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You are here: Home > Current Topics > Mind your Business > 14 November 2005 |
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Image: Ski resorts have busy times and less busy times - the busy times tend to be the school holiday period - this gives the industry the chance to exploit price sensitivity and maximise revenue at these times. Copyright: Alric Nicol At the time of writing, many schools and colleges will be either on half term or will have just gone back after half term. Businesses everywhere know when half term comes round and will gear themselves up to take advantage of the fact that parents and children tend to take a break at this time and will need entertaining. The recent moves by the government to 'persuade' parents to avoid taking children out of school for holidays and breaks has meant that the pressure on parents to conform and take their holidays at certain times of the year provides the opportunity for business to take advantage of this in terms of the prices they charge. A friend recently got very heated about this. She enjoys going skiing but because of the new 'guidelines' about taking pupils out of school can only go during the Christmas holidays or February half term and at these times the prices charged are very high indeed, not only for the holiday but also for the flights. She argued that this was simply 'unfair' and that businesses ought to be told by the government that they must not charge high prices during this time. I pointed out that it was not the government's job to do this and it would be virtually impossible to implement anyway. It did not seem to quell the anger felt by my friend! It is clear that prices are very much higher during times of peak demand. At these times, businesses can be reasonably sure that despite a high price, there will be enough people willing and able to pay the price to get the break they want. It is not only entertainment during school holidays, and so on, that do this. Travelling on the train in the morning and afternoon rush hours means that you have to pay a premium price for the privilege. The price of electricity is higher during the day time when demand is high, compared to the 'off peak' prices that are set at night time when demand is very low. Telephone calls have had a range of different price structures, sometimes relating to the time of day in which the call is made. 
Image: Paying for a family holiday can be expensive - how much value do we place on a holiday? Knowing this can be important for businesses in setting prices to ensure that they fill the places they have booked for the season. This is why 'last minute bargains' are often offered - it's all down to supply and demand and consumer surplus! Copyright: Arkos Arkoulis Price sensitivity however is not just about charging high prices to maximise revenue. It might also make sense to cut prices - sometimes dramatically - to encourage people who may otherwise not be part of the market to use the services or goods being provided. Biz/ed's In the News article on Price Sensitivity(http://www.bized.co.uk/cgi-bin/chron/chron.pl?id=2468) cited two cases where prices had been reduced to generate additional revenue through encouraging demand. The first was the case of the Little Chef chain of restaurants who have reduced the price of some of their main meals and mugs of coffee by nearly a half. The second was Sunderland Football Club who slashed the prices of its tickets for a Carling Cup game and filled the stadium as a result. The decisions about how to manipulate prices to maximise revenue might seem unfair at times but it is really just a case of businesses using sound logic and the principles of supply and demand to their advantage. We do after all have a choice about whether we buy these goods and services and ultimately it is all about the value we place on these items in relation to what we are being asked to give up to receive them. |
The theory behind price sensitivity is based on an understanding of the aims of an organisation and the concepts of price elasticity of demand and consumer surplus.
Most private sector business organisations will need to make a profit to survive. This may not translate to a profit maximising approach but nevertheless they will be looking to generate profits from activities.
Part of this process will be looking at what happens to revenue. Revenue is the amount received from the sale of goods and services and is found by multiplying the price of a product by the quantity sold.
Price has an important function in markets. It acts as a signal to both producers and consumers. For producers it gives them some indication about the returns they can expect from sales in relation to their costs - in other words whether it is worth producing a good or not. For consumers it provides an indication about value. Value is a very important concept in economics and business. It is difficult to define because we all have a different interpretation of what value means. In essence, the value we place on a good or service is indicated by the price we are willing to pay to consume that good or service.
If I am willing to pay £60 to watch Chelsea play a football match it implies that I place the enjoyment, excitement and satisfaction that I will gain from watching that match above whatever else that £60 will buy me at that time. In economics, human behaviour is often assumed to be 'rational'. If I get more enjoyment out of activity X than activity Y then it is rational to assume that I will choose X over Y. This then suggests that if I could also have bought a DVD player for £60 that I would get more satisfaction from 90 minutes of football than using the DVD player.
Image: Would a dishwasher have price elastic demand or would it be price inelastic? Copyright: Carlos Paes
It is this principle that opportunity cost is based on. Opportunity cost is the cost expressed in terms of the next best alternative sacrificed. Opportunity cost is central to the whole study of both economics and business as it is at the heart of the decision making that characterises the essence of both subject disciplines.
Value helps to explain why the demand curve slopes downwards from left to right. At higher prices, consumers have to sacrifice more utility (the satisfaction gained) from consuming other products. For some in a market, the price they are being asked to pay does not represent value for money - in other words they recognise that the sacrifice of other goods and services they are having to make represents a negative impact on their utility.
This is all very theoretical but it is what we do when we make decisions about spending every day. If you go into a shop to buy a chocolate bar, one of the things you will consider is the utility gained from that chocolate bar as opposed to the utility gained from the other chocolate bars on display. If, for example, a Mars bar has gone up in price you will have to think about whether the amount you are giving up will give you more utility than what you could buy if you spent that same sum of money on other goods.
Businesses therefore have to be very concerned about the extent to which consumers are price sensitive. If the price of a Mars bar is increased by 1p it might have a very small effect on the number of people deciding that it is now too expensive and choosing something else instead. However, if a business decided to increase prices for its range of dish washers by £50, for example, it might have quite a considerable effect on sales.
We have seen earlier how revenue is given by price x the quantity sold. If we look at the demand curve, we can see that at any price, the number of people willing and able to pay that price to acquire those goods or services is given. Thus the demand curve can give us an indication of the likely total revenue that will be gained at different prices.
In the diagram below, if the price were set at £10 then the quantity demanded would be 100, and total revenue would be £10 x 100 = £1,000. Notice that some people in this market (1 - 99) are prepared to pay more than £10 to acquire this good. They clearly value the product concerned more than £10.
If you think about this in relation to your own purchases it is easy to see what we are talking about here. Think of something you have recently bought. What price was it? Now think about what the maximum amount you would have been prepared to pay to acquire this product would have been. If this price was higher, then you are getting a degree of surplus value from that product. This is called 'consumer surplus'.
If you would have been prepared to pay £15 to acquire the product but the price you actually paid was only £10; then you have effectively gained £5 surplus value! Consumer surplus has an interesting application in auctions - eBay is an excellent example. When you use eBay you tend to be bidding for an item in an auction with other bidders. What you are prepared to bid is a reflection of the value you are putting on acquiring that good. You are likely to have an upper level in mind that you are prepared to bid. If, when the auction ends, you get the good for a lot less than you would have bid then you might be justifiably very pleased. You tell your friends that you got a 'bargain'. What we mean when we talk about bargains is that there is a lot of consumer surplus involved! (Next time you get a bargain, see what the reaction of your friends is by telling them you got a high level of consumer surplus from your purchase!)
For businesses, therefore, they always have to consider how the market will react to pricing levels in terms of the level of demand. They might know that by charging a higher price that they are excluding some people who might want their product. It might be that they do this deliberately as might be the case when trying to pitch the product as being 'exclusive'. But whatever price they charge, they have to think about the level of demand and what revenue it will generate. This will enable them to get some indication as to whether they will be able to make a profit from their activities.
A knowledge of price elasticity of demand is useful in helping make pricing decisions. Price elasticity of demand is the responsiveness of demand to changes in price. In simple terms, if the price rises or falls, we know that demand will change but crucially we will want to know how much it changes.
Price elasticity of demand is to do with proportionate changes. If the price is changed by 5% what effect will this have on demand? Will it change by more than 5% or less than 5%? That is really all that elasticity is about! Its importance is that it gives a business information about the possible effect on its revenues as a result.
Let's take the example of Sunderland FC's recent experience. Let's assume that the average price of a ticket for a Sunderland home game is around £30. The ground capacity is 47,000. If they sell every seat then the revenue per home game would be £1,410,000.
Sunderland will know that not every match will sell out - the opposing team may not be very fashionable, the Sunderland team itself might not be as exciting as it could be, and they will need to be mindful of the other options open to potential customers of what they could do with their £30, as well as the income of people in the locality and so on.
Image: Full house at the Stadium of Light for Sunderland's match against Arsenal in October 2005 - all because of price elasticity of demand.
Some games therefore might see relatively low crowds. The cost of staging a match is likely to be pretty much the same however many people turn up and so the marginal cost of filling an extra seat is very low if not zero. For competitions like the Carling Cup, the attendance at grounds across the country is not very high. Let's assume that Sunderland might be expecting a crowd of only 6,000 for such a match. 6,000 fans paying £30 each would yield a revenue of only £180,000. In addition the atmosphere in the ground would be very poor and would not help the players. Supporters also buy things like programmes, food and drink and thus the revenue generated from associated merchandise sales would also be likely to be low.
The club decide to offer heavily discounted ticket prices to encourage fans to turn up. The club charged £5 for adults and £1 for children. Let's assume that the average price was £5. The low price encourages people who would not normally go to the match because of the high price of tickets to go to the game. In the event the game sold out - 47,000 fans each paying £5 would yield a revenue of £235,000. Each of those fans might then spend money on programmes, food, drink and so on and the final revenue for the club would be significantly higher than would have been the case with only 6,000 in the ground.
The two animations below show how different price elasticities would affect revenue given different price elasticities.
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In this example, the demand is price inelastic. Reducing the price of tickets will lead to a fall in revenue in this instance.
In this example, the demand is price elastic. If the club decided to increase its ticket prices the effect on demand would be to reduce it. But the percentage change in the demand would be greater than the percentage rise in the price and revenue would fall. Again, there would be little point in increasing the price in such circumstances.
Price sensitivity therefore is important to all businesses when considering their pricing strategies. They will need to have some understanding of how their market will react to changes in price and thus what the impact is on their revenue.
