Optimize your pricing thanks to the calculation of price elasticity
In order to write a convincing commercial offer and to deploy its marketing strategy well, every company must optimize its pricing. The term pricing refers to the price management so that it is adapted to the market situation to maximize sales and thus generate profits.
Price is a key component of the marketing mix and is at the heart of a company's business model. The calculation of price elasticity is therefore essential to define the right price and to achieve marketing and sales objectives. The goal of most companies, whatever their sector, is to sell products in large quantities at an optimized price in order to make their business profitable.
We will explain here how to calculate elasticity and how to integrate it in the pricing strategy.
Price elasticity: definition and challenges
Price elasticity is a measure of the sensitivity of demand to changes in price, either upwards or downwards. Taking this indicator into account helps anticipate changes in demand for a particular product or service, as well as the resulting sales volume.
Knowing the price elasticity allows us to adapt the price to the demand. The optimal price defined must then positively affect the sale of the good and generate profits in the short or long term.
In an elastic market, price variations have a strong influence on the evolution of demand and therefore on the volume of sales. In order to generate profits, it is preferable to lower prices; in any case, it will be difficult to raise them.
Conversely, in a rigid market, demand is independent of price variations. To maximize profits, companies just have to increase prices while maintaining the same volume of sales. In some cases, a change in the price of a product leads to an increase in demand for substitute products: this is the phenomenon of cross-elasticity.
How to calculate and interpret price elasticity?
To optimize its pricing, every company must know how to measure and analyze price elasticity. The calculation consists of dividing the rate of change in demand by the rate of change in price. The result measures the magnitude of the change in demand in response to a price change.
The rates of change used in the calculation are obtained from the data collected and stored by the company. For example, in the retail sector, elasticity can be measured according to data from retailer panels.
If the result of the calculation is zero, it means that price changes have absolutely no influence on demand: the market is perfectly rigid. This result is rather rare and only applies to basic necessities such as food.
If the elasticity is positive, it means that an increase in price leads to an increase in demand. This result is found for characteristic products that customers buy to distinguish themselves socially, such as luxury goods.
If the elasticity is negative, then price changes strongly influence the change in demand. Elasticity is usually negative because naturally, demand decreases when the price of a product or service increases. The more negative the elasticity, the more price-elastic the demand.
How to use elasticity analysis to optimize pricing?
Price elasticity is only relevant if it is integrated into a coherent pricing policy. The definition and optimization of the pricing strategy must also take into account the cost of production and the perceived value of the good.
Cost and margin analysis
To get an idea of the optimal selling price to ensure the profitability of the activity, the company can calculate the margin on a product sold according to its costs.
The costs include all the expenses incurred throughout the manufacturing process of the good or the realization of the service. These variable and fixed costs must be offset by a margin on each sale. This margin is calculated by subtracting the cost of the good from its selling price.
Measuring the price elasticity allows the company to optimize the management of the margin. Indeed, by anticipating demand and sales volume, the company can adjust its costs. Let's take the example of a company that increases the price of a product and notices that some of its customers are losing interest in it. Despite this negative elasticity, the firm will be able to generate a margin by reducing the variable costs associated with the production of the product. Indeed, anticipating demand will allow the firm to reduce the level of production of the product in question.
Taking into account the value perceived by the customer
As you can see, price elasticity depends on the consumer's sensitivity to price. In order to optimize pricing, it is essential to understand customers' buying intentions. The purchase decision is guided by the customer's perceived value of the good, i.e. the price he is willing to pay for it. This perceived value is relative, personal, contextual and above all evolving. It is defined according to the expectations and costs related to the purchase of the good in question.
Among the customer's expectations regarding the acquisition of a property, we find :
- the use value related to the functional aspects of the good ;
- the sign value related to the symbolic aspects of the good;
- the hedonic value, i.e. the sensations that the good provides;
- the value of the service relationship related to the need for contact with the sellers.
- the monetary cost directly related to the money spent;
- psychological costs (fear of others' gaze, apprehension about the complexity of the good, etc.);
- transaction costs (time and effort of searching, travelling and waiting).
During their consumption experience, consumers incur costs such as:
Price is therefore the main factor in the customer's purchase decision. If the customer considers that the actual price of the product is too high compared to its perceived value, then he will immediately look for another good.
To get an idea of the price for which the consumer is ready to buy a good, the company can conduct a survey directly with a sample of customers. From the data collected, the company can then determine the price for which it would obtain the maximum number of buyers. This data is not very reliable in the long term, because the value perceived by the consumer can change from one day to the next.
Build a consistent pricing policy to drive sales
When setting the selling prices of their products or services, companies rely on their pricing strategy. Among all the strategies, these companies must determine which one best fits their business model.
The main pricing strategies
The most common strategies are those that consist of positioning oneself in relation to the competition, i.e.:
- the skimming strategy;
- the market penetration strategy ;
- the alignment strategy;
- the premium pricing strategy;
- the margin strategy;
- the low-cost strategy.
Differentiated or modulated pricing strategies
These strategies aim to vary the price of the same product according to :
- the target clientele ;
- the evolution of the demand ;
- the place of purchase (in-store or online);
- the distribution channel;
- the purchase period;
- the economic context (today the crisis of the covid-19);
- the company's specific needs (to compensate for a temporary increase in costs, for example).
The calculation of price elasticity is particularly used in the context of personalized pricing or dynamic pricing such as yield management.
Personalized pricing consists of adapting the price of products or services to the customer's profile and needs. This practice has been prohibited in Europe by the General Data Protection Regulation (GDPR), since it involves the use of each customer's personal data (web browsing, cookies, purchase history, etc.).
Dynamic pricing refers to a way of setting prices according to demand. Prices can change on a daily, weekly or monthly basis depending on the strength of demand. Dynamic pricing practices are becoming more and more common since the rise of e-commerce (especially at Amazon) and price comparison sites like Google Shopping. The variation of prices is simpler and faster thanks to real-time data processing.
The yield management strategy is a form of dynamic pricing. It consists in modulating prices according to available capacities, to increase or decrease demand. In the hotel sector, this means adapting prices according to the number of rooms. In the transportation sector, the number of available seats will determine this choice. In the specialized retail sector, it is the available stock that comes into play.
Whatever strategy you choose, price elasticity is an essential marketing tool for any company whose objective is to boost the sale of its products or services.