Determining the right price for your products and services in support of your value proposition is one of the most important decisions your business will make, and one of the most critical business acumen skills each of your team members must have. It is a complex and complicated process that often times results in the wrong decision which then negatively impacts your business performance and ability to compete. One of the most important concepts of pricing is understanding the concept of price elasticity.
Defining Price Elasticity
As much as a client or prospect may not say price is important, price is typically one of the top decision drivers of every customer decision-making process. Most customers, in most markets, are sensitive to price and the general assumption is that customers will buy more of the product or service if it is cheaper and less of the product if it is more expensive. This concept is called price elasticity and it is one of the most quantifiable economic equations that illustrates exactly how responsive customer demand is for a product or service.
A Quick Example
Right after the financial crisis of 2008, US gasoline prices were over $4 a gallon. At this price level, consumption started to go down dramatically and people found alternative means of transportation opting to take trains, buses, bikes, or walking to their destinations. As the price dropped to around $2 in 2015, consumption started to go back up, but not to the same levels as before.
Calculating Price Elasticity
So how do you calculate the price elasticity of demand? Here is a simple equation:
Continuing with the example of gasoline, let’s forecast that the price of gasoline goes up from $2 a gallon to $3 a gallon by July. That is a price increase of $3-$2 divided by $2 which equals 50%. Because of this 50% increase, Fred’s Gas Center has experienced a decrease in volume from 20,000 gallons a month to 16, 000 gallons a month. The change in demand is 20,000 – 16,000 divided by 16,000 or 25%.
When you enter these changes into the formula, you get:
It is important to note that the “negative” is typically ignored and the absolute value (.5) is used to interpret the elasticity.
Categories of Price Elasticities
To this point, we have defined price elasticities and given you an equation to calculate it. Now I am going to provide you with a “cheat sheet” on how to categorize price demand sensitivity after you have determined your number. The categories of price elasticity include:
- Totally Elastic – When very small changes in price result in significant changes in quantity demanded. This is a commoditized market where there is no product or brand loyalty.
- Slightly Elastic – When a small changes in price cause large changes in demand. The result of the equation is always greater than 1.0.
- Equally Elastic – When any change in price is matched by an equal change in demand. The result of the equation is equal to 1.0.
- Slightly Inelastic – When large changes in price cause small changes in demand. The result of the equation is always less than 1.0.
- Totally Inelastic – When the quantity demanded does not change when the price changes. This is the complete opposite of a commodity where there is small supply and customers will pay whatever they have to for the product.
Matching Your Price to Your Strategy
Your company wants to provide customers with a value proposition that meets their needs. Whether or not your customers are looking for low cost, great service, or innovative products, you must match the right pricing strategy with the right customer expectation and elasticity relative to your competition. The price elasticity calculation gives you a deeper understanding of how elastic or inelastic your pricing is to your selected customer segments and allows you to link your pricing strategy to your overall go-to-market strategy.
Helpful Tip – Be Patient
One of the most common mistakes made when trying to apply concepts of price elasticity is not being patient. Usually price elasticity “what-if’s” are calculated on a small price change and aren’t given enough time to play out in the market versus competitors. Pricing strategies must be consistent and it takes time for customers to react and align your pricing elasticities to your value proposition.