Page 415 - Marketing Management

392 PART 5 SHAPING THE MARKET OFFERINGS

• Price experiments can vary the prices of different products in a store or charge different
prices for the same product in similar territories to see how the change affects sales. Another
approach is to use the Internet. An e-business could test the impact of a 5 percent price in-
crease by quoting a higher price to every 40th visitor, to compare the purchase response.
However, it must do this carefully and not alienate customers or be seen as reducing competi-
tion in any way (and thus violate the Sherman Antitrust Act). 38
• Statistical analysis of past prices, quantities sold, and other factors can reveal their relation-
ships. The data can be longitudinal (over time) or cross-sectional (from different locations at
the same time). Building the appropriate model and fitting the data with the proper statistical
techniques calls for considerable skill, but sophisticated price optimization software and ad-
vances in database management have improved marketers’ abilities to optimize pricing.
One large retail chain was selling a line of “good-better-best” power drills at $90, $120, and $130,
respectively. Sales of the least and most expensive drills were fine, but sales of the midpriced drill
lagged. Based on a price optimization analysis, the retailer dropped the price of the midpriced drill
to $110. Sales of the low-priced drill dropped 4 percent because it seemed less of a bargain, but the
sales of the midpriced drill increased by 11 percent. Profits rose as a result. 39
In measuring the price-demand relationship, the market researcher must control for various
40
factors that will influence demand. The competitor’s response will make a difference. Also, if the
company changes other aspects of the marketing program besides price, the effect of the price
change itself will be hard to isolate.

PRICE ELASTICITY OF DEMAND Marketers need to know how responsive, or elastic,
demand is to a change in price. Consider the two demand curves in Figure 14.1. In demand curve
(a), a price increase from $10 to $15 leads to a relatively small decline in demand from 105 to 100.
In demand curve (b), the same price increase leads to a substantial drop in demand from 150 to 50.
If demand hardly changes with a small change in price, we say the demand is inelastic. If demand
changes considerably, demand is elastic.
The higher the elasticity, the greater the volume growth resulting from a 1 percent price reduc-
tion. If demand is elastic, sellers will consider lowering the price. A lower price will produce more
total revenue. This makes sense as long as the costs of producing and selling more units do not in-
crease disproportionately. 41
Price elasticity depends on the magnitude and direction of the contemplated price change. It
may be negligible with a small price change and substantial with a large price change. It may differ
for a price cut versus a price increase, and there may be a price indifference band within which price
changes have little or no effect.
Finally, long-run price elasticity may differ from short-run elasticity. Buyers may continue to
buy from a current supplier after a price increase but eventually switch suppliers. Here demand is
more elastic in the long run than in the short run, or the reverse may happen: Buyers may drop a
supplier after a price increase but return later. The distinction between short-run and long-run
elasticity means that sellers will not know the total effect of a price change until time passes.
One comprehensive study reviewing a 40-year period of academic research that investigated
price elasticity yielded interesting findings: 42

• The average price elasticity across all products, markets, and time periods studied was –2.62.
In other words, a 1 percent decrease in prices led to a 2.62 percent increase in sales.
• Price elasticity magnitudes were higher for durable goods than for other goods,and higher for prod-
ucts in the introduction/growth stages of the product life cycle than in the mature/decline stages.
• Inflation led to substantially higher price elasticities, especially in the short run.
• Promotional price elasticities were higher than actual price elasticities in the short run (al-
though the reverse was true in the long run).
• Price elasticities were higher at the individual item or SKU level than at the overall brand level.

Step 3: Estimating Costs
Demand sets a ceiling on the price the company can charge for its product. Costs set the floor. The
company wants to charge a price that covers its cost of producing, distributing, and selling the
product, including a fair return for its effort and risk. Yet when companies price products to cover
their full costs, profitability isn’t always the net result.