Economics Price Elasticity of Demand Formula: Avoid Messed Up Pricing🛢️
What is the economics price elasticity of demand formula? Is this formula messing up pricing decisions in businesses today?
For example, just consider the influence that this famous business economics 101 chart still has on most business executives’ view of price and revenue management. Huge influence. Yes, it is the one you are thinking of.
You got it: It’s this one. The price elasticity of demand formula below.
Take a look at this price elasticity of demand formula chart for a moment:
This chart basically sums up what most executives and leaders know about pricing (or what they don’t know).
And, because of this very price elasticity of demand formula, most sales directors believe that price and volume are always correlated; and that increasing prices, leads to fewer sales, lost volume and few new business opportunities.
Similarly, because of this price elasticity of demand formula chart, many finance directors believe that increasing all prices by 3% is a great idea to instantly increase profit when in fact it can be a terrible idea and a highly disruptive action in the market.
In basic terms, it shows that price and volume are correlated.
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Economics Price Elasticity of Demand Formula: Avoid Messed Up Pricing
What do you think is the problem with the price elasticity of demand formulas for pricing?
I: The line on this chart is not fixed and can move on an SKU by SKU and segment by segment basis.
II: A broad-brush approach to pricing is risky and can lose your hard-earned margin, volume and customers.
III: That this economic 101 chart is an incomplete view of price profit elasticity and delaying price innovation in B2B businesses.
Why is the economics price elasticity of demand formula not always true in the real world?
To explain further:
This pricing and economics price elasticity of demand formula is the root cause for your post price rise pain. Things like:
- Issuing credit notes straight after a price increase.
- Offering excessive discounts to win and maintain business.
- Cringing at the price exceptions report and a large spread of special pricing arrangements.
In the real world of business economics, price and volume are not always correlated. Even though we have been taught otherwise at university.
If you don’t believe me, look around you: There are many instances of highly-priced products that also have market dominance and yes, even in B2B commodity businesses and industry.
For example, certain cooking oils, timber, adhesives, chemical surfactants, agri-blends – can be classed as commodity products; all have strong market dominance and high relative prices.
And for some of these products, the role of business economics comes into play. But, again, even commodities products can contradict the traditional role of economics price elasticity of demand formula.
Why does the line move on the economics price elasticity of demand formula?
On an SKU by SKU basis, the price-volume chart that we all know does not always translate, and the line actually moves.
A belief that the line never moves has become a latent rule in our brains and one which is positively reinforced during pricing and business economic studies at university.
Applying this rule across individual SKUs and product categories are incomplete and lead to margin loss.
Contrary to the price elasticity of demand formula, value at a segment and SKU level is often relative, intangible and dependent on the buyer. It is a dynamic concept and it’s the job of a pricing team to continually search, identify and capture value to secure low-risk price premiums – kind of like picking up lots of 50-dollar notes off the floor.
A good pricing team never sets a price and then forgets about it for months – that’s it, my job is done, let’s see the money rolling in. It doesn’t work that way… Rather, a pricing team battles daily to disprove this price elasticity of demand formula chart to generate more revenue and margin for the business.
Even if the team thinks they’ve identified value, a pricing environment can and often does change. This is why the line on the price elasticity of demand formula chart moves, and a pricing team needs to constantly think about where it is and where it’ll be in 6-9 months.
A good pricing team is never complacent; they continually test and learn from focused and tactical price actions using the scientific process and a range of price methodology.
A team is always on the lookout for discovering sources of value and understanding how the market responds to price and perceives value.
They seek to capture additional price premiums whether this is in the product itself or the supply chain, network effect or community.
A pricing team is unlike a sales and finance team because it seeks to quantify intrinsic value and monetise intangible value to boost revenue and margin. This is a quantum leap from simple cost-plus pricing – you don’t need a pricing team for that.
The role of business economics concerning creating a good pricing strategy is to help the pricing team to analyse data. The decision then will derive from the product of economic theories and quantitative data.
Great pricing teams challenges conventional and ingrained and often incomplete views derived from traditional Business Economics theory:
- You don’t need a pricing team to just sign off and manage discounts and administer markups.
- Excessive price reduction to push volume is not the answer to profitable growth
- Your pricing team should be advised that dropping your list price by 7% so your distributors are happy, does not really make them happy it just lowers the bar for everyone else and encourages price wars.
- And they would never just increase customer prices by 3% across the board to cover output costs because their profitability analysis said this was a good idea.
A good pricing team will dispel myths, rumours about the market and competition; test assumptions and give you viable pricing options – and explain the trade-offs you’ll end up making with every go-to-market action.
- The role of business economics is to provide analysis derived from economic theories and business practices. Which can help in creating decisions that will provide the most efficient way to meet profit and demand.
- In many instances, the opposite is true; economics 101 is outdated, harmful, and a hindrance to pricing innovation and profitability. It is by fully understanding the role of business economics that a business can fully achieve profit maximisation.
- The role of the pricing management team is to complete this picture for the business. So that they can make more informed pricing decisions and drive sustainable growth and profitability in the process.
- But of course, taking a price increase is never as simple as the price elasticity of demand formula makes out. It takes pricing competence, and know-how to sort through the huge amounts of transactional data to find value. Then analyse this data to optimise prices across thousands of products; customers and segments – to be more exact it takes an expert pricing team.
- A key role for a pricing management function, therefore, is to challenge traditional economic principles every single day. Ensuring you capture the full price and value of your offer no matter the situation.
In very simple terms, you need to break old habits and ways of thinking about price and volume; otherwise, you risk overcharging some customers and undercharging other customers.
Business Economics 101 is not really inaccurate, it’s incomplete and can expose your business to risk. It neither tells the full story about your pricing power nor informs you of the risk of margin erosion. When you use price incorrectly.
Conventional business knowledge based on well-known economic principles may be widespread. But that doesn’t mean they’re always effective and applicable to set and manage price and revenue.
Even if you developed a new segmentation last year and painstakingly assigned customers; it will always feel like a work in progress because of the market changes.
Executive Guide To Best-In-Class Pricing Strategy, download whitepaper now.
Notes: What is Business Economics – Explained 📊
What is Business Economics?
Business economics, also referred to as Managerial Economics is a discipline based heavily on economic theory. The major theories of economics seek to define and measure different concepts like supply, demand, price, costs, competition, etc.
Business Economics consists of a variety of financial instruments and statistical methods (covered below). It is common practice for business leaders, for example, to utilise different economic concepts and theories as a ‘go-to’ to solve most of their financial problems even when they may not be the most applicable tool to use. The application of economic theories, concepts, and tools in business decision-making — referred to as business economics or managerial economics.
The Role of Business Economics
Business economics is considered to be a decision-making science. Decision-making is a process of choosing the best course of action from the available options. Thus, the question in business leaders’ mind is: Why is business economics essential? What is the role of business economics?
Listed below are some of the responsibilities and role of business economics:
- Recognising, evaluating the problems and finding proper solutions
Business economics covers several important concepts, like Demand and Supply analysis; Short-run cost and Long-run costs; also the Law of Diminishing Marginal Utility. These notions support business leaders in recognising and analysing problems and finding appropriate solutions.
- Determine, analyse different internal and external business factors
Economic tools such as econometrics assist business leaders to identify and analyse different internal and external business factors and their effect on the functioning of the business.
- Framing different policies
Business economics aids business leaders in framing different policies. Such as pricing policies and cost policies based on economic study and findings.
- Foresee the future
By studying different economic variables, like cost production and business capital, businesses can predict the future.
- Create relationships between various economic factors
Business economics helps in creating relationships between various economic factors, like market structure, income, profits, and losses. This guides business leaders with effective decision making and running the business appropriately.
Recently, a new trend emerged concerning the combination of business economics and operation research. The approaches such as inventory models, linear programming, the theory of games — considered as part of vital areas to study in business economics. That being the case, business economics is a very essential element that lets most businesses and individuals achieve their goals.
Advantages and Disadvantages of Business Economics
Business Economics may play a significant role in an organisation but it also has its drawbacks. Let’s discuss some strengths and weaknesses of business economics.
Advantages of Business Economics
- Provides tool and also techniques for managerial decision-making.
- Gives answers to common business management problems.
- Produces data for evaluation and forecasting.
- Supplies tools for demand forecasting and also profit planning.
- Guides the business economist.
- Assists in creating business policies.
- Helps the business leaders to know both internal and external factors influencing the business.
Disadvantages of Business Economics
- Business Economics focus on management analysis according to financial and cost accounting data. Therefore, the credibility of this information relies on the accuracy of the financial accounting data.
- Also, the basis of the analysis is on past information. And if a new scheme is introduced, the conditions change and the conclusions can’t be speculated using this past information.
- Business Economics is exposed to the personal preferences of the individual manager, thus affecting the final decision of the manager to a certain extent.
- Business Economics is a costly process because a company normally requires a specific number of managers to guarantee proper functioning.
- Since the science of Business Economics is quite new and is not fully developed yet, it is subjected to uncertainty in certain scenarios.
The Role of Business Economics to Organisations
Business economics is a wide-ranging discipline: It covers most of the basic problems a business leader or a company faces. It also connects two disciplines in one (management and economics) with the aim of applying theory to business problems and situations. The management discipline, for example, concentrates on a number of concepts that help the decision-making process of businesses. In contrast, economics is often used in business economics to balance the allocation of limited resources to achieve set objectives and targets.
- Most companies want to gain maximum profits, but they oftentimes face threat and uncertainty in obtaining the maximum profits. Thus, a business needs to present itself with new innovations in its product’s marketing and production.
- There are also some challenges in business economics. Sometimes the problems of the business are very unique that the theories and approaches cannot solve the problem.
- Business economics concentrates on the components and factors inside business operations and how they associate with the economy as a whole.
Business economics is a connection between two disciplines – which are management and economics.
The main area of study in business economics is the problems of businesses, considering both economic and non-economic factors.
The field of business economics deals with economic principles, typical business practices, strategies, the acquisition of required capital, the effectiveness of production, revenue generation, and overall management strategy.
Executive Guide To Best-In-Class Pricing Strategy, download the whitepaper now.
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