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Price Elasticity 101: The Necessities and Your Pricing Strategy

 

At the core of marketing is predicting how consumers will respond to different forms of stimulus. How much will getting Ryan Gosling (or Patrick's hero Hal Varian) to endorse the product raise sales? How would consumers feel about a teddy bear in the marketing email or on the package? Although businesses can never be 100% sure of the way customers will react, the purpose of every marketing and product teamd is to increase conversion, usage, and positive brand outlook.

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Pricing, and more specifically your company's pricing strategy, is the one area applicable to marketing and product that still contains a considerable amount of guesswork. Phenomenal marketing and product development can lead to an increase in your prices while maintaing the same level of conversion. The two areas of your business can also tank your conversion if done incorrectly. Yet, setting a price and communicating value shouldn’t be a blind man’s game. Similarly, price optimization and changes shouldn’t be a shot in the dark. Fortunately, there is a way to guide that process. One of the cornerstones of pricing strategy, microeconomics, and a great marketing/product foundation is the theory of price elasticity of demand, also known more simply as price elasticity. Let's lay out the basics of price elasticity and how you can increase demand by making your product offering more inelastic through marketing and product development.

First, the basics. What is Price Elasticity?

According to my fancy Economics degree, price elasticity is the measurement of how quantity demanded of a good will be affected by changes in its price. In other words, it’s a way to figure out the responsiveness of consumers to fluctuations in price. I know equations are negative amounts of fun, but this one is super simple: 

Price Elasticity of Demand = (% Change in Quantity Demanded)/(% Change in Price)

Since quantity demanded usually decreases with price, the price elasticity coefficient is almost always negative. Economists, being a lazy bunch, usually express the coefficient as a positive number even when its meaning is the opposite. We're a pretty difficult people. It’s important to note, however, a decrease in quantity demanded does not automatically mean that revenue decreases. The additional profit margin could make up for the slight decrease in purchases.

When the price elasticity of a good is less than 1, it’s considered inelastic. That means a one unit increase in price resulted in a less than one unit decrease in demand. On the other hand, if the coefficient is more than 1, the good is elastic. That means a unit increase in price will cause an even greater drop in demand. Theoretically, revenue will be maximized when the price elasticity of a good equals 1, or in other words, when demand is unit elastic.

Wait...what? Let's break this down with some examples

I just threw out a lot of words like "unit", "elastic", "coefficient", "lazy", etc. Yea, economists like to use fancy words to alienate those political science or communication folks (kidding, of course), so le's break this down a bit with some examples. 

When you're looking at something like a tank of gas, does a $0.50 increase per gallon affect whether you'll fill up or not? Typically, other than aggravating you, the answer is no, because many commuters rely on gasoline to get them to or from their jobs. In this manner, gasoline is considered inelastic, where it would take a drastic price increase to truly drive down demand. Boston's MBTA saw this recently with their price increase, when the price went up, but ridership wasn't really affected. 

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Conversely, if a slice of pizza you purchased every day for lunch went up $0.50 would it affect your purchase? As long as you weren't super attached to the pizza and had other options (more on this below), you probably would move to another lunch establishment. The pizza, and food in general, tends to be elastic, where even small price increases impact demand. 

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Why should you care and how can you increase demand and prices for your product?

Obviously, at least hopefully, you want your business to capture as much cash on the table as possible. As such, you need to make your product as inelastic as possible, increasing demand, regardless of how expensive you make the product. Essentially, you want your customers, whether through particular features, your service, or world class marketing, to not be able to live without your business. The inputs necessary for this phenomenon to occur will adjust with different customer segments, but the thought process for each segment remains the same. So, how do you determine your product's elasticity for each segment, and use this knowledge to your advantage? Here are a few things to think about:

1. Within each customer segment, are you selling a necessity or a luxury good?

Necessities tend to be inelastic (gasoline, electricity, water, etc.) while luxury ones are the opposite (chocolate, food, entertainment, etc.), because they are easier to cut out when the going gets tough. For example, you probably won’t stop buying light bulbs if the price went up by a few percents, but you might not book that cruise to the Bahamas if the cost rose. In this case, light bulbs could be predicted to be relatively inelastic, while cruises unfortunately wouldn’t.

Google has done a swimmingly good job with their AdWords platform in driving demand, because a considerable amount of businesses utilize their advertising to sustain their entire businesses. Of course, competitors are creeping up, but through your marketing and actual product make your offering a necessity. You must figure out the answer to: if our customers' revenue dried up (B2B) or income was halved (B2C), what about our offering makes us the last thing they cut out of their lives? 

2. For each of our segments, are there readily available substitutes?

I eat a lot of sandwiches (don't judge). If the price of Boar’s head deli cuts went up, I could easily switch to Sarah Lee Turkey breast. There are a ton of other brands of cold cuts available, so unless Boar’s head could convince me its quality was somehow worth the price increase, I will probably stop buying their meat.

If your product has a lot of competition that is pretty similar, raising prices will most likely drive consumers away. I’m just going to make a quick shout out to product differentiation here. In the SaaS and software space, product differentiation is a lot easier than if you're selling vaccuum cleaners. Therefore, build integral features that are essential to the customer and that your competitors don't have in their wheelhouse. Alternatively, become a part of your customer's backstory, where the switching costs from you would be so high, it wouldn't be worth the move. We use Hubspot on a hardcore level. Switching to another platform would be inconvenient from a tactical and procedural standpoint. Of course, a competitor with this in mind could create an easy solution, but it's doubtful (Boston love!). 

3. How much does your product actually cost?

I’m not talking about in comparison to your competitor’s goods, but rather how much does your type of good cost. You might sell some of the least expensive cars around, but even a cheap vehicle costs a lot of money. The higher the price, the more elastic it is, due to psychological pricing. For example, you probably don’t even know how much that pack of Paper Mate pens cost, so a price increase by few cents wouldn’t be a big deal. But you definitely know exactly how much that new car will cost you.

For your products, you can take advantage of the actual number on the sticker by providing offers at small, medium, and high levels. You're not going to offer a car at $50 (unless it's a real clunker), but you may offer a car rental program that allows you to have a smaller price point. Zipcar is great at this with their hourly and daily rates. Compete is even better with an ecommerce SKU in addition to their enterprise level plans. 

4. How long will this price change last?

All goods become more elastic in the long run. With time, it is possible to find substitutes or learn to live without something when it wasn’t possible under the pressure of time. The classic example is oil. If the price of oil rose tomorrow, people would grumble over breakfast for a couple days but still fill their tanks. In the long run, however, people might buy hybrids or smaller cars that use less gas. So even if you determine that your product is inelastic, be careful of what implications a price change could have down the road.

For instance, Rackspace was able to rock premium prices for a long time, because premium hosting solutions weren't available, even for small web applications. With the birth of the cloud though, prices have become more competitive and Rackspace has lost some of their lower end customers. Carbonite also faces this phenomenon with the number of back up solutions in the market. 

Overall, price elasticity should be an important consideration when developing your product and marketing strategies, in addition to being a basic building block behind your pricing. A huge factor that I'll repeat is that the price elasticity for different customer segments will vary. Thus, your marketing, pricing, and bundling must vary. At the end of the day remember, pricing is a process that you must integrate into your company's trajectory. 

For more on pricing strategy, download our Pricing Strategy ebook or check out what we have to say about our price optimization software

Comments

Excellent article - 
 
 
 
I'd also add the strange case of Giffen Goods, where the demand for a product actually increases as the price rises. 
 
 
 
Wine is a good example of this. They have done studies which indicate most drinkers cannot detect the difference between a $5 bottle and a $25 bottle... until they are told the price tag, in which case satisfaction / demand increases for the higher priced bottle.
Posted @ Wednesday, August 22, 2012 1:16 PM by MarginHound
Thanks, MarginHound! Love me some Giffen Goods. One of my buddies did his senior thesis on them back in the day. I wish we saw them more in the tech world! 
 
Posted @ Thursday, August 23, 2012 4:04 PM by Patrick Campbell
As someone who used to work in the CPG industry, looking at Price and Promo strategies, it's worth mentioning that price elasticity can be looked at as regular price & promoted price - i.e. when the regular price of a bottle of water changes from $0.99 to $1.29, the regular price elasticity will come into play (e.g -1.88) [which is high], which means fewer consumers will buy the product, but the profit per unit may be significantly better. 
 
Then when the same bottle of water is on promotion, there is promoted price elasticity - the consumer response to the promotion, which is a different measure. Typically this is higher that RP Elasticity.  
 
Using a combination of RP and PP elasticity can create an effective pricing strategy.
Posted @ Saturday, September 01, 2012 12:53 PM by Paul Morgan
Your comments on prices becoming more elastic in the long run and definitely spot on in the enterprise software space. (B2E) Often, misunderstood and ignored for way too long as alternative/replacement solutions enter the space
Posted @ Thursday, December 20, 2012 8:23 AM by Charles Herel
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