in product B’s price. Customers shift to product A when product B increases its price.

Negative Elasticity: (XED< 0)

Known as complementary products with joint demand, the quantity demanded of product A has decreased due to an increase in product B’s price. As products A and B are more enjoyable consumed together, like bread and butter, increasing the price of product B produces a decrease in quantity demanded both products A and B.

Unrelated Elasticity: (XED = 0)

There is no relationship between products A and B, such as tea and bread, so a change in price does not affect the quantity of the other.

In order to determine these predictive elasticities, WA uses Machine Learning methods to predict the quantity of demand of product A, taking into account the price of product B (or more products, if A is affected by more than one) as one of the main variables, along with seasonality features. We are able to create predictive scenarios and calculate the corresponding elasticity.

At Wise Athena, we consider Cross Elasticities to update the demand of the products when the price is changed, which is available for both cannibalizations and competitors. Perhaps most importantly, WA provides our clients with predictive elasticities (PED and XED), based on demand predictions for several pricing points. Price elasticity is not constant over time, retailers or geographical areas, and since we offer descriptive elasticities, we provide you with richer information. You receive powerful insight into your own business, as well as into the competition, in a predictive framework, thus making you better suited to make precise decisions.

All of this insight into Cross Elasticities of Demand with different products, allows CPGs to better identify the following:

1.
Substitutes
.

2.
Complementary
products according to
consumers’ behavior
and preferences.

3.
Allowance to improve targeted pricing strategies.

Let’s delve into these bullet points a bit more:

1. For products within the same company, if a product does not have substitutes, then they can increase prices without compromising significant quantity while increasing revenues.
2. If a product has a complementary product (they generally sell together), you can strategize to encourage demand in both products and create extra demand.
3. If you have a new product launch on the horizon, you can determine if it may be a substitute of an existing product, and then act accordingly.
4. For products of competitive companies, if company A increases prices, and your company’s products decrease in demand, this impact needs to be considered for pricing and marketing strategies in order to not lose market shares.

Wise Athena is happy to have shared this important information with you. Our approach is to provide your CPG company with consistent and committed customer care, resulting in both improved pricing strategies and increased revenue. Now that you understand more about elasticities, especially how Cross Elasticity of Demand’s change is measured, you can be confident you are making secure and informed decisions that will result in even greater success!

Written By Joanna R.
Senior Data Scientist at Wise Athena. Designing pricing strategies to help increase revenue in the CPG industry.

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