What it is:
How it works (Example):
The formula for price sensitivity is:
Price Sensitivity = % Change in Quantity Purchased / % Change in Price
Let's assume that when Tropicana orange juice prices increase by 50%, Tropicana orange juice purchases fall by 25%. Using the formula above, we can calculate that the price sensitivity for Tropicana orange juice is:
Price Sensitivity = -25% / 50% = -0.50
Thus, we can say that for every percentage point that Tropicana orange juice prices increase, purchases decrease by half a percentage point.
Why it Matters:
If demand for a product changes a lot when its price changes a little, it's safe to say that consumers of that product are very price sensitive. This often is the case for products or services for which there are many alternatives or when the product is essentially a commodity, such as orange juice.
Of course, the opposite is also true: if there is a small change in demand when prices change a lot, the product is said to be less price sensitive, or inelastic. This is often the case for products and services that people consider necessities and will purchase at almost any price. The presence of few good substitutes, the wealth and income of the consumer, and customer loyalty are also factors. At some point, however, there is a price at which demand for any good or service will fall to zero or near zero.