Business Analysis: Pricing strategies and Demand Curve
Pricing is a common term used in business to mean a seller’s approach to setting the monetary value of goods or services products. It is one of the most important aspects of a business. Pricing determines whether a company succeeds or fails based on demand and competition. The approach taken by a seller to describe how they pursue sales and marketing objectives through the price of a product is referred to as a pricing strategy. This is just like a marketing strategy because they follow the outline to achieve their goals. A company needs a pricing model to implement its pricing strategy. The model gives instructions and rules of setting and creating margins for their success. Hence, the pricing model is simply the skeleton of a roadmap when setting standards for product prices.
Pricing is a marketing activity. We can look at this based on the textbook definition of marketing as:
- A set of actions that communicate the value of a product to the customer and vise versa with the aim of selling and
- Marketing is meant to increase customer demands.
These definitions often includes ‘the four P’s of marketing’ whereby pricing is one of them, hence supporting its objective. The other three include Product, Placement, and Promotion, which all connect pricing to marketing.
In pricing, the seller has to set a list of price, also reference price, or base price) for chosen products. In this case, the reference price is the price a customer pays typically. This is to say, pricing has specified financial objectives. Hence, sellers price using one or more of the following financial goals in view. They assign the list price to:
1. Maximize unit sales and market share regarding unit sales.
2. To increase sales revenues and market shares based on sales revenues.
3. Give maximum leverage to gross profits
4. Leverage sales of similar products.
Besides, a company must use pricing to pursue positioning objectives, including:
· Communicating and reinforcing a brand reputation, creating a perception of product quality, desirability, or value.
Many people still find a hard time defining pricing because it is a wide subject. There are a few things a seller must keep in mind to get the best out of their products. They must not, for instance, price a product or service too low that it devalues it or too high for the reach of target customers. Based on this, we can explain pricing in a contextual manner.
First, we can use pricing in as a marketing activity. Here, the seller assigns a price for their product or serves with the aim of selling. This means they have to research properly what competition is selling and compare it to the cost of manufacturing. Secondly, pricing can be looked at from a marketer’s point of view, in which demand is a function of price. Quantitative demand curves reveal to sellers where to optimize sales revenues, units sold, or the profits gained. The third perspective is the economist’s viewpoint, where the price is a function of demand, the opposite of the second viewpoint. This leads to the fourth viewpoint, where marketers normally apply any of the two common pricing strategies or pricing models. The fifth and last viewpoint is where marketers try to avoid popular pricing mistakes.
Customer Demand and Pricing Analysis
Seller may wish to pursue one of more of their marketing objectives, as mentioned above. To do this, they will have first try to understand the relationship between price and other factors, including customer demand, sales revenues, product cost, gross profits, and product positioning.
In this analysis, the seller begins by estimating unit demand as a function of price, creating a price-demand curve. And for each price point, they use;
Sales revenue=unit demand x unit list price
Product cost(the cost of sold goods or service)= Fixed costs+ (unit demand x variable cost increment per unit)
Gross profits=Sales revenues – product costs
In this pricing analysis, there are often chances that maximum units solid, maximum revenues, and maximum gross profits all appear at different price points. The true price depends on the clear objectives set out but the seller.
The Price-Demand Curve For Marketing
A seller needs to estimate demand for one product, as shown above, as a function of price over the unit. In this case, the price-demand curve becomes a very crucial and important aspect of price analysis and decisions. Hence:
- Demand from the customer’s point of view is essential for estimating other factors. Processes like revenues, product costs, and gross profits all function under price and market demand. To analyze price, therefore, the price-demand consideration must be the first things a seller has to look out for.
- Customer demand is one of the most difficult aspects to estimate compared to all other factors. It is also the most uncertain. Price-demand curves are often changing, affecting the forecasting of revenues, costs, and gross profits.
- Sometimes forecasting sales and profits can go extremely wrong. In this case, the problem can be easily linked to an inappropriate demand curve.
In short, the marketer involved in a pricing setting, or the analyst must understand that “if you get the demand curve right, then you will get your sales and profit forecasts right as well.”
There is a clear relationship between demand and price that cannot be overlooked. This relation is formally called price elasticity of demand (PED, or PEoD). The PED shows how demand and prices shift in uniform. Based on the economic theory, you can find a mathematical foundation for measuring and modeling PED.
In the case of real-world pricing, sellers may have to refer to economic theory, whereby they will be able to suggest the general shape of the demand curve concerning a selected class of products. But then, experts in price analysis understand that there are other things in the market, economy, and environment to which demand also reacts. The factors are natural to built into the economist’s, though. Also, they estimate PED a very complicated process for marketers.
Marketer looks at demand from the price perspective, whereas economists consider price as a result of supply and demand. If a marketer applies the economist’s theory for marketing price analysis, they will quickly realize the graph curves differently. This is because economists begin by placing “demand” on the horizontal axis and “price” on the vertical. This is the reverse of a marketer’s perspective. It is vital to understand why there is such a difference in the conventions. First, price is a dependent variable to the economist. It is also a function of factors like supply and demand. And second, the marketer analyzing the relationship between price and demand, a product’s demand is a dependent variable. This means the marketer looks at demand as a function of price. In this case, “price” becomes the independent variable.
Conventions graphs in economics
In many instances, sellers and marketers turn to the economic theory when engaging in price setting. They use this together with a large part of empirical research on price and customer demand as the initial step to estimation the right price-demand curve for specific products.
There is a need for the marketer to understand how product pricing with demand. Let’s look at three scenarios.
In the first instance, in the case of “normal” products, demand decreases in response to increasing prices. Hence on a graph, you will see a negative slope, which explains why the products have a negative PED coefficient. In simple terms, the slope is saying that demand will be decreasing as the price goes higher. This only proves more that demand changes with a given price change. When the seller decides to change the price, therefore, they need to be very careful how they do it so that they don’t chase away their customers. This, of necessity, means the seller must be sure to go through thorough market research and to consider the competition before making a price alteration.
In this instance also, you will notice that the price-demand curve for products known and Giffin products should be involved to show the relations properly. In this case, the demand increase as a price increase. It is rare to find products that have genuine Giffin demand curves. But, many necessary ‘normal’ products, as discussed above, sometimes show Giffin-like demand features, at least for short parts of their potential price range.
The second instance, in this case, involves the demand shift for a typical product. The demand curve can change with market changes as well. This may happen when competitors raise their price of leaving the marketer, or when a seller’s promotional campaign is very successful. Here, demand slides back to the original location or somewhere else close to the end of product life. Sometimes it also happens when competitors drop their prices. In any, the seller needs to be cautious with the pricing strategy they take. You have to look at the effects of either lowering the price too to reach the market demand or keeping it high to prove your quality.
In the third instance, we look at the revelation of Giffen-like price demand characteristics. In this case, price changes with price in the normal direction for a product’s possible price range. There are situations, however, where products show Giffin-like behavior. For instance, we can still refer to one of the previous situations above where demand increases as a price increase. Products in this kind of demand curve include cosmetics and fashion accessories. Here, customers look as products with lower prices are “cheap” and without brand appeal. When price increases (up to a particular point), the value of that particular brand’s image also increase, and does demand. Customers judge these products based on their price tag.
How to calculate (measure) Elasticity of demand
Sellers must continuously refer to economic research to know the price elasticity of demand (PED) coefficients for specified products. It is through such data that they can know the general price-demand curve or profile for selected classes. However, besides price, other factors determine the demand curve. Such factors main include the influence of branding, competition, and seasonality. For this reason, brands try to include these aspects when creating demand curves and PEDs.
By knowing the exact PED coefficient, one better gets the accuracy in estimating the complete curve for priced demand. And this also answers the all-important pricing questions such as;
- How will changing prices by 10% affect unit sales
- What changes will we see on everything if we put everything on sale at “30% off”?
In calculating PED, the seller uses the following symbols;
Q1= unit demand at price 1
P1 = price 1( The price before change)
Q2 = Unit demand at price 2
P2= Price 2 (The price after the adjustment)
More meaning and interpretation of Elasticity of demand
The price-demand arc needs to be well understood if the seller wishes to attract customers and make a sale. Therefore, altering price by a specific percentage can result in a percentage change in unity demand by -1.17 times percentage price change. Here the PED is negative; hence it will give a negative slope on the price-demand curve arc. Simply put, the Elasticity of a “normal” product; as price decreases, demand increases. Also, the positive PED would show Giffin goods where demand increases with price.
Forecasting unit sales, product sales, product costs, and gross profits accurately can be challenging for a seller. They must first have the ability to forecast demand as a function of price with accuracy. The “price” from a seller point of view, is, however, not the only factor that affects customer demand of price elasticity demand. Hence, those estimating demand price elasticity must consider the following factors:
- Competitors as their prices as well as existing prices on the market.
- Possible responses from competitors, especially where price change and new products are involved.
- The presence of substitute products.
- The market size and seller’s accessibility.
- Expected negative and positive market growth.
- Temporary and permanent changes in demand.
- Branding strength and brand loyalty of the company and its competitors.
- The ability of the seller to use promotions to increase demand.
- The current economic environment.
These factors can significantly affect the seller pricing strategy. Hence, it calls for good use of pricing exceptions to list prices like discount and sale pricing. Sales and discounts can be the best way to analyze and implement pricing strategy.
Author: James Hamilton