Price Sensitivity Analysis: Getting the Price Right

The quickest and efficient way for a company to maximize profits is to get the price right. Setting the price right is an essential and primary management function, the wrong price can shrink profits quickly. Companies want to offer the best price to their customers. But what does this mean? Is this the lowest price the customer is willing to pay? Is it the price that will give the best value? Or is it the price that will produce the highest profit and sales for the company?

Price Sensitivity and Pricing Strategy

JCPenny, a 100+-year-old American department store chain, embarked on a new pricing strategy called ‘Fair and Square’ prices. To attract customers, instead of using existing offers of deep discount sales which they were known for, it will offer three prices ( Every Day, Month-Long Value and Best Prices) and all will end in “0” rather than psychological price ending with “.99”. This turned out to be a failure for the company with losses amounting to $985m with a 25% drop in sales.

Pricing strategy is the process of determining the competitive price of a product or a service. This strategy is often combined with marketing strategies such as understanding market demand, economic patterns, and level of competition. Commonly-used pricing strategies are:

  1. Cost-based. A mark-up is added to the cost of the product to obtain the final price.
  2. Demand-based. Final price of a product is determined according to its demand. If demand is high then the price is set high on the other hand if demand is low, price is set low to attract more demand.
  3. Competition-based. The company considers the prices of its competitors’ to set the final price. Management can set the price higher, lower or equal to the competitors.
  4. Others.
    • Value-based. Final price is primarily based on the perceived or estimated value of a product or service to a consumer rather than according to the cost of the product or service.
    • Penetration-based. Final price is set low to so as to enter a highly competitive market or gain market share.
    • Premium-based. Final price is set high and higher compared to competitors so as to differentiate the product or service (product has a distinct competitive advantage).

Price sensitivity, on the other hand, is the amount or level of change in a consumer’s behavior brought by an increase or decrease in a product or service’s price. A consumer’s purchasing behavior is influenced by many factors such as personal preferences, their level of income, current trends, etc. Price sensitivity analysis focuses on how consumers place the importance of a product or service’s price relative to the other factors. There are several factors that influence this level of importance or sensitivity.

Other factors that affect the level of price sensitivity are:

  • Perceived fairness in pricing. If one store advertises the price of  Good A at $2 and offers a discount of $.10 when a buyer pays cash and another store offers the same Good A at a price of $1.90 but charges a $.10 surcharge if the buyer pays using a credit card, which store would sell more of Good A to credit users?
  • Buyer’s ability to hold stock or inventory. A large retail chain with a warehouse at their disposal will purchase huge quantities from their supplier compared to a start-up or pop-up shops with limited access to storage space.

Determining and understanding consumer’s sensitivity to a product or service’s change in price can help management in achieving a successful pricing strategy.

Importance of Price Sensitivity Analysis:

  • Helps management in achieving a pricing strategy that will optimize company profits.
  • Information gathered can be used by management for price discrimination.
    • Price discrimination. Companies charge customers different prices for the same goods or services.
  • Helps management determine the effect of a change in price on total revenue.
  • Helps management explore opportunities to reduce the price sensitivity of consumers such as adding more value (high quality) features or benefits and.
  • Determines whether the business is able to pass on some or all of the fees, tax, and costs (any increase in supply, ingredients or components of the product) to the consumer.
  • Determines the value consumers place on a product or service.
  • Reveals the customer’s willingness to pay.

Price Sensitivity Analysis using Price Elasticity of Demand

In Microeconomics, the law of demand states that, with all other factors being constant, price and the quantity demanded of a product and service are inversely related to each other. When the price of a product rises, the demand for the same product will fall.

A graphical representation of this relationship between price and demand is depicted in a demand curve:

  • The Y-axis (vertical) represents the price of the product and service.
  • The X-axis (horizontal) represents the quantity (# units) demanded of the product and service.
  • At a price of $15, the quantity demanded is 1,000 units.
  • As the price goes down and reaches $2, the quantity demanded increased three times and reached 3,000 units.
  • However, at $2 it does not necessarily mean the lowest price gives the maximum profit for the company. Nor does increasing the price above $15 will be optimal for the company. Good pricing decisions require an understanding of several factors (one good tool is knowing the break-even price per unit).
  • Measuring how each level of price change affects demand is useful insight for management.

The law of demand is based on underlying assumptions:

  • There is no change in the price of related products
  • There is no change in the level of income of the consumers.
  • There is no change in preferences and taste of consumers.
  • There are no expected price changes in the future.
  • No substitutes are available in the market.
  • There is no change in other factors such as the composition and size of the population, economic trends, government policy, and seasonal factors.

As mentioned earlier, measuring how a change in price affects demand is a piece of vital information for management. Price elasticity of demand is a measure used to show the responsiveness (elasticity) of quantity demanded of a product or service to a change in its price given all other factors are constant or remain unchanged. The change in price and quantity demanded is determined by calculating the difference between the new and the old or original.

So using the demand curve as an example.

At the $10 price level, the quantity demanded is at 1,900 units.

If the company lowers its price to $7, quantity demanded increases to 2,300 units.

The quotient or the value calculated is referred by economists as the “coefficient” of price elasticity of demand. Normally price elasticity is negative mainly due to the inverse relationship between price and quantity demanded (recall the law of demand; the price goes up, demand goes down). However, to interpret the meaning, the coefficient’s absolute value (non-negative) is used to gauge the elasticity based on the rules listed below (the table is an expanded version to reflect its effect on total revenue):

In our sample calculation, the absolute value of the coefficient of price elasticity of demand is .7, which is less than 1 (<1) thus we can conclude it is inelastic. If the company changes the product or service’s price by 1%, the quantity demanded will change by .7%. A change in price will mean a smaller change in quantity demanded. For example, a 10% increase in the price will result in a 7% decrease in quantity demanded.

In reality, quantity demanded goods and services respond slower to price changes in the short run but in the long run, it responds more significantly. Thus demand is likely to be inelastic (<1) in the short run and elastic (>1) in the long run.

For example, if the price of gasoline goes up, people will still continue to buy it. However, over time people will start to look for alternatives such as carpool to work instead of driving their own car, others may choose to live near their office or even purchase new cars that get more miles per gallon of gasoline.

We can plot all the different values of Price Elasticity of Demand along the demand curve:

Using alternative tools: Price Sensitivity Meter and Monadic Price Testing

Created by Dutch economist Peter Van Westendorp in 1976, the Price Sensitivity Meter (PSM) measures price sensitivity not by calculations (unlike to PED) but by surveying people on their willingness to pay in four different price brackets. The PSM is based on four (4) survey questions:

  1. At what price would you consider the product or service to be so expensive that you would not consider buying it? (Too expensive)
  2. At what price would you consider the product or service to be priced so low that you would feel the quality couldn’t be very good? (Too cheap)
  3. At what price would you consider the product or service is starting to get expensive, so that it is not out of the question, but you would have to give it some thought to buying it? (Expensive/High Side)
  4. At what price would you consider the product to be a bargain—a great buy for the money? (Cheap/Good Value)

Questions 1 and 2 make the respondents focus on an acceptable price level. Questions 3 and 4 narrows down the optimal price level. A statistically significant number of respondents should answer these questions. After the survey responses are gathered, these are summarized and plotted in a graph (you can use Microsoft Excel’s Histogram chart or PSM software). Using the graph, you can determine the optimal price range and optimal price point. These can be taken into account for profit margins and revenue projection when deciding on the final product or service’s price.

PSM is suitable for companies that want to determine the price brackets of their new goods and services. This is useful in the early phases of product development so companies can establish price thresholds as well as determine whether there are sufficient prospective buyers. It is a good tool for gauging consumers’ price perceptions and expectations. Despite its simplicity, it is not a definitive tool for deciding what the price for the product and service is.

Limitations of PSM for Price Sensitivity Analysis:

  • Only recommended for new products and services.
  • Significant amount of resources to conduct a survey.
  • Questions are not entirely engaging for respondents (adding more open-ended questions allows more insights).
  • Deals solely on price and does not address the features or benefits of the product and service. Some respondents may not be familiar with the benchmark prices and their knowledge of the product and service is limited.
  • Does not consider consumer’s buying behavior as well as the product or service’s competitors and market sector.

Monadic Price Testing is a fancy term for a single or singular price point. It is monadic because each individual respondent is exposed to only one price scenario during the survey (no price brackets or ranges). Unlike PSM where there are multiple questions, respondents are asked a single question.  The respondent sees only one price and is asked to state his intention or interest to buy at that price point.

In a monadic test, the survey population can be split into different groups or segments. For example, a population size of 1,000 respondents are grouped into A, B and C. In Group A’s survey, the product is displayed at one price, Group B sees a different price, and Group C sees the third price. If the survey tests a wide range of prices, a demand curve can be created.

Limitations of Monadic Price Testing for Price Sensitivity Analysis:

  • Significant amount of resources to conduct a survey (large respondents are required if there are different price points).
  • Does not consider product or service’s competitors and market sector.
  • Exposes respondents to one single price point and may inadvertently censor extreme responses.

Arsenal of Price Sensitivity Analysis Tools

In this day and age, consumers are more much empowered mainly due to the advent of technology. Consumers can easily compare a product’s features with its competitors, easily look for alternatives and countless product reviews are available online No matter what or how many tools you use there is no magic bullet to determining price sensitivity. No information is too much in getting the price right. Price sensitivity analysis is hedging your product and company against the unknown and gives insight into the product or service’s real value.

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