Relationship Between Pricing and Demand

In most services, there is an inverse relationship between price levels and demand levels. Demand tends to fall as price rises.

This phenomenon has implications for revenue planning and also for filling capacity in businesses that experience wide swings in demand over time.

This relationship can be understood with the help of the following figure:

Relationship between Pricing and Demand

Price Elasticity

The concept of elasticity describes how sensitive demand is to changes in price and is computed as follows:

Price Elasticity

When price elasticity is at “unity”, sales of a service rise (or fall) by the same percentage that prices fall (or rise).

When a small price change has a big impact on sales, demand for that product is said to be price elastic. But when a change in price has little effect demand is described as price inelastic.

Demand can often be segmented according to customers’ sensitivity to price or service features.

For example, few theatres, concert halls, and stadiums have a single, fixed admission price for performances. Instead, prices vary according to:

  1. Seat locations,
  2. Performance times,
  3. Projected staging costs, and
  4. The anticipated appeal of the performance.

In establishing prices for different blocks of seats and deciding how many seats to offer within each price block (known as scaling the house), theatre managers need to estimate the demand within each price category.

A poor pricing decision may result in many empty seats in some price categories and immediate sell-outs (and disappointed customers) in other categories.

Yield Management

Service organizations often use the percentage of capacity sold as a measure of operational efficiency.

By themselves, however, these percentage figures tell us little about the relative profitability of the customer base.

High utilization rates may be obtained at the expense of heavy discounting or even outright giveaways.

Yield management is a process for capacity-constrained industries to maximize profitability by allocating the right inventory to the right customers at the right price.

RM concepts are pertinent to virtually everything that is sellable in advance, transient, capacity constrained, allows discrimination among market segments, has inconsistent demand patterns, and low marginal servicing cost.

Yield management attempts to identify and separate those customers whose demand is price-insensitive from those who will buy only when the price for a specific service is below a certain threshold, i.e., to distinguish between inelastic and elastic demand.

These extremities can be depicted on a continuum upon which customers at one end will pay anything for, e.g., wireless service, and customers at the other end would not buy it at any price.

Yield management pricing strategies are based on maximizing the revenue yield that can be derived from available capacity at any given time.

Effective yield management models can significantly improve a company’s profitability. Airlines, hotels, and car rental firms, in particular, have become adept at varying their prices in response to the price sensitivity of different market segments at different times of the day, week, or season.

The challenge is to capture sufficient customers to fill the organization’s perishable capacity without selling at lower prices to those customers who would have been willing to pay more.

Fencing Mechanism

Firms need to be able to separate or “fence off different value segments so that customers for whom the service offers high value are unable to purchase it cheaply.

Rate fences can be either physical or non-physical and involve setting qualifications that must be met in order to receive a certain level of discount from the full price.

Physical fences include observable characteristics of the customer (like child versus adult) and service characteristics such as a class of travel, type of hotel room, or inclusion of certain amenities with a higher price (free breakfast at a hotel, free golf cart at a golf course).

Non-physical fences include penalties for canceling or changing an inexpensive reservation, requirements for advance purchase, group membership or affiliation, and time of use (e.g., happy hours in bars before 8:00 p.m., travelers must stay over a Saturday night to obtain a cheap airline booking).

Customer-Led Pricing: Auctions and Bids

One method of pricing that has attracted a lot of attention with the advent of the internet is inviting customers to bid the price that they are prepared to pay.

The internet provides a good medium for auctions because of its ability to aggregate buyers from all around the world. In the same line, the web also offers many opportunities for consumers to bid on prices for goods and services.

Rather than approaching individual financial institutions for a mortgage or other loan, borrowers can enter their requirements and personal situations at a website that solicits bids for the required loans.

And online market makers let buyers decide how much they are willing to offer for many other types of services.

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