A lot of small business owners approach their pricing strategy like throwing darts with a blindfold. You toss a number out there to a prospective client and see if it sticks.
Is it the right one? A level of pricing that can support your business? A price that communicates the value you're offering sufficiently?
Who's to say?
I wasn't allowed to play with darts much as a kid, but I loved finding rubber bands around the house.
Elastic fascinates me because you can stretch or tie it around something, and it'll always rebound to its original shape - until you stretch it too far and it snaps.
I had a habit of picking up rubber bands, wrapping them around my fingers, and then firing them off at targets in the house. The rubber would stretch and create tension, and then, when released, it'd snap back into shape, catapulting off my finger.
You may have heard of a concept called the price elasticity of demand.
This concept refers to how sensitive customers are to fluctuations in the pricing of a product or service. Marketers assume that the more expensive a product, the fewer people will buy it.
But that's not quite the whole story.
Price elasticity allows you to deeply understand how strongly your customer's demand is for what you're supplying. It could be the secret to finding the pricing sweet spot you've been looking for this whole time.
Welcome back to The Profit Plot, a podcast where we help small business owners unlock the story behind their profitable business by unpacking one complex financial topic at a time. I am your host, Jeremy Millar.
Much like the gravitational pull that keeps us grounded on Earth, the forces of supply and demand govern the marketplace.
Now, this is not an economics show, I want to be clear about that. I'm an accountant, not an economist! But, understanding supply and demand can provide a significant edge for business owners looking to scale profitably.
Today, we are taking a closer look at one half of this balanced scale: demand, and how it sways with changes in price.
Let's imagine for a moment that you own a boutique coffee shop, a place where the aroma of freshly brewed coffee lingers in the air, and the community gathers to enjoy a cup of quality brew.
You currently sell a latte at $6 per cup, $7 with oat milk. You're thinking, "what would happen if I decided to increase the price by a dollar?" Would sales drop drastically, or would your loyal customer base not even bat an eye?
This is where the concept of price elasticity comes into play.
If a small change in price results in a change in the quantity demanded, we say the demand is elastic. On the flip side, the demand is inelastic if the quantity demanded remains relatively stable despite a price change.
We can measure elasticity by measuring the change in our sales with a really simple equation.
Let's say your coffee shop sells 1,000 lattes at $6 per cup within a normal period. You plan to increase the price of a latte to $7. That's almost a 17% increase in price - 16.67%. to be exact.
With the price increase of your cup of coffee implemented, you see demand fall to 900 lattes within the same period. A decrease of 10%!
Elasticity is measured by dividing the percentage change in quantity demanded by the percentage change in price. So, we're looking at .10 divided by .1667, which comes out to be .599.
For context, a "perfectly inelastic" demand level would yield a zero result. In this case, the level of demand would not change whatsoever when the price of a good changes. Our shift from $6 to $7 lattes would receive no dip in demand whatsoever if it was perfectly inelastic.
In the case of our coffee shop, we seem to have a "relatively inelastic" level of demand: our result was greater than zero, but less than 1.
If our price elasticity of demand were equal to 1, we would have unit elasticity. The percentage by which we change our pricing equals the effect on demand. Raising prices by 10% in this case would mean you see 10% less demand.
If our formula were to yield a number greater than one, we would be experiencing something that is relatively elastic. Small adjustments to our price would mean large changes in the demand from our customers.
The larger the number yielded from our formula, the more elastic.
As a business owner, understanding the elasticity of your products or services can help you make informed decisions. It lets you forecast how a price change might affect your sales volume and overall revenue.
There's an interesting thing about elasticity, though - it's helpful to quantify how elastic demand may be, but it needs to be put into context with the product or service you're providing.
In our example of a coffee shop, we saw that demand went down by 10% in our measurement period. Prior to changing the price, we saw a demand of about 1,000 units, whereas after, our demand was 900 units.
But we made more money.
At $6 per latte, 1,000 lattes equals $6,000. At $7 per latte, 900 lattes is $6,300.
In this scenario, we may have lowered our demand slightly, but we've increased our gross revenue because of the increase in price overall. Lowering demand also means that we need to produce fewer quantities of product, so our employees can focus on taking their time, potentially improving quality.
The price elasticity of demand also depends on the product we're selling. Our latte may have a relatively inelastic level of demand, but the pastries we sell may not.
Understanding this calculation can help shape marketing decisions for your business in a major way. You see, a marketer's goal is to create a brand that is significantly differentiated from others. If we can create brands that connect meaningfully with people, our products become more inelastic.
Products sold by brandless, unrecognizable companies are often treated as commodities - they don't have a big impact on a consumer's life, making pricing a sensitive subject.
Ultimately, brands can move products from relatively elastic to relatively inelastic through our marketing initiatives by standing out in the market.
And just like the rubber bands that fascinated me so much as a child, understanding the intricacies of price elasticity of demand allows us to stretch and grow our businesses without snapping the delicate balance of supply and demand.
It's all about finding that sweet spot - that optimal stretch where your business thrives, maintains its shape, and continues to catapult forward in the marketplace.
As we wind down today's exploration into the complex yet fascinating world of price elasticity, remember, the true art of business lies in mastering the subtleties of pricing to create a resilient business.
One that not only withstands the fluctuations of the market but also remains attuned to the pulse of consumer demand.
Before we close, I want you to consider something: how does branding influence price elasticity? How can building a powerful brand narrative create a buffer against price fluctuations? Are you trying to build a brand, or are you more interested in simply moving products?
If today's episode resonated with you, share it with a fellow entrepreneur or business owner. Let's foster a community that thrives not just on profits but on shared knowledge and collaborative growth. And remember, your journey into the narrative behind your business doesn't end here. There are still many layers to uncover, many stories to tell, and countless opportunities to learn and grow.
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Join us again soon as we venture to unlock the financial story behind your profitable business. Looking forward to having you here with us next time, on The Profit Plot.