Price Elasticity

Most businesses have a good understanding of their customers. They know the number of customers they serve, they understand their needs, they know the competition and they have a good feel for the opportunities and threats. What most businesses do not understand is the price elasticity of their products.

Price elasticity is an important concept in business. It describes the relationship between the price of the products and the demand for those products. Products have high elasticity if a small change in price results in a large change in demand. Think of this small price change as stretching (ie elastic) the market considerably. Products that have a high level of elasticity are foodstuffs, particularly basic food items. These are products people need and so a reduction in their price encourages purchases in greater volume. Discount coupons and special deals abound in supermarkets encouraging people to buy two for the price of one.

When a change in the price of a product has very little effect on its demand it is inelastic. There is no change, no stretching. Typical products here are those used in industrial applications. People buy nuts and bolts and motors and chemicals to use as components in things they make. If the price of nuts and bolts changes, they cannot consume more because their need is determined by the volume output of whatever they are used in.

At this stage it is important to make the distinction between the price elasticity of a generic product and the price elasticity of a specific brand. Take for example the fuel we use in our cars. Most of us are so dependent on cars for transport we will pay a heavy price for fuel. The elasticity of demand for gasoline is therefore inelastic (up to a certain point). However, if two fuel stations face each other across a road, people will be drawn to the station that offers fuel at just a few cents a gallon less. The price elasticity of a brand of gasoline is highly elastic and that is why most fuel stations charge approximately the same price.

Whilst it may be true that a company will not buy more nuts and bolts simply because they are cheaper, they may consider changing their supplier if an alternative supplier has products that are at a lower price. It is this price elasticity in a competitive environment that interests us.

It should also be remembered that price elasticity has its limits. If the price of butter is reduced relative to margarine, it will steal share. People will use butter in applications were previously they used margarine. However, there will come a point at which people can consume no more butter, even if its price was to drop to a ridiculously low level. There is only so much someone can eat.

Price elasticity works within common sense bounds. Strange things happen outside normal bounds. For example, during the potato famine in Ireland in the mid-nineteenth century, people bought more potatoes despite a heavy increase in their price. This is counterintuitive but it was the result of potatoes being an important part of the staple diet of people in Ireland at the time.  It was more efficient to feed families on potatoes, despite their higher price, than pay even more for the meat, chicken and other vegetables that were on offer. This is known as the Giffen affect after the economist that described it.

The relationship between price and volume is critical to all marketers. Price is one of the important levers that affect sales. It is also the only one of the 4Ps that collects value; the other 3Ps incur costs.

If we get the price of our products wrong, for example if the price is too low, money is left on the table. Equally, there will be a level at which the price will be too high and sales will be lost. For every product in every market there is an optimum price and we should know what this is.

Most managers in business think that they have a good understanding of price elasticity. In fact, it would be hard to believe that a company offers products at a price which they believe is wrong. However, surveys show that most managers price their products too low. Managers are constantly berated by their customers who tell them that their prices are too high (they would, wouldn’t they?) and they are fearful of losing sales by overpricing. They may also be guilty of failing to communicate to the customers the real value of their products. A product will seem overpriced if the customer doesn’t understand its true value. A company that sells features rather than benefits will find itself in such a position.

If you raise your prices by 10% and sales fall by 10% this is regarded as a neutral position and referred to by economists as elasticity of demand of  -1.0 (note that the minus indicates the negative relationship and the demand curve slopes to the right – see the diag).

If you raise your prices by 10% and sales fall by only 5% this is referred to as inelastic demand. In this case the price elasticity of demand would be    -0.5.

If you were to reduce your prices by 10% and as a result sales increased by 15% the demand would be considered elastic and the elasticity of demand would be -1.5.

A company that does not have a history of data showing the effects of price changes on volume may consider using market research to determine the elasticity of demand. A crude indication of elasticity of demand can be determined by asking a buyer of products the likelihood of making a purchase at a specific price. If the starting price is high and the purchaser says that they would not purchase, they would be asked a series of further questions at lower prices until they finally agree on a price that would trigger the purchase.  (See New Product Pricing).

This is only an approximate measure as the purchaser is not in a buying situation. Furthermore, the purchaser may hold off on saying that they will pay a certain price knowing that a lower one is forthcoming. This said, with all its faults, the method gives a good indication of elasticity of demand.

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A more sophisticated measure of elasticity of demand is to use conjoint analysis.

When a company has no access to data of any kind, it could make a judgement as to the elasticity of demand for its products based on the following criteria:

Your product faces elastic demand when...

• It can be easily substituted for another product

• The product has low switching costs

• It is considered to be a commodity rather than differentiated

Your product faces inelastic demand when...

• It is strongly supported by patents

• It is strongly branded

• It is written into specifications

• It has limited availability

• Someone else pays

• It is strongly supported by personal service

Some things to think about:

• Understanding the price elasticity of your product is vital. Many business to business companies are fearful of losing custom by pricing too high and so they undercharge. Use the checklist above (ie Your product faces ...) to get a high level view of whether your product is elastic or inelastic in its demand and consider using research to obtain a more precise figure.

  
  

• It should also be borne in mind that the price elasticity of your product will be determined by the degree to which you communicate its value. Differentiated products with strong brands tend to be inelastic and can command higher prices.