Companies can use the price elasticity of demand for products and services to set pricing policies. Price elasticity indicates the sensitivity of customers to changes in pricing, which in turn affects sales volumes, revenues and profits. Optimal pricing policies maximize profits by charging exactly what the market will bear. Managers may adjust their pricing strategies depending on changes in the competitive environment and in consumer demand.
The demand curve is a two-dimensional graph of price on the vertical y-axis versus quantity on the horizontal x-axis. This curve slopes down because demand generally increases as prices fall. A vertical demand curve means that demand is the same regardless of price, while a horizontal demand curve means that price is constant regardless of demand. The shape and slope of the curve depend on the product, consumer income and the competitive environment.
The price elasticity is the ratio of the percentage change in quantity to the percentage change in price. For example, if quantity decreases by 20 percent for a 25 percent increase in price, the price elasticity is -20 divided by 25, or -0.8. The price elasticity is always negative because of the downward slope of the typical demand curve. However, people generally refer to the absolute value of the price elasticity, which is 0.8 for this example. A price elasticity of less than 1.0 means that demand is not very sensitive to price, while an elasticity greater than 1.0 mean that demand is increasingly sensitive to price. The price elasticity is low for essential goods because people have to buy them even at higher prices. The price elasticity is high for non-essential and luxury goods because consumers may not buy them at higher prices.
Optimal Pricing Policy
Optimal pricing policy is also known as perfect price discrimination, which means that a company segments the market into distinct customer groups and charges each group exactly what it is willing to pay. The optimal price and volume refer to the selling price and volume at which a company maximizes its profits. It is impossible for a small-business owner to know exactly what consumers are willing to pay because he would have to poll them at regular intervals. Still, he can make reasonable assumptions based on historical sales patterns and set his product mix and pricing strategy accordingly.
Optimal pricing is possible only when there is a difference in price elasticity for different consumer groups. For example, a grocery store chain may price the same item higher in a wealthy neighborhood, in which consumers may be less sensitive to price, and lower in a working-class neighborhood, in which consumers may be more sensitive to prices. The factors that affect price elasticity include the availability of substitute products and the proportion of disposable income required to buy certain product. The price elasticity will be high if consumers can buy alternative products or if they have to pay too much of their income.