Software Growth

Price elasticity

Price elasticity of demand measures how much demand changes when you change price: percent change in quantity divided by percent change in price.

Price elasticity of demand tells you how sensitive your customers are to price. If a 10% price increase loses 3% of customers, demand is inelastic and the increase is a good trade. If it loses 25%, demand is elastic and you should have left the price alone. Every pricing decision for a SaaS, from the first price to a price increase, is a bet on elasticity.

How to calculate price elasticity

The simple version divides the percent change in quantity by the percent change in price. For anything beyond small changes, use the midpoint method, which uses average values so you get the same answer whether the price goes up or down (source).

Here Q is the number of customers (or signups) and P is the price. Because demand almost always falls when price rises, E comes out negative. Economists report the absolute value.

Worked example

Your plan costs $20 a month and you have 500 paying customers. You raise it to $24 and, after the dust settles, you have 460.

  • Change in quantity = (460 - 500) / 480 = -8.33%
  • Change in price = (24 - 20) / 22 = +18.18%
  • E = -8.33 / 18.18 = -0.46

The absolute value is 0.46, below 1, so demand is inelastic. Revenue confirms it: before, 500 x $20 = $10,000 of MRR; after, 460 x $24 = $11,040. You lost 8% of customers and gained 10% of revenue.

How to read the number

  • Below 1 (inelastic). Quantity falls by a smaller percentage than price rises. Raising the price increases revenue.
  • Above 1 (elastic). Quantity falls by a larger percentage. Raising the price reduces revenue, and cutting it raises revenue.
  • Equal to 1 (unit elastic). Revenue does not change.

Revenue is only part of the story. Fewer customers also means lower support cost and, usually, fewer low-value accounts. Patrick McKenzie notes that customers who care most about price are disproportionately the hardest to serve, and that those who pay more tend to be more sophisticated users who ask fewer basic support questions (source). A move like the example above often improves profit by more than it improves revenue.

Why SaaS demand is often inelastic

  • The price is small next to the value or the cost of the problem.
  • The product is embedded in workflows, so switching costs are high.
  • Buyers are businesses spending company money.

Jason Cohen's observation in "How do I raise prices?" fits: his template email argues that most customers stay and often appreciate the honesty (source). That is an observation from his experience, not a measured rule, so measure your own.

How to measure yours

  1. Change the price for new visitors only, or test two prices on separate segments.
  2. Compare conversion rate and revenue per visitor, not just signups.
  3. For existing customers, track churn for the cohort that got the new price against a control group.
  4. Wait at least one full billing cycle. Churn from a price rise often arrives at renewal.

Pitfalls

  • Elasticity is not constant. A customer who accepts $24 may leave at $60.
  • Small samples mislead. Twenty trials at each price tell you almost nothing.
  • Other changes get mixed in. If you ship a feature, run a campaign and change price in the same month, you cannot attribute the result.
  • Segments differ. An agency and a solo freelancer will not react the same way. Estimate by segment.

For a small SaaS with a few hundred customers, you will not get a clean statistical estimate. Use elasticity as a framework for reading small, careful tests, and combine it with research on willingness to pay.

Sources

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