Economic Theories Behind Pricing Strategies

Economic theories shape pricing strategies, helping to predict market reactions to product prices. This refresher highlights the core aspects of the theory of price, focusing on the Law of Supply and Demand and price elasticity.

The theory of price is a fundamental concept in economics that explains how the prices of goods and services are determined in a market. It also provides a framework for understanding how prices influence consumer behaviour and producer decisions.

This article does not intend to provide a comprehensive explanation of all economic theories; for that, it is best to consult foundational economics literature. Instead, it serves as a refresher on the key components of the theory of price:

• The Law of Supply and Demand
• Price elasticity

The Law of Supply and Demand

The Law of Supply and Demand is a fundamental principle in economics that describes how prices and quantities of goods and services are determined in a market economy. It is based on the interaction between sellers' supply and buyers' demand for a product.

• Law of Demand states that, all else being equal, as the price of a product decreases, the quantity demanded increases, and vice versa. This creates a downward-sloping demand curve.
• Law of Supply states that, all else being equal, as the price of a product increases, the quantity supplied increases, and vice versa. This creates an upward-sloping supply curve.
• Market Equilibrium occurs when the quantity of a good or service supplied is equal to the quantity demanded at a particular price level. At this point, the market is in a state of balance, and there is no tendency for the price to change, assuming other factors remain constant.

If the market price is above the equilibrium price, there will be a surplus of goods (excess supply), leading producers to lower prices to increase sales. Conversely, if the market price is below the equilibrium price, there will be a shortage of goods (excess demand), prompting producers to raise prices. These adjustments continue until the market reaches equilibrium.

Consumer Surplus and Producer Surplus

Some consumers are willing to spend more on a product than the equilibrium price. The total difference between the equilibrium price of an item and the higher price a consumer is willing to spend is call the consumer surplus at the equilibrium. Similarly, some producers are willing to sell a product at a price lower than the equilibrium price. The total difference between the equilibrium price of the item and lower price producers are willing to accept is called the producer surplus at the equilibrium.

Both consumer surplus and producer surplus are economic terms used to define market wellness by studying the relationship between the consumers and suppliers. They explain the opportunity cost consumers forego to gain a marginal benefit (MB) for buying a good or service. To the producer, it is the willingness and ability to produce an extra unit of a product based on the marginal cost (MC) of producing more goods.

The consumer surplus and producer surplus together are the total surplus, also known as total welfare. It is used to determine the well-being of the market.

Change of Market Equilibrium

Market equilibrium can change if there is a shift in either the supply curve or the demand curve, resulting in a new equilibrium price and quantity.

Factors that can shift the demand curve include:

• Changes in consumer preferences
• Income levels
• Prices of related goods
• Expectations of future prices or income
• Increases in population
• Seasonal changes

Factors that can shift the supply curve include:

• Technological advancements
• Prices of related goods
• Number of sellers
• Expectations of future prices
• Government policies
• Natural factors (weather, natural disasters)

Price Elasticity

The Law of Supply and Demand is closely connected to the concept of price elasticity, a critical element that informs pricing strategy.

Price elasticity is a measure of the relationship between a change in the quantity demanded, or supplied, and the corresponding percent change in price.

In general words, price elasticity measures how sensitive the demand or supply of a product are to changes in its price. For elastic products, price reductions can lead to increased revenue, while price increases may result in revenue loss. Inelastic products may allow for higher prices without significant demand declines.

There are four types of elasticity that informs pricing strategy:

• Price elasticity of demand
• Cross price elasticity of demand
• Income elasticity of demand
• Price elasticity of supply

Price Elasticity of Demand

Price elasticity of demand (PED) is a crucial concept for developing or choosing a pricing strategy, as it helps businesses understand how price changes might affect their sales volume and revenue. It measures how sensitive the quantity demanded of a product is to changes in its price.

Based on its definition price elasticity of demand can fall into one of three buckets:

• Elastic demand (PED > 1): For products with elastic demand, reducing prices can significantly increase sales volume, potentially increasing overall revenue. Conversely, increasing prices might lead to a significant drop in sales. For example, cars, clothing, soft drinks, electronic gadgets.
• Inelastic demand (PED < 1): For products with inelastic demand, increasing prices can lead to higher revenue since the drop in quantity demanded will be relatively small. For example, petrol, basic utilities like electricity and water, cigarettes, salt.
• Unitary elastic demand (PED = 1): When the percentage change in quantity demanded is exactly equal to the percentage change in price; this is very rare.

There are also two extremes of this elasticity, forming two more buckets:

• Perfectly Inelastic Demand (PED = 0): There is no change in quantity at all when price changes. For example, insulin for diabetics, or life-saving medical services.
• Perfectly Elastic Demand (PED = ∞): The response to price is complete and infinite; a change in price results in the quantity falling to zero. For example, commodities in a perfectly competitive market. Agricultural products like wheat where producers are price takers. A tiny increase in price would result in the quantity demanded dropping to zero as consumers can buy from another seller.

Key factors that affect price elasticity of demand:

1. Availability of close substitutes: If consumers are unable to substitute a good, the good would experience inelastic demand, and vice versa.
2. If the good is a luxury or a necessity: The price elasticity of demand is lower if the good is something the consumer needs, and higher if it is a luxury good.
3. The proportion of income spent on the good: The price elasticity of demand tends to be low when spending on a good is a small proportion of their available income.
4. How much time has elapsed since the time the price changed: In the long term, consumers are more elastic over longer periods, as over the long term after a price increase of a good, they will find acceptable and less costly substitutes.

Cross Price Elasticity of Demand

Another important concept is cross price elasticity of demand (XED) that measures how the quantity demanded of one product changes in response to a price change in another product:

• XED > 0 indicates that the two products are substitutes. If the price of Product B increases, the demand for Product A increases. For example: Coke and Pepsi, butter and margarine.
• XED < 0 indicates that the two products are complements. If the price of Product B increases, the demand for Product A decreases. For example: printers and ink cartridges, cars and petrol.
• XED = 0 indicates no relationship between the two products. For example, a change in the price of bread is unlikely to affect the demand for washing machines.

Knowledge of cross price elasticity of demand aids in positioning products strategically in the market, setting prices to prevent product cannibalisation, and deciding on promotions and discounts.

Income Elasticity of Demand

Income elasticity of demand (YED) measures the responsiveness of the quantity demanded of a product to a change in consumer income.

There are three classifications for how goods or services respond to changes in income: negative, positive, and neutral (or zero).

• Inferior goods (YED < 0) have a negative income elasticity of demand. This means that when incomes rise, demand for those goods declines. For example, cheaper cars are inferior goods. When our income is low, we choose cheaper cars. However, as soon as we can afford it, we go upmarket, i.e., we buy more expensive vehicles.
• Normal goods (YED > 0) have a positive income elasticity of demand. When incomes go up so does demand for normal goods. In this context, both luxury goods and necessity goods are normal goods.
  • If income elasticity of demand is greater than 1 (YED > 1), it is a luxury good.
  • If it is less than one but more than zero (0 < YED < 1), it is a necessity good.
  • When we go upmarket from cheaper cars because our income has risen, we buy a luxury car. Luxury cars are normal goods.
• YED = 0: Staple goods have a zero income elasticity of demand. This means that changes in people’s income have no impact on the sales of those goods. For example: salt, ketchup, flour, and milk.

Price Elasticity of Supply

Price elasticity of supply (PES) measures the responsiveness of the quantity supplied of a good to a change in its price.

• Elastic supply (PES > 1): Quantity supplied changes significantly with a small change in price. When supply is elastic, firms can easily increase production in response to price increases. This is common in industries with scalable production processes. Knowing this, businesses can use dynamic pricing strategies to maximise revenue, increasing prices when demand spikes and quickly ramping up production to meet increased demand.
• Inelastic supply (PES < 1): Quantity supplied changes little with a large change in price. In this case, businesses know that increasing prices won't significantly increase the quantity supplied. This might be due to production constraints or fixed resources. For example, a company selling unique handmade products knows it cannot quickly ramp up production in response to price increases, so it might set higher prices to maximise revenue from limited supply.
• Unitary elastic supply (PES = 1): Quantity supplied changes exactly in proportion to price change.

As an example of application of the price elasticity of supply, we can consider producing consumer electronics. In this industry supply is often more elastic. So, a company might use rapid price adjustments during product launch phases to balance demand and production capacity effectively.

Final Thoughts

Developing pricing strategies based on economic theories is crucial for businesses seeking to navigate complex market dynamics successfully. The Law of Supply and Demand, for example, help predict how changes in price might influence demand for a product or service.

Price elasticity, a key concept in pricing strategy development, enables businesses to gauge how sensitive customers are to price fluctuations. By accurately understanding and calculating price elasticity, businesses can avoid the pitfalls of setting prices too high or too low, ensuring a balanced approach that maximises both customer satisfaction and profitability.