When deciding on the price to charge in the market, many companies look to price elasticity— how the volume sold changes with the price charged to work towards what they hope will be a profit maximizing price.
While elasticity is a very useful concept, it should be utilized with care for three reasons:
- Elasticity can be measured at both the market and brand level. The concept is most useful at the market level, where an increase in volume with a decrease in price signifies new customers entering the market, the condition needed for an elastic market. This happens in the growth stage of market development. Measured at the brand level, it is not clear whether increased volume brought about by a price change is incremental to the market or share taken from a competitor. If it is the latter (most likely the case in a mature market), lowering price may lead to a brief increase in volume, but most likely, it will elicit a price response from competitors to drop their price to protect their market share. At best, this will reestablish equilibrium at a lower market price, eroding margins for all; at worst such a move could begin a price war, irreversibly decimating industry profits.
- Elasticity is, by definition, a top down measure, measuring the price response of the market. But, as Reed likes to say ‘we don’t sell to markets, we sell to customers’. I like to think of it from a bottom up perspective by asking the question ‘why didn’t a certain customer buy our product or service?’ Elasticity assumes it is due to a too-high price, but there can be many other reasons; for example:
- Customers are not fully aware of who you are or what you do; this happens in the introduction stages of market entry. You need your team focused on adoption of the product or service; marketing and communicating your value to customers who will derive the biggest outcome from adopting your product.
- Customers see adoption of your product as risky. If the failure of your product or service would cause major issues for the purchasing company and the buyer individually, they may stick with the status quo, even if the benefits of your system stack up well. Reducing risk, especially in early markets is a key driver of adoption. Strategies include simplifying the product, offering to hold the customer’s hand through the implementation process with a full-service offer and, if possible, allowing the customer to trial the product in small amounts.
- There are significant switching costs. Reducing the cost of switching by making your offering compatible with the system the customer already uses, for example, may be a driver of adoption above low price.
- You need high quality data. Like any data-driven decision, the more data you have, the more confident you can be in the outcome. However, with pricing, you need to be especially careful that your data tells you what you think it tells you. For example, if some salespeople give more discounts than others, it may be that procurement demanded a discount and received one, even though the company would have been willing to accept a higher price. If this data is simply fed into software with no critical analysis, the outcome may be recommendations to give even more discounting authority to these salespeople – reinforcing this bad behavior. Unfortunately, we’ve seen this outcome many times in our pricing analysis projects.
Elasticity can be a powerful tool in the kit of a pricer, but used without critical thinking, it can be a very dangerous one, reinforcing bad behavior and even precipitating price wars. What is your experience with using elasticity analysis for decision-making?
However, elasticity, as it relates to price setting, is an important aspect to your commercial strategy. But, what is happening in the execution of that strategy? I’d love to send you an article on the importance of the last mile of your commercial strategy. Click below to receive it.