Want to Nail Pricing? Understand Market Dynamics First.
Pricing is a game – one with asymmetric and imperfect information. So what does this mean for you? Basically, you’re very unlikely to nail pricing the first time. And even if you do come close, you’ll have to adjust as your product and market mature.
While you’ll never get pricing 100% right the first time, there’s no reason you shouldn’t set yourself up for the best possible chance at success. To do that, you must first understand market dynamics. In other words, how will customers and competitors respond to initial pricing and subsequent changes? Even if you keep your prices constant, your competitors will not, which will impact how your own customers think about your offering.
Market dynamics can be understood through three basic lenses:
- Price elasticity
- Value maps
- The maturity of buyers and sellers
The most important of these is price elasticity. Specifically, how price elasticity of demand and cross price elasticity interact.
Price elasticity of demand is the basic economic insight that price influences demand and that in most cases (with the exception of certain luxury goods) demand will increase as the price goes down. Markets where demand goes up quickly as price goes down have a high elasticity of demand – for instance, data storage. Demand for this service has soared while the cost has come down significantly.
In other markets, demand changes slowly with price and strict upper levels on demand exist. U.S. demand for automobiles seems to have a relatively low price elasticity of demand today, meaning that even dramatically lowering prices wouldn’t have much of an impact on overall demand.
Cross-price elasticity is the tendency of customers to switch vendors (or products from the same vendor) in response to price changes. In some markets, there are well understood alternatives and when the price of one increases some customers will abandon it for the alternative. This is true of many medical devices. The total demand for needles may be more or less fixed, but hospitals will quickly switch to a cheaper alternative of similar quality.
Elasticity does not have to be linear. In some markets, there are zones where elasticity is high and other zones where it is low. In the Z shaped market in the below image on the left, two distinct niches are likely to emerge in the two zones of stability. In the cotangent style elasticity curve on the right, there will be only one niche for mass-market products with a separate market for very expensive custom solutions (indicated by the light green area).
Things get really interesting when you look at price elasticity of demand (market elasticity) and cross price elasticity (competitive elasticity) together. There are four market dynamics to consider and you need to know which is true of your own offering and the markets it competes in.
Competitive: The standard assumption of economics is that most markets will have relatively high price elasticity of demand and cross price elasticity. Economists have modeled these markets with great precision and can generally predict how demand will change and how market share will shift with some precision. Very few innovative companies can or should compete in this type of market.
Commoditized: In these markets there is low price elasticity of demand and high cross price elasticity. These are scary markets to compete in as it is easy to trigger a price war that destroys market value. The classic example is the price of gasoline. Short term, demand for gasoline does not change all that much in response to prices. It is hard for people to change to more efficient cars or other modes of transportation (but in the long-term it’s a different story). What they can, and will do, though is switch to an alternative supplier. Most of us will drive some distance to buy gas at a lower price. In markets with this dynamic one has to be very careful about changing prices. If you cut prices demand will not change and your competitor will be forced to match you. If you increase prices your customers will move to your competitors.
Niche: In some cases there is low cross price elasticity, but relatively high price elasticity of demand. These are good markets to compete in. One can tune prices to optimize for revenue, profit or profit margin without being unduly concerned about how competitors will respond. Building such markets generally depends on having a deep understanding of customer needs and investment in building solutions that satisfy these needs. Herman Simon’s book Hidden Champions of the Twenty-First Century: The Success Strategies of Unknown World Market Leaders describes many of these companies in detail (Simon is a founder of the major pricing consulting firm Simon Kucher). Companies that execute on this strategy are generally focused on well defined and relatively small market segments that they’re able to dominate. These companies are often only known within the segments they target.
Open: This is where most early-stage companies play. Price elasticity of demand and cross-price elasticity are both low, not necessarily a good thing. These dynamics generally mean that customers don’t really understand the value AND competitors are not obvious. Lowering prices doesn’t have much impact on demand as price is not the main issue in these markets. Instead, companies in this area should be concerned with answering “What is the value?” and “What are the alternatives?”
To gain a basic understanding your own market dynamics and where you play, ask these questions:
What will my customers do when I change my price?
- Will they buy more or less?
- How will this change their perception of value?
What will my competitors do when I change my price?
- Will they ignore, match or go farther?
- Will my competitors take the lead and change prices first?
What will customers do when I change my price?
- Will they switch in response to a price change or not?
Try not to get tricked by temporal shifts. Good luck!
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