How Could the Knowledge of Demand Elasticity Lead to Make Pricing Decisions
The relationship between “Demand Elasticity” and “Pricing Decisions”, it can simply treat this as the relationship between “Buyer” and “Seller”.
Generally, the role of buyer and seller is in an opposite standpoint, no matter in which century or even during the Stone Age. The conflict between buyer and seller is because they all want to maximize their profit; under this criterion no one is willing to give away their profile.
Although the standpoint for buyer and seller are in opposite, but indeed they cannot live without each other. The seller affects buyer but also affected by buyer, there is always a proverbial saying in China – “There is no compulsory trading, everything is just one party willing to sell and the other party willing to buy”.
How Could the Knowledge of Demand Elasticity Lead to Make Pricing Decisions
The Pricing Decision
Price is the amount of money charged for a product or charged for a service, it is the values that customers willing to pay and give-up in order to obtain the benefits of having or using a product or service.
Price is a unique nature among the Marketing-Mix elements. It is because Price is the only element in the marketing mix that produces profit and revenue, the other three elements: Product, Place and Promotion are representing costs and values needed to input.
Factors to consider when setting Prices
The pricing decision of a product or services may be subject to a number of factors, for those factors it can be divided into two main categories, they are internal factors and external factor.
Internal Factors to consider when setting Prices
Internal Factors: Marketing Objectives
Return on Investment (ROI) – a company marketing objectives can be set to the requirements of all products that meet a certain percentage of return on the organization's spending in marketing products. This level of return and estimated the sale will help to determine the appropriate price level to meet ROI objectives.
Cash Flow – companies may like to set the prices at the level which can be ensured the sale will at least cover the cost of production and distribution. This is the most likely an organizational goal for new products, so that the new products can simply establish in the market. This goal can let company no need to worry about the profitability of new products, and input more effort in building a market for the product.
Market Share – when companies would like to obtain or to retain a substantial and large part of the market, they will set the prices at the level artificially low. It can let their product become easier to accept by the customer and the marker.
Internal Factors: Marketing Strategy
Marketing strategy is to help the company achieve its business and marketing objectives, also, to enter target market. Price, of course, it is a core element. It is because all decisions must work together with the final price setting and the price setting may also affect how other marketing decisions are made.
Internal Factors: Costs
For most companies, when setting the prices of a product or services, they will determine how much cost is needed for getting the product or services to the customer. Obviously, the price must exceed the production cost; otherwise companies will suffer a loss. Costs can be divided into two categories: Fixed costs and Variable Costs.
When companies need to analyzing the costs needed for getting the product or services to the customer and market. These costs can be divided into two categories: Fixed Costs and Variable Costs.
Fixed Costs are the costs that will not affect by the production or distribution, for example: Rent; Utilities, Interest and Executive salaries.
Variable costs are the costs that affecting by production or distribution, for example: raw materials, components of the product, packaging and logistic.
External Factors to consider when setting Prices
External Factors: Competitors and Other Products
Direct Competitor Pricing – before making the pricing decisions, most companies will research and evaluate competitor's products or services and the prices setting. The final price will be closed to the existing market prices. Especially in highly competitive industries, such as air travel, companies will respond to their competitor's price adjustments quickly, so as to reduce the impact
Related Product Pricing - Products that offer new ways for solving customer needs may look to pricing of products that customers are currently using even though these other products may not appear to be direct competitors.
Primary Product Pricing – company may treat their products as a complementary to a primary product. For example, the Bluetooth headsets are considered complementary to the main products mobile phones. The pricing of complementary products may be affected by the change of price for the primary products, because customers will compare the price for complementary products based on the primary product price.
External Factors: Government Regulation
Company must caution of the Government Regulation that affect how the price should be set in the market for selling their products. These regulations are mainly promulgated by the Government, if you do not follow by the rules may have legal consequences. For example, some Middle East Countries, their Government promulgated that for luxury items, the prices should be artificially high, so as to retain an unsophisticated country.
External Factors: Types of Markets
Pure competition: it means that a market with many buyers and sellers trading uniform commodities where no single buyer or seller has much effect on market price.
Monopolistic competition: it means that a market with many buyers and sellers who trade over a range of prices rather than a single market price with differentiated offers.
Oligopolistic competition: it means that a market with few sellers because it is difficult for sellers to enter who are highly sensitive to each other's pricing and marketing strategies.
Pure monopoly: it means that a market with only one seller. In a regulated monopoly, the government permits a price that will yield a fair return. In a non-regulated monopoly, companies are free to set a market price.
The Demand Elasticity
Demand is the need of customer, when the prices of the needed item raised, customer will buy less of it. Relatively, when the prices lower down, customer will buy more, that's the law of demand. Elasticity is a measure of how much buyers and sellers respond to changes in market conditions, it allows us to analyze supply and demand with greater precision.
The law of demand tells us the direction of change; elasticity tells us the magnitude of change as well. Demand Elasticity is a measure of how much the quantity demanded of a good responds to a change in the price of that good.
The price elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in price.
Type of Demand Elasticity
It can be simply divided the Demand Elasticity into five types: Unitary Elastic, Relatively Elastic, Relatively Inelastic, Perfectly Elastic and Perfectly Inelastic.
Factors Affecting the Price Elasticity of Demand
The availability of substitutes – it is the most important factor affecting the elasticity of the goods or services. In normal circumstances, the more substitutes, the more elastic demand. For example, if the price of a cup of coffee rose by 2 U.S. dollars, consumers can replace the caffeine in the morning from a cup of coffee instead of a cup of tea. This means that coffee is an elastic good; because higher prices will lead to a significant reduction in the demand of consumers begin to buy more tea.
Amount of income available to spend on the good - This factor affecting demand elasticity refers to a person's total spending on purchasing product or services. For example, if the price of a bottle of orange squash rose from 1 U.S. dollars to 2 U.S. dollar and income remained unchanged, the income available to spend on orange squash which is 4 U.S. dollars. Now, it can only buy 2 bottles of orange squash rather than 4 bottles. In other words, customers are forced to reduce their orange squash's needs. Therefore, if there is a rise of prices, but remain unchanged for the income, the amount of income available to spend on purchase, there will be an elastic reaction in demand; demand will be sensitive to a change in price if there is no change in income.
Degree of necessity or luxury: luxury products have greater elasticity. Some products that initially have a low degree of necessity. It is just a habit forming and can become "necessities" to some consumers.
Time – The third influential factor is time. If the price of cigarettes per pack goes up 2 U.S. dollars, a smoker only have few substitutes, then the smoker will continue to buy his or her daily cigarettes. This means that tobacco is inelastic because the price change will not have a significant impact on demand. However, if the smoker that he or she cannot spend extra 2 U.S. dollars a day, began to quit for some time, the price elasticity of cigarettes to consumers has become elastic in the long run.
Price points – decreasing the price from 10 U.S. dollars to 9.99 U.S. dollars may elicit a greater response than decreasing from 9.99 U.S. dollars to 9.98 U.S. dollars.
The relationship between Demand Elasticity and Pricing Decisions
The demand curve shows the number of units the market will buy in a given period at different prices. Generally, demand and price are inversely related. When higher price, there will just occurs lower demand.
Before setting prices, companies must understand the relationship between price and demand for their products. Companies should figure out is there any demand (needs) for their products in the market. If the demand from the market is 0, then no matter how good of the product, the demand remains unchanged.
Price elasticity of demand show that the response of demand to a change in price. Inelastic demand occurs when demand hardly changes when there is a small change in price. Elastic demand occurs when demand changes greatly for a small change in price.
Demand Elasticity and Pricing Decisions, since they have different standpoint, but they must rely with each other.
So as the maximize profit, company should basic on different market and different demand elasticity to set the price. For example, under the uniform pricing situation, when the elasticity of demand higher than 1, which means company should decrease the price so as to increase the total revenue (maximize the profit).
When the elasticity of demand less than 1, that means company should increase the price and increase the total revenue (maximize the profit).
If a company cannot understand or evaluate the situation of demand elasticity, they will be hard to earn the maximize profit.
Demand Relationships and Pricing Decisions for Related Products by Rene P. Manes, Francoise Shoumaker and Peter A. Silhan
Managerial Economics analysis and strategy (4th edition) by Evan J. Douglas
Managerial Economics for business, management and accounting (2nd edition) by Howard Davies
Macro economics (4th edition) by N. Gregory Mankiw
Ed meaning: http://www.econman.net
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