What are the Types of Price Elasticity of Demand? Avoid a Messed Up Pricing Formula 🛢️
What are the types of price elasticity of demand? Is your formula messing up your pricing decisions lately?
For example, consider the influence that this famous business economics 101 chart still has on most business executives’ view of price and revenue management. Yes, there’s a huge influence!
The factors affecting the price elasticity demand formula are shown below:
Take a look at this price elasticity of demand chart for a moment.
This chart basically sums up what most executives and leaders know about pricing (and often what they don’t).
Because of this price elasticity of demand formula, most sales directors believe that price and volume are always correlated. They think that increasing prices leads to fewer sales, lost volume, and a few new business opportunities.
Similarly, because of this price elasticity of demand chart, many finance directors believe that increasing all prices by 3% is a great idea to instantly increase profit. What they don’t know is how it can be a terrible idea and highly disruptive in the market.
In basic terms, it shows that price and volume are correlated.
An elastic demand creates a major change after a minor price change. Say, you make a slight price increase and your demand decreases all the way down to zero. Or when you apply a price slash on your products, demand increases sharply up to infinity.
An inelastic demand is when there is no change in product demand after whatever price changes were made. This is often applicable for essential products/goods.
A unitary elastic demand is when the price change produces the same amount of change in demand, whether it was a price increase or decrease.
Pricing capability correlates with other factors affecting price elasticity. In other words, the demand changes according to the necessity and convenience of products. Take food stalls in cinemas and stadiums. Or even the price of in-flight add-on meals that are strategically priced for profit and convenience.
Take salt, medicine, petrol, or utilities for example. As these are essentials, people will buy at whatever price because there aren’t a lot of alternatives available. Then there are limited edition products, like a new pre-order book from your favourite author. Or a musician’s freshly released song/album. These are seasonal items just like holiday-themed products (Christmas or Valentine’s Day).
Table of Contents:
Types of Price Elasticity Demand: Avoid a Messed Up Pricing Formula
What do you think is the problem with the factors affecting price elasticity of demand for pricing?
1. The line on this chart is not fixed and can move on an SKU by SKU and segment by segment basis.
2. A broad-brush approach to pricing is risky and can lose your hard-earned margin, volume and customers.
3. That this economic 101 chart is an incomplete view of price profit elasticity and delaying price innovation in B2B businesses.
Why are the types of price elasticity of demand and its 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. The same case is even in B2B commodity businesses and industries.
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.
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 with the different types of price elasticity?
On an SKU by SKU (stock-keeping unit) 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. It’s a lot 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 methodologies.
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.
Successful pricing teams challenge conventional 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. Lastly, it explains 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. This is to help 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 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. In fact, 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’ll always feel like a work in progress because of the market changes. Here are other ways to make a strategic plan for business to improve your pricing.
Price Elasticity in Making Better Price Rise Decisions
How confident are you making price rise decisions? Are more customers complaining that your prices are too high (or threatening to find an alternate supplier) when you put your prices up or issue your annual price increase? Knowing the results of the factors affecting price elasticity is the equation to make better-informed and detailed price rise decisions.
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. It may leave them feeling that you are unfairly raising 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. So, simply rolling out a 2-5% annual increase across all products and customers may be easy. But often, it leads to margin erosion and missed revenue opportunities. In this case, 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 your pricing strategy options and skills help pricing managers gauge the market’s response to a prospective price rise, discount, or marketing campaign. We then explain how to take full advantage of the powerful link between price and profit by incorporating profit curves within your price elasticity models.
What is price elasticity?
Price elasticity modelling helps price 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 the best pricing strategy options. 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?
Some of the industries that often show price elasticity from time to time are cars, houses, and furniture. While industries that show an inelastic demand, regardless of the price are gasoline, salt, beef, textbooks, and prescription drugs.
The conventional microeconomic 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.
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. In simpler words, people keep buying them in the same quantities when the price changes. Some people keep buying products regardless of the price. They value the product that they are willing to pay extra.
Of course, this is why the Government puts a tax on petrol sales, alcohol, and cigarettes. It’s a lot similar to Giffen Goods (see blog on product pricing) when demand actually increases as 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. In fact, it’s a relatively advanced pricing principle that seeks to monetise variations in pricing strategy options. So, do this by understanding customers’ willingness to pay via their unique value drivers.
To understand why individuals attach unique value drivers to certain products, read more about customer value pricing.
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. Then, you divide that 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 dresses 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:
Price elasticity of demand = Percent change in Quantity demand/Percent in Price change
Note that the negative is traditionally ignored. In addition, the absolute value of the number interprets the elasticity metric. 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.
Take Reliance JIO from the mobile industry in India, for instance. Initially, JIO introduced its network at very low-priced data rates with $6 for 1GB data of more than 2 months. This includes free calls and roaming services. Now, compared to the market, it charged $4 for the same service for 1 month. Obviously, customers preferred and relied on JIO after it released its commercial mobile services in September 2016.
Since then, it only took JIO to reach its 130 million mark. In fact, at the end of March 2018, JIO showcased a subscriber base of 187 million. That means that JIO added close to 9 million users in the months of April, May, and June in that same year. Nowadays, JIO has expanded its collaboration and commerce partnership with Google and Facebook including their very own made-for-India smartphone.
What are the factors affecting price elasticity?
Is your product a necessity or a luxury? Assessing this informs you if you are a leader or disruptor in the market. It will help in predicting the change or reaction of consumers with regard to your product service or demand. Products that belong to a luxury category tend to show an inelastic demand. While basic necessities like food and medicine receive an elastic demand.
Are there available substitutes within the market from competitors? If there are similar services/products in the market, you will be intentional and calculating in making the best price rice decisions. There’s a possibility of customer churn if you rush a price rise decision at any given time.
Consider the customer’s income that is spent on your services or product. If your customers spend a large percent of their income on your products and services, then this often shows an elastic demand. In this case, any reasonable price change will not dramatically affect consumer spending.
Observe and keep track of the time it took to generate a response from customers and their buying behaviour. Always target the long-term and sustainable time frame when planning your pricing strategy options. In truth, reasonable and acceptable price changes from the perspective of consumers matter. Always consider their possible reactions and if a price rise will risk customers switching to your competitors.
How can you make money from the best pricing strategy options?
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 pricing strategy options and modelling.
Profit curves in price elasticity models are crucial. This is because they help pricing managers identify the most profitable price point along the demand curve.
Combining profit curves within pricing strategy options is a very lucrative, yet surprisingly under-utilised concept. Most commercial teams fail to add profit curves to price elasticity models. Instead, they favour outdated, established, and convenient methods. That ranges from cost-plus and copy-the-competition prices methodology (match-to-market pricing).
Notes: What is Business Economics? 📊
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 in the types of price elasticity of demand
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 roles of business economics:
- Recognising, evaluating the problems, and finding solutions
Business economics covers several important concepts, like Demand and Supply analysis, short-run cost and Long-run costs, and 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 to their advantage.
- Create relationships between various economic factors
This helps in creating relationships in market structure, income, profits, and losses. It guides business leaders with effective decision-making and running the business competitively.
Recently, a new trend emerged concerning the combination of business economics and operation research:
- inventory models
- linear programming
- the theory of games
Advantages and Disadvantages of Business Economics in the types of price elasticity of demand
Business Economics may play a significant role in an organisation but it also has its drawbacks. Let’s discuss some of its strengths and weaknesses.
What does Business Economics do for you?
- Provides tools and techniques for managerial decision-making.
- Gives answers to common business management problems.
- Produces data for evaluation and forecasting.
- Supplies tools for demand forecasting and profit planning.
- Guides the business economist in creating business policies.
- Helps the business leaders know both internal and external factors influencing the business.
The Downside in Business Economics
1. The science of business economics is quite new and is subject to uncertainty in some scenarios. But business economics focuses 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.
2. The basis of the analysis is often on past information. If a new scheme is introduced, the conditions change and the conclusions can’t be speculated using the same past information.
3. Business Economics is exposed to the personal preferences of the manager. This affects his/her final decision to a certain extent. It can also be a costly process because companies normally require a number of managers to guarantee functioning organisational processes.
Types of price elasticity demand: The Role of Business Economics in Organisations
Business economics is a wide-ranging discipline that covers most of the basic problems a business leader or a company faces. It 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 concepts that help the business decision-making process.
- Most companies that aim for maximum profits oftentimes face uncertainty. Thus, they need to present themselves with new innovations in their product marketing and quality.
- There are also some challenges in business economics. Sometimes the problems organisations are very unique to the theories and approaches. Hence, business economics concentrates on the components and factors within operational capacity.
Business economics is a connection between two disciplines – management and economics. The main area of study in business economics considers 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.
For a comprehensive view on driving pricing strategies to maximise growth,
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