Using Economics to Set Your Prices

price elasticity

How much should you charge?

That’s an important strategic question. But rather than carefully analyzing the answer, many small business owners just “wing it.” As a result, their prices end up too low or too high to maximize their revenue. Knowing just a little micro economics can help small business owners figure out the “right” price for their products and services.

Charging the highest or lowest price in the market isn’t always the best approach. A business’s revenue – as you know doubt know – is the product the price charged for a product multiplied by the quantity sold.

Charge a high price and you might sell too few units to bring in the highest possible revenue. Charge a low price and you might not sell enough units to maximize your sales dollars.

Price Elasticity

This is where knowing a little micro-economics can help. Whether you are better off charging a high price or a low price depends on the price elasticity of demand for your product.

Although the term “price elasticity” makes some readers eyes glaze over and gives others frightening flashbacks of college classes, the concept is pretty straightforward. It’s just economist-speak for what normal people would call price sensitivity – a measure of how much more of your product customers want when the price goes down or how much less they demand when the price rises.

If you want to maximize your revenues, you need to know the price elasticity of demand for your products. When demand for your product is “price elastic,” customers’ willingness to buy is very sensitive to the price you charge. Edge up your price just a little, and demand drops a lot. In this case, raising your price will cause your total revenues to fall.

Although you will generate more revenue per unit by charging more, the number of units you sell will fall by more than your revenue per unit rises.

By contrast, when your customers’ demand for your product is “price inelastic,” the quantity they are willing to buy isn’t very sensitive to price. While the number of units you sell might fall in response to the price increase, that decline will be less than the boost in revenues you get from charging more per unit.

Is Customers’ Demand for Your Product Price Elastic or Inelastic?

Think about a couple of basic characteristics of your product or service:

First, Does the Product Have a Lot of Close Substitutes?

If you are selling something with a lot of close substitutes – brownies if you sell cookies, for example – demand tends to be pretty elastic. Raise your prices only a little and the customers you affectionately call cookie monsters will switch to the substitute source of a sugar high, leaving you with less revenue than when your price was lower.

Second, is Your Product a Luxury or a Necessity?

If you are selling a necessity (like a prescription drug), prices tend to be pretty inelastic. People can’t easily do without necessities so the cost has to rise a lot before people will go without their purchases. That’s different than luxuries (like high-end restaurant meals). People might readily do without those if prices rise.

Third, How Differentiated is Your Product?

If your customers think you have a great brand or other characteristics that differentiate your product from those of competitors, then their demand for your product won’t be very price sensitive. Consider Apple, for example. People aren’t so quick to buy a competitor’s smart phone in place of an iPhone when iPhone prices rise.

Fourth, Who Pays for Your Product?

When users pay personally, as in the case of vacation travelers, demand for hotel rooms tends to be elastic. Raise prices just a little and your customers are suddenly looking to pitch a tent in a campground. But when those same users are travelling on a corporate expense account, they hardly flinch when you boost the price of the rooms at your hotel.

Understanding price elasticity of demand is important for small business owners. Knowing your customers’ price sensitivity will help you to set a price that maximizes your total revenue.

Stretch Dollar Photo via Shutterstock

Scott Shane Scott Shane is A. Malachi Mixon III, Professor of Entrepreneurial Studies at Case Western Reserve University. He is the author of nine books, including Fool's Gold: The Truth Behind Angel Investing in America ; Illusions of Entrepreneurship: and The Costly Myths that Entrepreneurs, Investors, and Policy Makers Live By.