Join Stefan Michel for an in-depth discussion in this video Why is price elasticity overestimated by executives?, part of Value-Based Pricing.
- One important aspect of the second capability pricing economics is price elasticity. So price elasticity measures the change of the demand depending on the change of price. So for example, if I increase the price by five percent, and the demand goes down by five percent, then the elasticity would be minus one, because five percent decrease minus five percent demand divided by five percent price increase equals minus one.
Now we say a market is more elastic if this number is greater. So if I increase my price by five percent, and the demand goes down by 25 percent, that means I have minus 25 decrease in demand divided by five percent increase in price, so the elasticity is minus five. So this would be a more elastic demand. Why is that important that we understand elasticity? Well, if the elasticity was zero, we could increase the price without losing any customers because the demand will be unchanged.
So the higher the demand, the more customers we lose with a price increase. So it's important that we understand the elasticity to figure out to which point can we increase the price without losing too many customers. So it's a fundamental question for every pricing decision. Now what's interesting is that in reality, and this is what I observe over and over and over again, is that executives and entrepreneurs drastically overestimate the price elasticity.
I give you a simple example. Three years ago if you were to ask someone in the Swiss tourism industry what would happen if the price of the Swiss restaurants would increase, or hotels would increase by 20 percent, what would happen to the demand? And most people would have said, well, Switzerland is already very expensive, so an additional increase of 20 percent would probably drive down the demand by at least 20 percent.
OK, so that would be a price elasticity of minus one. But actually, through the currency change of the Euro to the Swiss franc, the Swiss prices did increase 20 percent to the Euro. So we had this scenario that the prices that were already high got 20 percent higher. What happened to the demand? Almost nothing. Of course, we lost some tourists, especially from Germany and other Euro countries, but not that many.
Maybe three or four percent. Now when you think about it, if you increase the price in their currency by 20 percent and you only get minus four percent demand decrease, that's a very, very low price elasticity. So why do so many executives overestimate the price elasticity? And that means they fear that they lose too many customers if they increase the price. I have two explanations for that.
One is the customers always tell them that they are too expensive. OK, when I negotiate with my clients, I never had the client to say, "How much do you charge? "Oh, that's good, I would have paid 25 percent more." No, you never hear this. They always say, "Ah, it's too expensive for I don't come. "It's too expensive", so you get biased information from your customer. But even worse, typically you get biased information from your sales force. Think about the large company, take a consulting company, who pitches for a big project.
Three consulting companies go to the client, everyone does a pitch, and your people come back and they have not won this project. So they lost the pitch. Now which explanation will they give to the CEO? I give you two options. A, they come back and say, "We really screwed up "that presentation. "We had no clue what the customer wanted, "and we were not well-prepared." Or B, "We lost because we were too expensive." So of course, I exaggerate here a little bit.
But typically the information we get from the market always tells us that we are too expensive, even in cases where we are not. There's an interesting study in Germany who ask representatives of an industry, of the whole industry, about their price positioning. They asked do you think your company is less expensive or neutral or more expensive than the competitors? Now logically, the average should be the same.
You have some that are less expensive and some that are more expensive. But what turns out in the study is, as predicted, the majority of the companies in a given market thinks that they are more expensive than the average, which is logically impossible. But this has to do with the perception that we are already too expensive, and this wrong perception prevents us from charging a higher price. Why? Again, because we assume that the demand will go down drastically even if you increase the price a little bit.
So this is why many companies leave money on the table. Because they overestimate the negative market demand, they don't really capture the value that they create with their customer.