Do you have an idea for a product to sell or service to provide? Congratulations, you are now just guaranteed to make tons of money, because no matter the price, people will buy what you are selling! Crank it up or turn it down, it’s all profit. Easy peasy!
Okay, myth busted, that’s not true, even slightly. The sad thing is that many small business owners fail to heed the most basic advice of economists, and have little to no understanding of microeconomics.
A basic understanding of supply and demand is essential for anyone going into business. At some point, you’ll have to price your goods or services. If you understand consumer demand, and how their behavior will respond to price increases or price decreases, you can make small changes for big profit.
This is just one of the many determinants of how to price elastic goods. There’s a host of principles to be aware of: elasticity of demand, income elasticity of demand, elasticity coefficient or more.
This isn’t a microeconomics class, so it’s not necessary for you to be able to write a treatise on all of these topics. Rather, looking at some real world examples of how pricing affects demand can help you see what are inelastic and elastic goods or services.
The price of gasoline is often used by economists in microeconomics texts to illustrate inelastic demand. If you own a car, and live outside New York City, you know why. You need your car to get just about anywhere!
The quantity of demand in a market is always going to respond to some extent to a higher price, but what inelastic demand means is that it won’t change very much. Consider this hypothetical scenario:
It’s January, and your gas station, based on the market, has priced gas at $4.00 a gallon. You sell about 1000 gallons per day. Now, it’s February and there’s been a series of global crises. A hurricane has hit a refinery, and in addition, an oil-producing nation has been invaded by its neighbor. With the wholesale cost skyrocketing, you have to raise your price to $6.00 a gallon. Guess how many gallons you’ll probably sell? Probably about 1000.
Why? Because as long as people haven’t been laid off or locked down by a pandemic, they still need to get to work, get to the store, the doctor, their kids baseball game or whatever else they do. They need gas and at least in the short run, they’ll pay just about anything for it.
What if you decide to be a wise guy, and raise the price to $8.00 a gallon? Well in this case, you probably will run into elastic demand because it’s fairly easy for your customers to find substitute goods that still make their car engines go rumm rumm rumm. This shows how inelastic goods will become elastic at some point. Your goal is to take them up to but not past that point.
As long as supply and demand is affecting the market equally you’ll find that your total revenue stays the same. The gas costs more for you. You pass that on to the customer. The customer pays it because they need it, so you end up at about the same spot.
It’s really good for you to understand the unitary elasticity of what you sell. If you do, you can tweak the price to match your target consumer’s income. The last thing you want to do is under charge for a product. You don’t want to over charge and fall into the right spot on that demand and supply curve so you are getting the most profit possible.
By studying the marketplace and getting to know your customers, you can get a sense of what the absolute value of what you sell is to the buyer, and you can price accordingly.
It’s fair to say that some businesses and business owners may have a hard time figuring out that sweet spot of where to price. Making small percentage changes is key. It makes me think of driving a boat. When you are trying to maneuver into a tight dock, you don’t push the throttle all the way forward. You just inch it forward and see where it takes you. A bit too buch? Ease it back.
The same can be said for price elasticity of demand. Look at your costs and determine what will at least pay for that. Then, go just a bit over that. If meeting your costs is difficult, you are going to have to look deeply at your fundamentals.
As long as sales support your costs, then you can institute small price rises and inch the price up and see how it affects your profit. Remember that selling more quantity isn’t as important as realizing greater profit.
These are things that people don’t typically need. For instance, let’s say you are in the coffee business, and you sell handcrafted, organic, sustainably farmed coffee. It’s delicious. At a low price point, let’s say you sell 500 cups per day. This results in a low profit because your costs are great, and you are not getting much for each cup.
The law of demand dictates the point at which people will no longer pay for your product. This is usually on a slope, rather than a vertical line.
The point of this article isn’t to make you an expert on demand changes as they relate to price. Rather, it illustrates just how important it is for you to understand basic economics if you are going to have any chance of being successful.
The dim success rate of most small businesses shows how just having a dream of owning a little bakery, antique store or massage studio isn’t enough to keep you afloat in the long term. Pricing is one of the biggest reasons that people go out of business. Don’t make the same mistake.
You’ll need to study both the marketplace and your consumers, and thoroughly grasp all of your costs before you set a price.