How to set prices Many believe the best way to increase profits is to increase prices. This misconception represents a mathematical approach to business whereas business is not about mathematics – it is about economics. In mathematics one plus one always equals two but in economics one plus one could equal one, two or three depending on the dynamics of the situation. Maximizing profits requires an understanding of price elasticity.
Price elasticity is the analytical artwork of those seeking to maximize profits by finding the price at which a company can make the largest profits. It is a business strategy with roots in a supply and demand curve and is flavored with the cost of delivery to the customer.
With few exceptions, as price increases demand decreases. Therefore an increased retail could result in higher delivery cost. This is particularly true in retail where lower sales can inhibit volume discounts from suppliers. Failure to order and truckload, pallet or layer quantities can drive up costs even if discounts for such orders were not negotiated when the volume level was attained.
Here is an example of price elasticity from Amazon.com. In exploring the most profitable price for electronic book they discovered that at $9.99 the typical book sells 1.74 copies of the same book priced at $14.99. They extrapolated out to 100,000 copies of a particular book. At the higher price revenue would be $1,499,000. By reducing the price to just $9.99 they are offering the book below the $10 threshold, which is often a psychological barrier. The result is that at the lower price revenue would be $1,738,000.
In the case of Amazon the cost to deliver an e-book does not change based on volume so the math is simple once the economics are applied. This is rare among products and services to help is needed from marketing and logistics. The marketing role is to ensure customers are aware of the 33% decrease in price so that the 74% increase in volume is achieved. Logistics needs to evaluate the shelf landed cost of the products as merchants work to gain price concessions for the increased logistical efficiencies.
In The Strategy and Tactics of Pricing authors Thomas Nagel, John Hogan, and Joseph Zale destroy the concept of using standard markups to set prices. The authors have included a chapter on value creation which look at subjective psychological drivers as opposed to tangible monetary drivers would marketing products for increased price elasticity. They conclude that properly marketing a product will increase the value proposition thereby influencing price elasticity.
Like Amazon, companies that invest their energy exploring price elasticity in light of cost and marketing are finding the investment and time make a heavy contribution to the bottom line while, contrary to the standard logic, lower prices will increase top line sales.