Price elasticity: Use price elasticity to make better price rise decisions
Price elasticity: How to use price elasticity to make better price rise decisions
How confident are you making price rise decisions? Are more customers complaining your prices are too high (or threatening to find an alternate supplier) when you put your prices up or issue your annual price increase?
Even though you may think that a small, annual price increase of circa 3% is fair; and although your price increase is below CPI (Consumer price Index), some of your customers may think otherwise and feel you are unfairly putting up your prices.
Price rise management (like all price leadership decisions) needs to be handled with care and skill. Setting the right price is difficult, but it also protects hard-earned margin and sales volume. Simply rolling out a 2-5% annual increase across all products and customers is easy but often leads to margin erosion and missed revenue opportunities. You will lose customers using a blanket price rise approach.
In this article, we will provide a quick refresher on price elasticity. We will then explain how price elasticity skills can help pricing managers gauge the market’s response to a prospective price rise, discount or marketing campaign. We then explain how you can take full advantage of the powerful link between price and profit by incorporating profit curves within you pricing elasticity models.
What is price elasticity?
Price elasticity modelling helps pricing managers figure out how their customers are going to respond to a change in price (e.g., a price rise, an annual price increase or tactical discounting) when considering strategies of pricing. Most customers tend to be quite aware of the prices of products or services they buy on a regular basis.
Think about a product you like and buy regularly. Do you know when the price of your favourite product has been discounted? How do you feel when the price of your favourite product has been increased? Do you stop buying the product because the price is too high or do you keep buying it regardless of the increase in price because you really want it and now?
The conventional micro-economic theory states that we tend to buy a product or service more when it is cheaper and less when it is more expensive.
Take cigarettes for example, Tobacco companies across the board have continually and substantially increased the prices of a packet of cigarettes (now $20 for a packet of 20) while maintaining steady volumes (the amount that people smoke) over time (i.e., we keep buying them) despite all the government campaigns (or education) and legislation on suppliers to directly advertise their product to influence consumers. Note: interestingly tobacco companies now make considerable profits on the holding of large cash balances before paying the collected tax or duty to the tax authorities. It could even be argued that they are paid to collect tax on behalf of the government!
When certain items are inelastic – i.e. the demand curve is pretty much flat no matter what the price – or in plain English, people keep buying them in the same quantities when the price changes. Some people keep buying products regardless of price, they are want or value something else about the product that they willing to pay the extra price to get it. This of course is why the Government puts tax on petrol sales, alcohol and cigarettes. I even remember the concept of Giffen Goods (see blog on product pricing) from my economic studies a long time ago – when demand actually increases when we increase the price.
This value based purchase response phenomenon is not just isolated to cigarettes or B2C product pricing, it is also applicable to B2B product pricing. Variation in price response (i.e., how individual customers respond to prices) is a key principle of value based pricing – a relatively advanced pricing principle that seeks to monetise variations in price response by understanding customer willingness to pay via their unique value drivers.
How do you calculate a price elasticity?
This is the formula for price elasticity of demand:
Basically, it calculates the size of the price change on demand by identifying the percentage change in customer demand, divided by the percentage change in price.
Let’s look at an example. Say that a retail company increased the price of one of its dresses from $100 to $120. The price increase is $120-$100/$100 or 20%. Now let’s say that the increase caused a decrease in the quantity sold from 1,000 dress to 900 dresses. The percentage decrease in demand is -10%. Plugging those numbers into the formula, you’d get a price elasticity of demand of:
Note that the negative is traditionally ignored and the absolute value of the number is used to interpret the price elasticity metric, as it’s the magnitude of distance from zero that matters and not whether it’s positive or negative.
The higher the absolute value of the number, the more sensitive customers are to price changes.
How can you make money from price elasticity modelling?
Now we know that price elasticity is closely related to the concept of price response, it naturally follows that tracking the relationship between price variation and price response is key to drawing accurate profit curves in your price elasticity model.
Profit curves in price elasticity models are crucial because they help pricing managers identify the most profitable price point along the demand curve.
Combining profit curves within a price elasticity model is a very lucrative, yet a surprisingly under-utilised concept. Commercial teams tend not to add profit curves to price elasticity models and favour instead their established and convenient methods, cost plus and copy-the-competition prices methodology (match-to-market pricing).