How to determine the price elasticity of demand for your product
Most businesses want to capture as much of the cash on the table as possible. To do this, you need to make your product as inelastic as possible, increasing demand, regardless of how expensive you make the product.
You want your customers, whether through particular features, your service, or world-class marketing, to be unable to live without your business. The inputs necessary for this phenomenon to occur will adjust with different customer segments, but the thought process for each segment remains the same.
So, how do you determine your product's elasticity for each segment and use this knowledge to your advantage? Here are a few things to think about:
1. Is the product a necessity or a luxury?
Necessities tend to be inelastic goods (gasoline, electricity, water), while luxury ones are the opposite (chocolate, food, entertainment); they are easier to cut out when the going gets tough. You probably wouldn't stop buying light bulbs if there were a small percentage change in price, but you might not book that cruise to the Bahamas if the cost rose.
Google has done a swimmingly good job with their AdWords platform in driving demand because many businesses utilize their advertising to sustain their entire businesses. Of course, competitors are creeping up, but your marketing and actual product make your offering a necessity.
You must figure out if your customers' revenue dried up (B2B) or consumer income was halved (B2C); what about your offering makes it the last thing they cut out of their lives? This is the income elasticity of demand and can be highly elastic or inelastic.
2. How available are close substitutes?
I eat a lot of sandwiches (don't judge me); if the price of Boar’s Head Deli cuts increased, I could easily switch to Sarah Lee Turkey Breast. There are a ton of other brands available, so unless Boar’s Head could convince me its quality was somehow worth the price increase, I will probably buy substitute goods. If your product has a lot of competition that is pretty similar, raising prices will most likely drive consumers away.
I’m just going to make a quick shout-out to product differentiation here. In the SaaS and software space, this is much easier than if you're selling vacuum cleaners. Therefore, build integral features that are essential to the customer and that your competitors don't have in their wheelhouse.
Alternatively, become a part of your customer's backstory, where the switching costs from you would be so high it wouldn't be worth the move. Switching CRM, for example, can be inconvenient from a tactical and procedural standpoint. Of course, a competitor with this in mind could create an easy solution to this exact problem to boost sales.
3. How much does your product actually cost?
You might sell some of the least expensive cars around, but even a cheap vehicle costs a lot compared to other types of products. The higher the price, the more elastic it is due to psychological pricing.
For example, you probably don’t even know how much that pack of Paper Mate pens costs, so when the price rises by 10% (just a few cents), you likely won’t notice. But, if the price decreases by 10% on that new car you want (hundreds or thousands of dollars), you’re sure to notice.
You can take advantage of the actual number on the sticker for your products by providing offers at small, medium, and high levels. You won't offer a car at $50 (unless it's a real clunker), but you may offer a car rental program that allows you to have a smaller price point. Zipcar is great at this with its hourly and daily rates.
4. How long will this price change last?
All goods become more elastic in the long run. With time, it is possible to find substitutes or learn to live without something. The classic example is oil. If the oil price rises in the short run (say, tomorrow), people would grumble over breakfast for a couple of days but still fill their tanks.
However, people might buy hybrids or smaller cars that use less gas in the long run. So even if you determine that your product is inelastic, be careful of what implications a price change (even a small percentage change) could have down the road.
For instance, Rackspace could rock premium prices for a long time because premium hosting solutions weren't available, even for small web applications. With the birth of the cloud, prices have become more competitive, and Rackspace has lost some of its lower-end customers.
Overall, price elasticity should be an important consideration when developing your product and marketing strategies, in addition to being a basic building block behind your pricing. A huge factor that I'll repeat is that the price elasticity for different customer segments will vary. Thus, your marketing, pricing, and bundling must vary.
Pricing is a process that you must integrate into your company's trajectory. For help with your pricing strategy, try our free pricing audit.