Price elasticity of demand

We will talk about an economic concept today. Boring, I heard. Not really. I think if you continue reading you might find it interesting. I talked in the past about discounting, fixed cost, branding, etc. But, I never explained those marketing approaches from an economic perspective. Please allow me to.

Price elasticity of demand (PED) is a way to measure a sensitivity of a change in price when a quantity demanded change. The formula is simple – % change in quantity divided by % change in price. There are 3 possible outcomes:

  • Elastic – if the change in quantity is greater than the change in price
  • Unitary – if the change in quantity equal to the change in price
  • Inelastic – if the change in quantity is less than the change in price

The interesting part that could apply in the marketing world is that most of the goods out there (my company’s product included) are price elastic, meaning when the price drops, the quantity demanded increases. There are a few important points to note here:

  1. If it’s easy for your customers to substitute your product with another (e.g. substitute products or lots of offers from competitors), when you increase your price your demand will drop. This is because customers simply buy from your competitors or buy a substitute product.
  2. The more discretionary a purchase is, the more its quantity will fall in response to price rises.
  3. The less discretionary a good is, the less its quantity demanded will fall. It means the price is inelastic i.e. customers agree to pay premium prices for brand named items, additive products (e.g. alcohol, cigarette), and required add-on products (e.g. iPhones to use iTunes).

From an economic perspective, to get out of the discounting game, we have to find a way to move our product’s price from being elastic to being inelastic. Building a brand is one way. Making your product additive is another.

Not too boring? Interesting?


Prospect Theory

I am in search of a way to fight with a discount tactic. As I work in the hospitality industry, it’s a mammoth task to fight against the influence of Online Travel Agents (OTAs). Customers always look for good deals, deep discounts. It’s really difficult.

However, it doesn’t mean there is no hope. I just need to think harder and do more research. I came across the theory called “Prospect Theory”. The main idea of this theory is people don’t evaluate things in absolute terms. They evaluate them relative to a comparison standard, or “reference point”. Basically, if I tell you a cup of cappuccino in Australia costs $4.00. It’s just a single number that doesn’t mean much. But, if I also tell you that a similar cup of cappuccino in Thailand cost about $3.00. Then, the first idea that comes to mind is that coffee in Thailand is cheaper than in Australia.

This theory makes me think that we don’t always have to give a massive percentage discount e.g. 50% OFF. What we could do is to do the same tactic as many retailers i.e. have a reference point. For example, instead of saying getting 10% off for your next booking, we could say book now and pay only $99/night (normal price is $109/night).

That is just one way to do it. I am sure there are other ways. I will share with you if I find more ways in the future.