How do you know what you should charge for your products or services? How will you know if it’s ok to raise prices? The outcome for your business to these decisions could be highly profitable or disastrous.
One way to figure out what to charge is to find out what everyone else is charging. That’s a perfectly reasonable approach and a good place to start, but that may not always work.
Another approach is to understand the elasticity of your product or service.
Elasticity is the sensitivity to changes in price. For example, furniture stores, jewelry stores and car dealerships are always having sales. That’s because these products are highly elastic. A sale has a strong impact on purchase decisions when a product is elastic. It can also cause a larger than expected drop in sales if the price is increased.
Other products like gasoline and cigarettes aren’t sold at sale prices often and in the case of gasoline, almost never. That’s because people aren’t going to use a lot more even if the product is offered for less money. The entire market will use slightly more, but individual consumers may or may not. This also means the prices for these products can increase with very little impact on the amount people buy, in other words, you can raise the price and the amount people buy will fall very little.
Whether a product is elastic or inelastic has a great impact on revenue. When you increase the price you get more for each item you sell, but you sell fewer items. If you decrease the price, you get less per item but you sell more of them. If a product is elastic increasing the price will cause your revenue to fall. If you decrease the price your revenue will rise, in other words, a discount or sale will increase your revenue.
On the other hand if your product is inelastic, your revenue will rise when you increase price and fall when you decrease price, lucky you!
When you change prices you are both gaining and losing revenue at the same time. Whether the gains outweigh the losses depends on the elasticity of the product. When prices are increased, you’re gaining from the increased price, but losing from the decreased quantity. If your product is elastic, the gain from the increased price will be more than offset by the decreased quantity, meaning your revenue will fall.
As a small business you won’t be able to measure the elasticity of your products or services directly, unless you’re a former econometrician turned baker, but you can use a few guidelines to determine the elasticity of your products.
Here are the things you need to consider:
- Is your product a necessity?
Necessities are much more likely to be inelastic than luxuries. Think about it, which one do you really need, gas to get to work or a streak for dinner? You can always eat hamburger instead of steak, but what other fuel are you going to put in your car?
- How many substitutes are there for your product?
The less there are, the more inelastic the demand for your product. There’s two way to look at this, one is can you use a different product or can you buy the same product someplace else for less?
With the example of gas, there aren’t other fuels you can use unless you buy a new car or convert your current car, both choices are expensive and probably not something you can do on your way home tonight. There are other gas stations though. As with most inelastic products, the demand for the product itself is inelastic, but much more elastic across brands.
- How much time does someone have to make a decision about purchasing your product?
You may not be able to buy a new electric car on your way home from work tonight, but next month or next year may be a very reasonable timeline. If you’ve got a broken pipe that’s leaked all over the kitchen and is threating your new hardwood floors, the time you have to make your decision is very limited, however if you are thinking about remodeling your kitchen your timeline is highly flexible.
- How expensive is your product or service compared to my customers’ incomes?
A new car is a big expense and takes up a large proportion of income. A pack of gum, which is probably not a necessity and can be purchased at a moment notice, is not expensive. Even if the price of the gum doubles, it’s still not a lot of money. If the price of a car goes up just 10%, suddenly it’s a lot more expensive!
Most small businesses will have an intuitive feel for the elasticity of their products and services, but if you are thinking about adding a new product or if you haven’t increased your prices in many years, these are things you’ll want to keep in mind as you make these decisions.