Economics of Software Part 2: Elasticity Explained "Product people - Product managers, product designers, UX designers, UX researchers, Business analysts, developers, makers & entrepreneurs March 03 2021 True Guest Post, Software, Mind the Product Mind the Product Ltd 1991 Product Management 7.964

Economics of Software Part 2: Elasticity Explained

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In the second of this 2-part post, we will learn about elasticity. How you can apply it to software, and how it could benefit you.

If you missed Part 1, feel free to check it out now. In it we learned about demand, supply, and market equilibrium, how you can apply these concepts to software and how certain theories, like the law of supply, are not applicable.

What is the Elasticity of demand?

Here is the definition of Elasticity of demand:

In business and economics, elasticity refers to the degree to which individuals, consumers, or producers change their demand or the amount supplied in response to price or income changes.

Now you must be saying, ‘Enough of this textbook definition, what does it really mean?’ Well, I don’t blame you. As we discussed earlier, demand is a consumer’s desire to purchase goods or services. This desire is often fulfilled by paying for the goods or services. Now, if the market or producers decide to increase or decrease the price, there will be an impact on the demand (in most cases). As the law of demand states, a price increase will result in a decrease in demand. Elasticity is a way to measure the delta in the change of demand. This change results in three scenarios:

  1. Highly elastic
  2. Highly Inelastic
  3. Unit elastic

Let’s understand these scenarios by considering a few non-tech examples:

Highly Elastic

The demand is highly elastic means the relative change in the quantity was bigger than the relative change in the price. For example, suppose you are a supplier of daily vegetables in a locality, and you decide to increase the price by 10%. In that case, it will result in a significant drop in the demand (the demand for your vegetables could drop by more than 10%). Since there are many vegetable suppliers in a locality, your customers will simply move to other suppliers.

It could further create a situation like  ‘Perfectly elastic’ where the demand is perfectly elastic when there is ‘no change in the price’ and regardless of the change in demand. For example, essentials like salt, vegetables, bread, etc. No matter if the demand increases or decreases, essential items will always have a fixed price (until and unless there is some severe catastrophe).

In a highly elastic market, the producer always goes through the strain while the consumer could dictate the price due to high demand and competition. Hence, from a supplier’s perspective, an increase in the price will likely decrease the revenue.

Highly Inelastic

The demand is highly inelastic means the relative change in the quantity is less than the relative change in the price. For example, if you manufacture medicines for diabetes and decide to increase prices by 10%, the demand will not drop by 10%. It may remain unchanged, but the change in demand will likely stay below 10%. The primary reason for this is, there are very few companies manufacturing diabetic medicines. And generally, if your doctor has prescribed a medication, how many times do you go against it and use alternative medicine?

The demand is ‘perfectly inelastic’ when there is ‘no change in the quantity’ demanded even if there is a change in the price—for example, chronic medications, vaccines, etc. Even if pharmaceutical companies decide to increase the price of medicines for chronic diseases, the demand will rarely drop.

In such cases, consumers are at the mercy of a producer who has absolute power. Hence, from the supplier’s perspective, an increase in the price will likely increase the revenue.

Unit Elastic

The demand is unit elastic means, the relative change in the quantity is the same as the relative change in the price. It also means that an increase in the price is not going to impact the revenue.

graph showing unit elasticity in software

Elastic and Inelastic Software Products

Now that you understand elasticity let’s try to categorize software products in elastic and inelastic.

Elastic Products

As elasticity states, elastic products are highly volatile to the change in the pricing. In the case of price change, the delta by which the product’s demand will drop will be more prominent. Also, the demand for these products is generally really high as well.

Here are some of the elastic software products:

 

Category Examples Why are they elastic?
To-do Lists Todoist, Things, Apple Reminders, Microsoft To-Do, etc. To-do List apps are one of the widely used software which is not limited to any industry. It makes it a high-demand product.

Many To-do Lists applications are either free or cheap. Hence, if tomorrow someone like Todoist decides to charge $99 per month, what are the chances of people migrating to other applications? (Really high!)

Note-taking Apps Simplenotes, Apple Notes, Evernote, Bear, etc. Like to-do list apps, we have note-taking apps that are also widely used applications regardless of the industry.

If any of them decide to increase the price by even 20%, there are high chances of customers churn because of options available.

IDEs Vim, Sublime Text, Xcode, Visual Studio Code, Jetbrains, etc.  Similar to Note-taking apps, IDEs are often distributed for free (or open-source)

Hence, it becomes difficult for paid IDEs (read Jetbrains) to survive. Can you imagine a developer paying $99 per month for an IDE when Visual Studio Code is available for free? (Certainly not)

Games Plenty of them! Gaming is a $100b industry, and there are many games for pretty much everything. However, there are evangelists and huge fan-following for certain games. But if you look at the bigger picture, the chances of free games (with ads) having high demand is significantly high.

 

Inelastic Products

As per the definition of inelastic demand, inelastic products’ demand does not change due to a change in the pricing. From the supplier’s standpoint, this makes it a very lucrative opportunity because the price increase keeps the demand relatively the same and increases the revenue.

Here are some of the elastic software categories:

 

Category Examples Why are they inelastic?
Customer Relationship Management (CRM) Salesforce, Intercom, Zendesk, Freshdesk, Zoho CRM, etc. CRM tools generally contain all the communication conversations and activities. The bigger your company, gets more data it collects. Hence, moving away from it becomes extremely difficult because data migration is not an easy task.
Collaboration Apps Slack, Google Workspace, etc. Communication or collaboration is the most critical activity while working. Collaboration apps like Slack, Google Workspace contains all the communication within the team. Migrating this is also not an easy task, especially if your team size is more.
Cloud Hosting AWS, Azure, Google Compute Cloud, etc. Once you have decided to choose a cloud hosting provider, you will be very unlikely to change it because the cost of change could be high, especially if you have a high traffic application or website.

 

Is Your Application Elastic or Inelastic?

Before we answer this question, let’s understand a few characteristics of elastic and inelastic products to differentiate them from each other:

 

Elastic Products Inelastic Products
Usage Most of the applications are single-user apps. Most of the applications require more than one user.
Demand There is generally high demand for such products. The demand could be high or low, but it depends a lot on the industry and the product.
Differentiation The success of the applications depends on various factors like user experience, quality, innovation, etc. These applications may not be radical as long as there are ‘teams’ using them daily.
Ease of Migration It is easy to migrate from these applications since the number of users is less. It is difficult to migrate since your entire team is using it. And the bigger the group, the more difficult the migration.
Unit economics Reaching scale is super crucial to meet unit economics. It means offering cheaper or freemium plans. Unit economics could be met by a handful of customers but getting that handful of customers could be difficult.

 

Using the above characteristics, you can figure out if you are building an elastic or inelastic product. Understanding if you are making elastic or inelastic products is crucial because it will determine your approach. Here are a few takeaways:

  • The bottom line is, you should aim to build inelastic products, or rather your apps should have inelastic aspects. But that does not mean that you can’t make amazing elastic products.
  • As mentioned above, if your application is elastic, you have to focus more on the scale, innovation, and user experience. Elastic products are easy to replace; hence, they should offer cheaper plans and superior experience.
  • Superior experience is the key for elastic products because then only you can charge irrationally. Think of those CPU intensive games.
  • Even if you are building an elastic product, you could still introduce the ‘collaboration’ aspect or bring in the ‘freemium’ model so that your monetization will be dependent on how many people use it for collaboration. For example, many applications like Todoist, Notion, Google Workspace offer a free product for single users. But they also provide collaboration by offering ‘team plans.’
  • And if none of the above works, then settle for ads. But again, to make ads work, you need to have scale.

Factors Impacting Elasticity

Now that you understand what elasticity means let’s understand different factors that could impact it.

  1. Substitute products: The more substitute products are available, the higher elasticity for your product. For example, there are so many substitute to-do list applications available (free and paid) in case of to-do lists that will make your product highly elastic. However, if you compare it to a spreadsheet product like Microsoft Excel, there are very few substitute products, even if there is a massive demand for it.
  2. Complimentary products: These products are generally dependent on some other products. For example, Shopify based applications. These apps are heavily dependent on Shopify. If the demand of Shopify users drops, the subsequent demand for complementary products will also decrease. The same is applicable for social media APIs based apps like Buffer, Hootsuite. Since social media apps are under scrutiny for data privacy, they could change the APIs whenever possible, leaving dependent apps closing their shops.
  3. Migration difficulty: These days, almost every product offers its APIs trying to copy the playbook of Salesforce, Facebook, Shopify, etc. You see, these products are no longer but a platform. It created a new ecosystem by opening their APIs (and created a marketplace). But is it applicable to you as well? Opening your APIs makes it easy for your competitors to write migration utility, which puts you in a customer churn position. Even though Salesforce has opened its APIs, it is tough to migrate to any other CRM tool due to the unavailability to migrate custom workflows created in Salesforce.
  4. The proportion of income spent: Even though there is an advantage of having more and more team members using your product (making it inelastic), it has its disadvantages. Imagine your company is paying $100,000 annually for a Salesforce subscription, and your entire team of 100+ salespeople is using it. If tomorrow, Salesforce increases the pricing by 20%, resulting in paying an additional $20,000. That is a lot of money! And this may encourage the company to look for other options.

How Does This Help Me as a Product Manager?

  • Always try to build inelastic products, and it does not mean you have to operate in a market with low demand (think Microsoft Office).
  • Be careful about opening your APIs. Although APIs allow you to create a rich ecosystem that makes your product even more inelastic, it also comes with a disadvantage of your competitors making migration utilities.
  • Avoid being a complimentary product because you are always at the mercy of the parent product. If it decides to change its business model, you may well have to shut the shop (think social media companies).
  • Understanding your product’s contribution to expenditure is essential. If your price change is creating a big hole in your customer’s pocket, then you are doomed!