Elasticity and all that jazz
By Gary Dean, managing director of strategic consultancy, The Truffle Pig Consulting Co.
Back in February I wrote about having confidence in your pricing on my LinkedIn profile that sparked some discussions and debate.
The principal message was ‘know your value’; of course, your value is not just in your own hands to judge, it’s in the hands of the people you supply goods or services to. More of that later.
There is a factor in thinking about demand and pricing, and that’s another concept within micro-economics known as the Income Elasticity of Demand – IED for short.
Sounds weird right? The concept is one of our strategy tools and follows on from April’s article regarding examining supply and demand. Income elasticity of demand (IED) can often affect the potential price you can attach to what you sell, and its influence varies depending on how critical that item is to the potential purchaser.
The demand for a good or service is tied to the income of the customers who purchase it, so if the income changes, demand can be affected. The IED conceptual value is expressed as a percentage of the change in demand, arrived at by the change in demand divided by the percentage change in income.
Why does this matter to you? Well, the value of IED for what you sell can help indicate how sensitive the sale of it will be to changes in the economy, that place you cannot influence.
For example, GDP increases by 3% and the demand for what you sell increases by 4.5%, so the IED is 1.5. Conversely, if the demand only increased by 1% the IED would be 0.33.
Most things sold have a positive IED, but not all. A high IED number is a red flag in times of low growth or recession.
Let me give you some examples; if the IED is less than one then that item is seen as a necessity to most buyers, the demand doesn’t shift much in either good or bad times. An example could be fruit and vegetables, bacon and eggs.
If the IED is more than one then the item is seen as a superior product, it will be bought frequently in good times, but purchases will be cut back a little in bad times. An example is eating out at a nice restaurant or buying perfume. These items are therefore elastic.
If the IED is greater than two we are starting to see potential trouble, the item is viewed as a luxury, demand can fluctuate significantly. Examples could be sports cars, Caribbean holidays, Rolexes or indeed certain types of non-urgent home improvements. These items have high elasticity.
An IED of zero means the demand is inelastic, sometimes referred to as ‘sticky’, because no matter what happens the purchasing volume and demand for that item doesn’t change much regardless of price.
An example is bread, milk and salt (I was going to say pasta and toilet rolls but we know how that went, but you get the point).
Finally, a negative IED of less than zero means that item is viewed as an inferior choice and demand will fall in good times but increase in bad times, an example might be bus travel, ready meals, or canned fruit and meats.
Knowing the IED values of the things you offer is often seen as important not only in developing your ideas regarding demand, but also the price points you set at different times and how secure the demand is against a macro-economic impact over which you have no influence. These details are important in shaping your development (or survival) strategies, but for me it’s not a complete story.
Let’s jazz things up by throwing a ‘thought spanner’ in the works.
All the above is logical and evidenced based, and the above exercise can certainly help you produce demand forecasts that might give you or your finance department comfort, and as such is valuable.
However, markets and people do not behave in predictable and logical ways much of the time.
In the post on LinkedIn that I referred to earlier I wrote ‘if you believe that it is only the price that your customers care about then you haven’t done enough for them to value anything you offer apart from the price. Value is everything.’
Creating ‘value’ is conceptual, it’s not based on logical analysis or tangibility in my opinion, it’s all in the mind of the receiver of that value.
When I personally talk of value, I take the meaning to the widest limits, those of character and characteristics, of business culture, of moral and personal ethics, these are the factors that shape the beliefs that motivate people to act in a certain way the most.
And here’s the good news, you can shape the ‘value perception’ of what you offer, it’s in your hands.
If you and your organisation demonstrate the values of honesty, integrity, kindness, fairness, courage and confidence the value others have of your organisation will be desirable to them. You can buck the influence of the demand trend that effects other players in your market. You can reduce the influence of price because your value goes way beyond it.
Building this value transcends the logical part of the buying process. If it didn’t, we would all simply purchase the same basic things to survive each day without any further thought.