Getting the right price for your product or service is difficult. In fact, determining the price is one of the most difficult things a marketer has to do, in large part because it has such a big impact on the bottom line of the business. One of the essentials of pricing is understanding what economists call price elasticity.
To better understand this concept and its impact on marketing, I spoke with Jill Avery, senior lecturer at Harvard Business School and author of HBR’s Go To Market tools.
What is price elasticity?
Most customers in most markets are sensitive to the price of a product or service, and the assumption is that more people will buy the product or service if it is cheaper and less will buy if it is. is more expensive. But the phenomenon is more quantifiable than that, and price elasticity shows exactly how responsive customer demand is for a product based on its price. âTraders need to understand how elastic, sensitive to price fluctuations, or inelastic, largely ambivalent about price changes, their products are when they think about how to set or change a price, âsays Avery.
âSome products have a much more immediate and dramatic response to price changes, usually because they are considered nice to have or not essential, or because there are many substitutes available,â says Avery. Take for example beef. When the price increases dramatically, demand may drop as people can easily substitute for chicken or pork.
How is it calculated?
Here is the formula for the price elasticity of demand:
Let’s look at an example. Let’s say a clothing company increased the price of one of its coats from $ 100 to $ 120. The price increase is $ 120 to $ 100 / $ 100 or 20%. Now let’s say that the increase caused the quantity sold to decrease from 1,000 coats to 900 coats. The percentage decrease in demand is -10%. Plugging these numbers into the formula, you would 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, because it is the magnitude of the distance from zero that matters and not whether it is positive or negative.
âThe higher the absolute value of the number, the more sensitive customers are to price changes,â says Avery. As she explains in her âMarketing Analysis Toolkit: Price and Profitability Analysis,â there are five areas of elasticity. Products and services can be:
- Perfectly elastic where any very small change in price results in a very large change in the quantity demanded. The products that fall into this category are mostly “pure products,” says Avery. “There is no brand, no product differentiation and customers have no significant attachment to the product.”
- Relatively elastic where small changes in price lead to large changes in the quantity demanded (the result of the formula is greater than 1). Beef, as noted above, is an example of a relatively elastic product.
- Elastic unit where any change in price corresponds to an equal change in quantity (where the number is equal to 1).
- Relatively inelastic where large price changes lead to small changes in demand (the number is less than 1). Gasoline is a good example here because most people need it, so even when prices go up demand doesn’t change much. Additionally, âproducts with stronger brands tend to be more inelastic, which makes building brand equity a good investment,â says Avery.
- Perfectly inelastic where the quantity demanded does not change when the price changes. The products in this category are things that consumers absolutely need and there are no other options to get them. âWe tend to only see this in cases where a company has a monopoly on demand. Even if I change my price, you still have to buy from me, âsays Avery.
Marketers need to know where their products fall on that spectrum, but “the actual number is less important than knowing what area your product is in and what will happen to consumer demand if you change your price,” says -she.
How do companies use it?
This is one of the key metrics for marketers, says Avery. âOur job is to create products and services that have unique and lasting value for customers compared to other options available in the market. Price elasticity is one way for us to measure our performance in this regard, âshe explains. âIf my product is very elastic, it is seen as a commodity by consumers. It tells you how effective you are at marketing your products to consumers.
âThe goal of a marketer is to turn their products from relatively elastic to relatively inelastic,â she continues. âWe do this by creating something differentiated and meaningful for customers. When, through branding or other marketing initiatives, a company increases consumers’ desire for the product and their willingness to pay regardless of the price, it improves the position of the company by compared to its competitors. But it can go the other way. âThis is an important metric to watch because your product may become more elastic if a competitor begins to offer attractive substitutes or if consumers’ incomes decline, making them more price sensitive,â says Avery.
Keep in mind that price elasticity isn’t just a factor in the quality of your marketing. It is also affected by the type of product you are selling, the income of your target consumers, the health of the economy, and what your competition is doing. âYou can’t look at it in isolation,â says Avery. âYou have to look at it in the context of the industry and its competitive structure and in the context of the lives of consumers. “
As you may have understood, this is a number that you can only calculate for sure after making an actual price change and seeing the resulting impact on demand. And to be really sure, you will need to change your price a few times to see what would happen at each price point. This is not what companies tend to do in practice. Rather, they send out questionnaires, organize focus groups, or conduct small-scale experiments in certain markets, to give them an idea of ââwhat would happen if they changed their price.
While it’s important to understand the price elasticity of your product or service, much more often in corporate contexts people talk about price sensitivity in a more qualitative way, Avery explains. You will hear managers say âmy product is price sensitiveâ or âwe are lucky to have a product that is not price sensitiveâ. Elasticity is not the same as sensitivity, she cautions. âSensitivity is more of a qualitative concept where elasticity is quantitative. But they are closely related.
What are some of the common mistakes managers make with price elasticity?
Many managers assume that they understand the whole picture based on their experience with pricing their products in the market, that they know how consumers will react to almost any price change, Avery says. But companies have rarely tested extreme price changes. More likely, a business has a small sample of consumer responses to certain price changes, such as what happens when the price is raised or lowered by 5-20%. More extreme price changes can elicit significantly different reactions from consumers. âThe math is not complicated,â she says, âbut it is difficult to determine how this will play out in the market, because price elasticity is a dynamic concept. What consumers are historically prepared to pay for a particular product is not necessarily what they are prepared to pay today or tomorrow.
Therefore, elasticity can often be an inaccurate calculation. âIt’s impossible to know what customers will do at each price or in the market,â says Avery. Of course, marketers can get a good idea of ââwillingness to pay from survey responses, but “the challenge is that what people say they will do is not what they actually do when they do. ‘they are standing on the shelf “. It’s best, she suggests, to do an A / B test in the market, come up with your product at the new price and see what the demand is, and compare it to the same product at a different price. This is how you will get the most accurate information. Avery points out that in a digital context, this is easy and inexpensive to do. âYou can offer your product for $ 10 and two minutes later change it to $ 2 and then sit back and see the resulting consumer response,â she says.
But it’s not just about finding the right number; you also need to understand consumer behavior. âYou can do market testing every day,â says Avery, âbut you also want to understand why consumers act the way they do. Understanding the why of consumer behavior is essential to predict how they will react in the future. This information will inform your marketing efforts. Therefore, smart marketers complement any quantitative testing with qualitative research to determine the underlying reasons for consumer behavior.
It’s also important to keep in mind that understanding the price elasticity of demand for your product doesn’t tell you how to manage it. âAs a marketer, I want to understand my current price elasticity and the factors that make it elastic or inelastic, and then think about how those factors change over time,â says Avery. Ultimately, you want to stay relevant to consumers and differentiate yourself from your competition. Once done, you can adjust the price up or down to better represent the level of value you provide to your customers. Your current price elasticity is just one data point that helps you make those future decisions.
Read reminders on net present value, breakeven point, debt-to-equity ratio, and cost of capital.