Ever wonder how items get priced? Well maybe just me, but as someone interested in economics, I can't help but be curious on the elusive enigma of pricing. Big companies have formulaically figured it out with big tec and deep pockets but what about small businesses?
There has to be simple but effective ways that these small companies can use, and … there is! More importantly being educated as a consumer will allow you to see through glamour of discounts and other pricing strategies. With these goals in mind, I researched marketing, psychological, and mathematical solutions to aid in ever changing markets.
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Firstly, I was curious if there were any existing data models that used company sale data to create trends and analytics to achieve optimal pricing. And there are, its called Periscope by Mckinsey. Periscope collects a company's sales data and makes highly calculated predictions such as price optimization, markdown strategy, econometrics (basically if econ and statistics had a baby), and competition analytics. Periscope sounds amazing and incredibly useful right?
The only issue is that it costs more than most small business make in a year. It is complicated technology to be integrated and to train staff how to use. All these big companies use technology like this making small to middle companies suffocate in the run to keep up. Not to mention all the fast-paced internet trends acting like carrots that small businesses can't quite grasp.
As I mentioned I happen to be quite interested in economics after taking micro and macro in high school. While small business does not need to know every graph and model learning some terms and phenomena would help them function in the modern world.
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Get Out Your Thinking Cap!
Let's start with a fundamental concept: price elasticity of demand. Essentially it measures how a change in a products price affects demand for the product. For example, if a purse was put on sale you would take the percent change of the quantity bought divided by the percent change of the price.
That is how you find the Price Elasticity of Demand value. Here’s what they mean.
- Elastic Demand (PED > 1): A small price cut causes a significant rise in demand.
- Inelastic Demand (PED < 1): Price changes have little effect on demand.
- Unitary Elasticity (PED = 1): Price and demand change proportionally, keeping total spending constant.
- Perfectly Elastic (PED → ∞): Any price increase drops demand to zero.
- Perfectly Inelastic (PED = 0): Demand remains unchanged despite price shifts.
Depending on what a company is sells they have multiple things to consider. Like how many substitutes they are competing with. For example, a coffee company have many substitutes and probably shows elastic demand.
Another consideration is if they are a necessity. Something like gas is needed no matter how much the price rises. Also, if the product they are selling attracts a wide variety of customers of if its ultra specific. Knowing what happens when a price changes will help a company find out information about discounts and price increases, so they can be more prepared the next time around.
Price Optimization
Now that we covered the basics of how to know how customers will react to difference in pricing lets cover price optimization. Changing a price within a margin of 1% could result in 11% increase in profit. That being said many larger companies use technical systems that calculate all of this. But smaller companies do not normally have the data collection abilities or manpower for that. Here are useful strategies:
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Value Based Pricing
Value based pricing is essentially the idea that you should price at the level a customer is willing to pay. If you take Miu Miu for example, the cost it takes to produce the clothes is pennies compared to what is charged. Part of the reason is the fact that for the brand, status, and style of clothes customers are willing to pay more.
Now it is important to take the business and customers into consideration. A store like Walmart is popular for its low pricing and bulk selling. If your shop has a boutique reputation, with high end styles then go ahead and price at what customers think they should be paying. Sometimes people like to buy at a more expensive level because it makes them think they are getting a higher quality product. Psychology!
The one thing small business have over large corporations is easy access to market research. Small companies know who their customers are and most likely interact with them day in and day out. Engage with them and gauge their idea on pricing and experience. This approach does more than cover costs and a small markup it adds an addition “perception tax” capturing more profit.
Competitor Based Pricing
Competitor based pricing is a technique that looks at competing business in your sector and what their pricing is. There are three approaches to his technique. The first is premium pricing which prices a product above market value.
This can lead to the product being seen as luxury. Only downside is that if let's say your latte tastes like watered down coffee beans, no one is justifying the expense.
The next is price matching. You use the same price as your competitors. Matching price puts you in the running and if you differentiate your brand you can build a loyal customer base.
Lastly, is loss leader pricing. It is exactly what it sounds like, you put your price below the market value in hopes of attracting a large volume. Now, this is a risky practice and would need strategic planning and not price slashing. Run the math to see how much you would need to sell to make a profit.
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Bundle Pricing
You know when Hollister is having a buy one get one 50% off sale and you walk in with a clear mission. Only issue is there is a really cute top… oh! and another pair of shorts. But, i guess it is buy one 50% off.
That is how stores get you to spend more money. Using bundle pricing to offer an introductory discount, a starter kit of products, or buy one discount companies can hook a customer to a product and keep them coming back. It helps a company sell inventory while also getting customer to come back. This is why clothing brands sometimes do “blind bags” it gets people excited while allowing them to get rid of left over inventory.
Moral of the Story
While I am aware that business owners may already know all of this my goal was more to teach someone the ins and out of microeconomics. I wanted to explain simple pricing strategies without getting technical and too much of a snoozefest. It is important to me as a consumer that other teens out there are considering the costs and prices of goods before they buy them.
Next time you go into a store, stop and wonder why something is priced a certain way. Knowing the strategies companies use will help you become a more informed customer.
