How loyal are your customers? How long have your clients been coming to your place of business? Do they consider your services to be unique, one-of-a-kind, irreplaceable?
I was having a conversation recently with a business owner who, not surprisingly, was looking for ways to increase the bottom line of her company. Although she has done well in her business, she was contemplating whether she should raise her prices, but concerned about how many customers she would lose if and when she did decide to increase her prices.
Coming from an economics mind-set, my first question to her was “what is the price elasticity of your target market?” She looked lost. She knew all about what her competitors were charging and she was very aware of her costs, her gross margins and her operating expenses, but she didn’t know about elasticity.
So I decided to give her a quick lesson in supply and demand and price elasticity.
Every business needs to determine what prices they are going to charge for their product or service, but often business owners make these decisions based on their costs, an industry standard gross profit margin or an even simpler approach – just charge less than the competition!
Most everyone thinks they understand “supply and demand” – as the price increases the quantity demanded decreases – but the really important question is by how much? How much depends on your customers’ price elasticity – their sensitivity to a change in price of your product or service. More specifically, price elasticity of demand shows the relationship between price and quantity demanded and demonstrates the effect of a change in price on quantity demanded.
Here’s a simple example:
If you price your service at $25 and your weekly demand for the service is 20 customers, your revenue is $500. If you raise your price to $35 and your weekly demand drops to 17 customers your revenue is now $595. If you were to drop your service price to $20 and your weekly demand increased to 22 customers, your total revenue dropped to $440. So in this example, if you thought you could increase traffic by dropping prices and therefore increase sales, you’d be losing revenue off the top.
If you like concepts in mathematical terms, here is one formula called the mid-point method:
(D2-D1) ÷ (D1+D2)/2
(P2-P1) ÷ (P1+P2)/2
Since the relationship between price and quantity demanded is inverse, your answer will be a negative number. Just ignore the negative sign when interpreting your results.
Values between zero and one indicate that demand is inelastic (this occurs when the percent change in demand is less than the percent change in price). You might very well increase revenue by increasing your price.
If the value is greater than one, demand is elastic (demand is affected to a greater degree by changes in price). Therefore, you want to be careful raising prices, since your demand could drop off significantly enough to reduce your overall revenue.
Price elasticity is rarely a 1, meaning that for a 10 percent increase in price you will lose exactly 10 percent of quantity demanded.
The challenge for business owners is to decide how to gather this information about their customers. You certainly don’t want to be changing your prices every week to collect your data!
Keep a couple of things in mind:
- Do your customers think of your service as a luxury or a necessity in their lives? If they think of it as a necessity they will not be terribly sensitive to price increases.
- Do you think you have a loyal customer base? Do your customers consider your service to be unique, “special”, one-of-a-kind? If they do, most of them won’t jump ship when you increase prices.
- How many competitors do you have and how close are they to you? If there are quite a few businesses offering the same service and close by – you want to be very careful. Your customers could substitute someone else’s services quite easily and demand could drop off quickly- indicating high elasticity – and leading to big drops in your revenue.
Get to know your customers and you’ll learn a lot about their elasticity and you’ll know whether raising your prices is the answer to bigger revenues.