Pricing Elasticity - Does it Actually Exist?

Black Friday (which seems to be Black The Whole Of November these days) is behind us, and the Boxing Day sales are almost here. All of this discounting has got me thinking about Price Elasticity.

Many organisations use price as a way to stimulate demand. Let’s have a sale and we’ll shift a lot more of our goods or services, they think. In fact, for too many businesses, price seems to be the only way they stimulate demand.

Which begs a question. Does price elasticity actually exist?

Yes.

And no.

Before I expand on that, let’s be clear about what I mean by price elasticity. It is often represented as a curve sloping down, showing that as prices go up, the quantity demanded drops, and vice versa. If you really want to know, the formula is:

Price Elasticity of Demand = % change in quantity demanded / % change in price

Let’s address the ‘yes’ answer.

Price elasticity can be a short-term process, where short-term changes in prices cause a short-term change in demand which then drifts back to the long-term level; or a long-term process, where price and subsequent demand changes are stable.

Examples of markets where changes are short-term include retail, hospitality, food & beverage, and energy (e.g. heating oil). Markets with long-term stable changes to demand include telecommunications, education (e.g. private schools), and healthcare.

So what are some examples?

In 2015 a paper by Jonathan Hall, Cory Kendrick, Chris Nosko examined Uber surge pricing. A breakdown in surge pricing during a concert allowed them to compare demand (as measured by wait times) with similar events when surge pricing was working. The impact? Surge pricing reduced wait times from 8 minutes to 2.6 minutes by reducing demand.

Airlines, in general, are another classic example, again from the world of transport. They use dynamic pricing, which adjusts prices continuously to moderate or stimulate demand.

Black Friday deals drive increases in sales volumes. For example, Shopify reports that conversion rates increase from an annual average of 2.5% to 4.3% during the sales.

So there are clear examples where changing a price also changes demand.

Which brings us to the ‘no’ answer.

There are many industries where price elasticity does not exist at all or is very weak. These include essential goods such as water, gas and electricity, life-saving or critical healthcare, monopolistic or regulated markets, luxury goods, niche/specialised markets, and to a certain extent addictive products such as tobacco and alcohol.

In these markets, to a certain extent, it doesn’t matter if prices increase or decrease, demand stays roughly the same… until a threshold is passed, and then demand plummets.

This is important. A business needs to be totally clear about which type of market they are in. Too many businesses worry that even a small price increase will devastate demand. But when I work with clients or when businesses tell me their pricing stories it turns out it’s generally not the case – those businesses stress over the price increase, they put it off, and eventually when they do it almost no customer notices.

I remember speaking to one business providing specialist industrial equipment to other businesses. There were three companies in the market. They had about a 20% market share, another competitor had 10%, but the biggest (and most expensive) competitor had 70%. They were convinced they had the best performing equipment on the market. They were also convinced that customers only bought on price, despite a higher-priced competitor having 3.5 times their sales!

Conversely, companies often use a price reduction as a way to stimulate sales (just like Black Friday), and yes, they do see an increase during the promotional period… followed by a decrease immediately afterwards, because all they have done is move some demand forwards without changing the total demand in the market or getting a higher market share.

There are some core messages here:

First, don’t just assume your customers respond to price increases or decreases with changes in demand, work out what the fundamental drivers of demand really are.

Second, if you are not in a classically price elastic market, don’t be afraid to try higher prices.

Third, wherever possible test the impact of a price change before rolling it out to all customers.

And finally, don’t forget to also communicate the value the customer gets from you whenever you talk to them about price.