Price Elasticity Isn't Perfect, But It Is Powerful

Price elasticity is never perfect. There are always errors in data collection. Markets and competitive price positions change constantly. Consumer purchase preferences change regularly. However, price elasticity consistently helps answer some fundamental pricing questions.

You need to increase profits. But how?

Which of your items are overpriced? Underpriced?

Which of your competitors do your customers compare you to? For which items? Are you monitoring them often enough?

If you change prices, what will happen?

The fundamental decision you need to make on any given product at any given location or channel is to increase price, decrease price, or keep it the same. Price elasticity helps do this by:

- Estimating optimal price to achieve maximum profit and comparing to current price

- Identifying if a price must be increased or decreased to achieve a specific goal

- Forecasting impact on profit, sales, margin and other results

- Estimating how much metrics will change based on price sensitivity

Price elasticity determines an optimal price, then bounds it by other information, such as competitive price points, pricing relationships with other parts, channels, or segments, and business constraints like minimum margin or vendor minimum pricing.

One topic that is not discussed outside academia and pricing scientist gatherings is the fact that not all price elasticity approaches are created equal. Elasticity representing price sensitivity is fairly obvious for a high profile retail product sold on a regular basis with frequent price changes to position against multiple competitive substitutes. Calculating elasticity can be difficult where not enough data or price changes exist for items in a large assortment that don’t have a long demand history, few price changes, or few competitive alternatives. There are unique approaches to do this with intermittent demand models and inference using relevant item attributes.

There are also new techniques emerging for supplementing price elasticity (representing market price sensitivity) with competitive elasticity that measures price sensitivity to selected competitors. Price sensitivity is growing for items sold online, particularly on channels like marketplaces where many similar substitutes are available and price becomes the key decision point. Identifying which competitor(s) are meaningful can help focus competitive price monitoring and positioning once optimal pricing is determined.

Price elasticity is a fundamental building block in achieving higher level, global objectives. These can take many forms, such as:

- Scenarios to achieve improvements in profit, margin, sales, revenue, or other metrics [Prolific link]

- Lifetime value of the customer to maximize long term customer relationships

- Pricing to reduce inventory

- Optimizing project quotes

The technology at the leading edge changes so rapidly that you have to keep current after you get out of school. I think probably the most important thing is having good fundamentals.”

-- Gordon Moore

There are many ways to construct sophisticated pricing strategies; getting the fundamentals of price elasticity right is the first step in the journey to success.

Bottom line: A key decision in changing prices is directionality. Price elasticity helps forecast what will happen to profits, revenue, margins, and other key metrics based on different moves. This supplements other information in a pricing decision like current competitive price position, what other business and legal constraints need to be considered, and what overall strategic objectives are. Price elasticity is never perfect, but it is still a powerful input into any pricing decision.

I am sure there are many people in my network who will point out what I missed! If you liked this article or think of something to add, please leave a comment or ask a question.

p.s. Many of my friends will wonder why I picked the photo of the listing aircraft carrier. It is the HMS Ark Royal, deemed lucky by the crew after many near-misses. She had flaws as an early, innovative carrier design but still successfully completed many key missions…and thus the choice.

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