Pricing Academy Article
When it comes to pricing and choosing the right price for a product, one of the first things you will stumble upon is the discussion of supply and demand. And why shouldn’t you? It’s the pillar that almost all pricing related theories are built around. However, you don’t need to dig very deep into the concept before you start to hear talk of elasticity, price elasticity and elasticity of demand.
Price elasticity measures the way consumers, individuals or producers respond to changes in price with change in demand or supply of a product.
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Price elasticity can be divided into two different types
1. Price elasticity of demand
Price elasticity of demand refers to the degree to which the effective desire for something changes as the price changes.
2. Price elasticity of supply
Price elasticity of supply is a measure of how sensitive our quantity supplied is to a percentage change in price.
Let’s take a simple example to illustrate price elasticity. Think of a product like insulin. The drug is vital for people suffering from diabetes and having to live without it is not an option for millions of people around the globe.
In essence, changing the price of insulin is not going to reduce its demand and thus volumes sold. Of course we know that at some point no one will be able to afford the product any more but for a long time the price will be inelastic meaning that the price goes up and the demand stays the same.
Now take 1 euro for instance. If you offer someone the chance to buy 1 euro from you for 1 euro no one is going to do that (unless the buyer is a coin collector and your coin happens to be way nicer than his, in that case someone might go for it but other than that, it’s a no go).
Now what would happen if you sold 1 euro for 85 cents? Someone would probably already buy it. Lower the price further and more people would buy until you reach a point where the demand evens out. Still, the euro is a good example of an elastic price.
The elasticity of price is affected by both internal and external factors, in this case factors relating to
the product and other factors. The most important internal factors affecting price elasticity are:
- Degree of necessity
- Being time-bound
- Accessibility of substitutes
The outside factors affecting price elasticity will be covered with a more detailed approach later in this article and in our eBook about AI in pricing. So let’s look more closely at the internal factors and use our example of insulin to illustrate.
The degree of necessity with a product like insulin is of course very high. The higher the need, the more inelastic the price is. People won’t stop needing insulin just because the price went up. If we look at something like fuel, it’s still considered inelastic but less so than insulin. People need fuel to commute to work for example but at some point when the prices rise people are going to find other means of transportation. Now if you look at something like indoor plants, they are a necessity for very few which means their price will be elastic and the demand will drop if the prices rise.
Preferences and buying behaviors may change over time which leads us to our second factor; price elasticity being time-bound. Let’s think of insulin again. Are people’s preferences or buying behaviors when it comes to insulin likely to change over time? Well no, not really. Unless you are cured, you’ll be buying insulin for the rest of your life. Fuel is a good example in this context as people have become more aware of the effects of global warming and some are already committed to driving electric cars or cycling to work.
Another example of how demand can change over time is the seasonal products related to weather. Bobsleighs are a lot more likely to be extremely elastic in price during summer but during a winter with heavy snowfall you might already be able to hike up your prices quite a bit before it will show on your sales volumes.
COVID-19 also provided a great example when people started hoarding toilet paper and hand sanitizer. These products suddenly had such a huge demand that some retailers were able to triple the price and still sell the products.
The last factor relates to the accessibility of
substitutes. Now this is quite logical isn’t it?
The more substitutes that are available, the
easier it will be for a consumer to buy a substitute instead of paying more. If you have only
one pharmaceutical company producing and
selling insulin, they can hike up the prices a lot
before people will stop buying but if you have
ten producers on the market for this kind of
drug, you are most likely all going to be pricing
your products nearly exactly the same. We’ve
all been to the pharmacy and been asked if we
want to switch out whatever the doctor ordered
for a cheaper substitute from another manufacturer
and quite a lot of us have at one point said yes.
Sniffies AI-articles are based on the e-book "AI in pricing"
What if the product seems inelastic?
Sometimes a product can seem inelastic and typically in those situations we are either too cheap (always selling a lot) or too expensive (never selling anything). Because of this we have not achieved the elastic curve and the only situation where the product’s whole elastic curve is truly inelastic is when the market is at 0 (i.e. no products are sold to anyone). This is what we mentioned earlier, even though insulin is vital, at some point it will be too expensive for anyone to buy.
What if the product seems elastic?
If the product seems elastic it can mean a couple different things. First it can mean that the price points that have been tested have all been in the “sensitive area” meaning that the changes have all led to change in demand. Another thing that can lead to a product seeming like it’s elastic is simply by chance.
The dynamic nature of price elasticity
When reading the text above, one might get the feeling that a product’s price is either elastic, inelastic or something in between. This however isn’t really the case. Price elasticity actually has much more of a dynamic nature that is present in two different ways:
1. Price elasticity changes during product lifecycle
2. The size of the elasticity or inelasticity depends on the price point.
If we start by looking at the first statement; price
elasticity changes during the product life cycle.
This of course means that during the different
stages of a products life cycle the product price
can be either completely elastic, completely inelastic or anything in between.
A new product introduced to the market surrounded by hype can have a huge demand, people don’t care about the price, they have to have it. At this stage the product’s price is nearing inelasticity. The other extreme is when the product is at the end of its life cycle, there is a lot of competition and your product only gets sold when the price is just right. In this situation the price is very elastic. The value in understanding price elasticity is very much dependent on understanding that the price elasticity is so dynamic. Of course it would be nice if we could study the price elasticity once, decide on something
and then use the same hypothesis when pricing the product in the future but unfortunately that is a bit too optimistic. Lucky for us, we have computers who can help us follow the elasticity of a product’s price and suggest how we should capitalize on the knowledge.
The other factor to take into consideration when it comes to the dynamic nature of price elasticity is that the amount of elasticity or in-elasticity varies depending on the price point.
If you look at price elasticity as a curve that is made up of price points and then connected to form a continuous line, it is easier to understand why the dynamic nature is present all the time. Now let’s move one step forward and start imagining price elasticity as something that there can be more and less of. Instead of thinking of it as a value that just describes the price’s elasticity, also think of it as a scale in between inelastic and elastic. Since the price evolves and price elasticity is calculated between two price points it means that the value defining the amount of elasticity is different depending on the price points used for the calculation. A product can be almost inelastic at some points and elastic at another, depending on the price.
Outside factors affecting price elasticity
As mentioned earlier, price elasticity is based on internal factors ( degree or necessity, being timebound, accessibility of substitutes) and outside factors. Now it’s time to look at the outside factorswhich can be boiled down to:
1. Market size
2. Market competition
3. Customer characteristics
4. Events in the world
If we start with market size, it is quite obvious that the amount of customers and the amount of actors affects the pricing and therefore the price elasticity. If you have a market of 100 people vs. 100 000 the difference between the customers is already something that is quite noticeable. In a smaller market you might have to think about capturing everyone on the market to be a success whereas on a large market that is rarely the case. The size of the market and its effect on price elasticity mostly boils down to how consumers differ and the more consumers there are on the market, the more different individuals there are who you have to get to buy your product.
Competition affects price elasticity by adding the element of having to consider at what price consumers are likely to buy from a competitor instead of from you. The more competitors, the more you have to focus on where your pricing strategy should be in comparison to your competition and the overall flexibility of setting prices tends to diminish.
As mentioned above, customer characteristics are a big influencer. No two people are alike and the more potential customers your market consists of, the more different kinds of demands are you able to/required to meet and sell to. Changes in people’s way of thinking is one way that really affects price elasticity. We all know that being environmentally friendly is becoming a bigger thing and businesses selling eco-friendly products can see a more inelastic price compared to their not so-eco-friendly competitors. This is all due to the customers way of thinking about what is important in a product. Another good example is how certain brands have a luxury-image in people’s minds and customers are therefore willing to pay more since they have a stronger belief that a raise in price makes the product more desirable.
There is no more powerful example right now of how events in the world affect price elasticity than the COVID-19 pandemic. In a matter of weeks almost the entire world had to shut down, people retreated into their homes and prepared to stay there for a long time. This led to products that you normally buy once in a while without thinking being the most sought after and the demand skyrocketed when people started hoarding things like toilet paper, hand sanitizer, hygiene products and canned foods.
Before the pandemic, hand sanitizer was sold in moderation by pharmacies and grocery stores but as soon as the pandemic was a reality, suddenly every store wanted to carry something similar to hand sanitizer and while the hospitals were first in line for all produced products, small companies switched focus and started producing and selling hand sanitizer at a huge markup.
There is no doubt that price elasticity is as much affected by internal as external factors, making it challenging to estimate. Luckily AI and especially reinforcement learning has proven quite successful at generating forecasts in the most sensitive area, something we will discuss more in our eBook about AI in pricing.
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