Business people are aware of the relationships created by the laws of supply and demand. One of those relationships is referred to as the elasticity of pricing. Elastic pricing is the study of how raising or lowering a price affects demand. When using elastic pricing, the supply of the product is not a major factor in determining where a price will be set. When developing an elastic pricing strategy, it is important to study and understand ratios and how the ratio of price change affects demand.
It is critical to analyze the ratio of the percentage of the price drop versus the effect on demand while engaging in an elastic pricing model, according to allbusiness.com. The proper ratio is one where the percentage in demand increase is greater than the percentage in price decrease. For example, if you drop the price of an item by 10 percent, but there is a 25 percent increase in demand then that is a positive ratio that proves you have a product that responds to an elastic price model. The profit margin you need dictates how successful a ratio really is. If you require a high profit margin, then you will need a greater gap between the price drop and the demand increase. You may find that your demand and your pricing are sufficient to sustain your business and that dropping the price does not bring in an adequate rise in business to justify the lost profit.
One of the best ways to gauge the success of an elastic pricing strategy is to put the numbers on a graph and analyze the demand curve. NetMBA.com points out that the x-axis would be product demand and the y-axis would be the price of the item. A completely elastic item would generate a horizontal line at any price. This means that as the price changes, the demand would increase. An inelastic item would be one that generates a perfectly vertical line from the x-axis up. This means that no matter how much you change the price, demand remains exactly the same. In the instance of an inelastic item, you run the risk of losing profit if you lower the price. With an elastic item you could generate more items sold if you lower the price and this would generate more profit.
One of the main components of an elastic pricing strategy needs to be the establishment of thresholds. A threshold is the point where the lowering of the price no longer generates sufficient demand to cover your operating costs. When you lower the price, you also run the risk of lowering the value perception of your product in the customer's eyes. In other words, if your customers continually see you lowering your price, then they are going to assume your product has lost value. Establishing acceptable thresholds depends on profit and at what point demand starts to suffer. As customers see your product as low-priced, you may experience a sharp drop in demand. At that point, you can no longer raise your price to make your product profitable without making upgrades and offering more for the price. This could increase costs and put you in a loss situation.