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What is price elasticity and how does it work?
I have a client who wants to increase their profitability by selling at higher prices.? Their challenge is simple; how much can they increase the price, what effects will a price increase have on their volumes and where is optimum profitability found?
What is price elasticity?
The concept of price elasticity is a measure of how the sales volume will change in relation to a change in the selling price.? So as you reduce the price, theoretically the sales volume will go up.? And as you increase the price, the sales volume will reduce.
The interesting bit is that the changes are usually not linear.? So if you half the price, you won?t double the volume.? Or double the price, you won?t half the volume.
The effect of this is that at some point there will be an optimum combination of price and volume that creates the greatest profitability.? And it is that combination my client is seeking.
An example
My client is selling a software product with a licence fee price of $750.? At this price, they sell an average of 40 licences a month.
They plan to increase the price initially to $800, and expect a minor change in the volume to an average of 38 licences a month.
If the thinking is correct, the new price/volume combination will increase profitability by $400/month.? Here?s how:
- Current situation:? 40 licences/month at $750 each generates total revenue of $30,000
- New situation:? 38 licences/month at $800 each generates total revenue of $30,400
- All other factors unchanged
If the thinking is wrong, and the volume actually reduces to 37, then profitability will be reduced by $400.? Or if the volume remains unchanged at 40, the profitability will be increased by $2,000.
Testing
You might be wondering where the idea of a volume reduction from 40 to 38 came from.? Is it just an assumption, or is there some basis for the theory?
In this case there is a basis of theory.? To test the idea, the company did a simple A/B test in which it emailed an offer to a segment of its existing mailing list.? The offer went in two forms where the only variation was the price.? In 50% of the emails it was the current $750, in the other 50% the price was the increased $800.? The response rate of the two was then compared to come up with the volume of the reduction.
Here?s what to do next
If you?re interested in how this could help you, or feel I may be able to help you with some of the challenges you?re facing, please get in touch for an informal discussion.
There?s no commitment, we?ll just discuss your situation to see if working together might be a good fit. ?Contact me?now.
Best regards
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