How to Test For Price Sensitivity

In the real world, businesses want to know by how much they can increase their prices without losing too many sales. We know this conceptually as price sensitivity.

Many businesses use pricing research to help them to understand price sensitivity.

The research questions centre around understanding what trade offs customers make in their purchasing decision, and which attributes they rate as more valuable than others insofar that they are willing to pay a premium for them.

This is a better approach than market research questions that ask people what they are prepared to pay for a product.

What people may say about pricing, and what they actually do at the point of purchase, can be very different so you have to be cautious about making important pricing decisions based on it.

Generally speaking, the variables that impact upon price sensitivity are:

  • The competitive environment – how your competitors price their products, the techniques they use and the range of pricing available
  • The customer’s perceived differentiation of the products – the lower the perceived differentiation, the greater the propensity to assume a product is a commodity, the greater likelihood there is little room to move away from competitor pricing.
  • The perceived positioning of the brand – the greater the quality attributed to the brand, the greater the ability for marketers to increase their prices.

 

Tradeoff Research Methods

Tradeoff research models, such as Simalto, are used to help determine price sensitivity (which is closely related to perceptions of value).

(The Simalto model is covered in Pricing Models Explained.)

It provides a framework, which is essentially a tradeoff grid, which a respondent completes to illustrate which product attributes are more important and what the customer is prepared to sacrifice. Those sacrifices may be quality versus price tradeoffs, or they may be related to different product features or service levels.

Tradeoff or Conjoint Analysis, which is closely related to Simalto, is a statistical technique used in market research to determine how people value different features that make up an individual product or service.

The objective of conjoint analysis is to determine what combination of a limited number of attributes is most influential on respondent choice or decision making.

(An attribute is a general feature of a product or service, for example, colour, weight, speed or size.)

A controlled set of potential products or services is shown to respondents and by analyzing how they make preferences between these products, the implicit valuation of the individual elements making up the product or service can be determined.

Price Sensitivity

These implicit valuations (utilities or part-worths) can be used to create market models that estimate market share, revenue and even profitability of new designs.

The respondent’s analysis may be along the lines of:

“Although DVD 1 is cheaper, I can’t playback any DVDs I have bought from Amazon. For $100 more, I can playback the DVDs I own and, as an extra bonus, I don’t have to buy recording discs.”

The Formula for Price Elasticity of Demand (PEoD)

Price elasticity measures the sensitivity of quantity demanded if a price is changed. To be able to calculate it, you will need to know the following information:

  • The percentage change in quantity demanded (in other words, you need to know the old quantity and the new quantity)
  • The percentage change in price (in other words, you need to know the old price and the new price)

THE FORMULA FOR PRICE ELASTICITY:

PEoD = (% Change in Quantity Demanded)/(% Change in Price)

WORKING CALCULATION EXAMPLE:
Tom Smith wants to understand the price elasticity of his widgets.

Here is what he knows:

Old price = $1.00
New Price = $1.15
Quantity Demanded (old) = 150
Quantity Demanded (new) = 120

First, Tom Smith will need to calculate the percentage change in the quantity his customers bought.

The formula for him to do this is:

(QUANTITY DEMAND (NEW) – QUANTITY DEMAND (OLD)) / QUANTITY DEMAND (OLD).

In other words,

(120-150) / 150 = (-30/150) = -0.2 (or -20%)

Next Tom Smith needs to calculate the percentage change in price. The formula for him to do this is:

(Price (NEW) – Price (OLD)) / Price (OLD)
($1.15-$1.00) / $1.00 = 0.15

With these two figures we can now calculate the price elasticity.

PEoD = (% Change in Quantity Demanded)/(% Change in Price)

PEoD = (-0.2)/0.15 = -1.33

In price elasticity values we ignore negatives. So this value is equivalent to 1.33.

As a general rule, the following applies:

  • Price is elastic when PEoD > 1 (it is sensitive to price changes)
  • Demand is unit elastic when PEoD = 1
  • Demand is Price Inelastic when PEoD < 1.

We can conclude, then, that demand for Tom Smith’s widgets are somewhat sensitive to price changes.

READ: More about pricing strategy

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