Market dynamics and pricing scenarios (managing pricing in a time of uncertainty)
Steven Forth is a Managing Partner at Ibbaka. See his Skill Profile on Ibbaka Talent.
In normal times, market dynamics are fairly predictable. Part of the background upon which pricing strategy is played. But these are not normal times.
See Scenario planning for pricing (managing through uncertainty)
The standard framing of market dynamics is in terms or price elasticity of demand and cross price elasticity. The interactions between these two critical pricing factors defines the market dynamics and constrains your pricing strategy.
Price elasticity of demand is the degree to which demand increases in response to a change in price. Conventional economics uses this, along with price elasticity of supply, to define an equilibrium price in which demand and supply are balanced (this is also known as the market clearing price).
Cross price elasticity is the extent to which buyers will change suppliers in response to a price change. In markets with high cross price elasticity buyers are willing to change vendors in response to even small price changes. In sticky markets, with low cross price elasticity, buyers tend to stick with their vendor even when there are pricing differences.
Knowing which of the four quadrants you are in defines your possible pricing strategies.
This is good theory, but what happens when these underlying market dynamics start to change, as they are doing now in many sectors in response to the economic shutdown associated with COVID 19. When this happens, and may it happen only once or twice in your career, you need to prepare for different scenarios. Here are sixteen possibilities to consider.
Remember that different parts of your market may respond in different ways. Sectors like travel and retail are under huge stress, while some parts of the healthcare industry or online collaboration are experiencing a demand surge. You may need to segment customers by scenario!
The sixteen possible market dynamic scenarios
From Low Cross Price Elasticity
and Low Price Elasticity of Demand
Starting from the bottom left quadrant, where both cross-price elasticity and price elasticity of demand are both low …
1. If you find yourself in this quadrant and see no reason that your market dynamics will change, excellent, carry on. This is the best segment in which to carry out pure value-based pricing as you do not need to worry about the impact of price on demand and your customers will not easily switch in response to a price change. In the current market, you may still want to offer distressed customers a break on payment terms or volume guarantees. And you should explore layering in usage or consumption-based pricing if you have not already done so.
2. Dropping prices will not lead to increased demand, but it may lure over some of your competitors customers. Should you drop prices? Probably not. In this quadrant the big risk is a price war that can permanently reduce prices. Dropping prices in the current economic crisis could also be seen as opportunistic and predatory. Caution is required.
3. You are entering a commodity market. This may be the result of customers no longer being able to take advantage of your differentiating functionality in a down market. It may be time to take to market a barebones offer. Price will be se by market forces.
4. Demand will increase if you lower prices and there is little risk of a price war as cross price elasticity is low. Do you know your revenue optimizing volume and your profit optimizing value? You need to figure these out, and then adjust price to the level that maximizes whichever you are trying to optimize for, revenue or profit. Be careful about increasing prices in the current environment.
From High Cross Price Elasticity
and Low Price Elasticity of Demand
Starting from the top left quadrant, where cross-price elasticity is high but price elasticity of demand is low …
5. If you are used to operating in this quadrant, where overall demand does not respond to price changes but buyers are ready to switch vendors in response to a price break, you should already know what the boundaries you operate in are. You know just how much you can change prices without provoking a competitive response. Continue to monitor the situation and be even more cautious than usual.
6. Lucky you. Customers are not willing to change vendors in the current market. Cross price elasticity has declined. Do your homework before you change prices. Make sure you understand the emotional, community and economic value drivers that matter. Remember that these may have changed over the past few weeks (this will be the theme of our next post which will be on customer value). We probably need to do research to revalidate and quantify your value drivers for the new world we are operating in.
7. Out of the frying pan into the fire. You are used to operating with an eye on your competitors, but now changes in price also lead to changes in demand. As in scenario 3. consider offering a bare bones product that is positioned to fight in a commodity market. In this unprecedented time, many products that once had meaningful differentiation are being relegated to commodity status.
8. Market dynamics have inverted. Where customers were once price sensitive but overall demand did not respond to price changes, the opposite is now true. This is likely a better position to be in. As in scenario 4, carefully adjust prices to optimize volume for either revenue or profit. Do not move quickly to raise prices though. Market participants will remember and eventually punish companies that try to take too much advantage of the current troubles.
From High Cross Price Elasticity
and High Price Elasticity of Demand
The top right quadrant, where price elasticity of demand and price elasticity of supply are both high.
9. This is the kind of market described in conventional economics. Demand responds to changes in price and buyers are willing to switch vendors in response to price changes. This is a commodity market and it becomes more efficient the more transparent it is. Of course efficiency is not always in the sellers interest! In general, B2B companies make more money when cross price elasticity is low.
10. In some cases we are seeing customers become less willing to switch vendors. Price elasticity of demand remains high while cross price elasticity declines. Sometimes this is a result of loyalty. People are less likely to want to change during a crisis. When this happens, and you find yourself in the bottom right quadrant, you should adjust prices to optimize volume so that you can maximize volume, revenue or profit (these are almost always different prices). Before you act, think through what might happen after COVID 19 crisis and how you want to be positioned.
11. In some industries both price elasticity of demand and cross price elasticity are coming down, creating the ideal conditions for value based pricing. This is one reason we are advocating adjusting subscription pricing to make sure it includes a subscription component. This is especially effective when some of your customers are doing much better than before while others are slumping.
12. One of the most common patterns we are seeing is that cross price elasticity stays high while price elasticity of demand weakens. There are actually two very different cases here. In some cases price elasticity of demand has dropped because there is very little demand. Airlines are experiencing this. In other cases, demand is through the roof; people are willing to buy what they can from whoever will sell i to them. See Extreme Demand Scenarios below.
From Low Cross Price Elasticity
and High Price Elasticity of Demand
The bottom right quadrant, where cross price elasticity is low but price elasticity of demand is high.
13. If you are already operating in this quadrant you have optimized your prices to get the volume that helps you achieve your goal. The goal could be volume, revenue or profit operation. This does not mean you can ignore pricing. Market dynamics may be stable but demand may have changed. Think through what is likely to happen in the post COVID 19 market and where you want to be positioned.
14. Some customers may become more loyal during a crisis, but others become more price sensitive and cross price elasticity can increase. If this happens with some of your customers you will lose pricing power and have to adjust prices to match the market. As noted above, you may want to create a stripped down offer for these customers, one that matches the value offered by alternatives. If buyers are not willing to pay for differentiation don’t provide it.
15. Perhaps the worst case scenario is to move from low to high cross price elasticity and high to low price elasticity of demand. This generally happens when underlying demand weakens. As in scenario 14 you have lost pricing power, but demand is also soft and a price war in this situation can cause long-term damage to a market. Tread with care.
16. Normally one wants to operate in a market with low price elasticity of demand and low cross price elasticity. These are the ideal conditions for value-based pricing. But when this is a result of a reduction in price elasticity of demand, well, it usually means that underlying demand has weakened. Make sure your pricing is responsive to changes in value to customer (V2C). If it is too difficult to change your pricing model in a timely manner, you may need to consider discounts for customers who are getting significantly less value than intended.
Extreme Demand Scenarios and Price Elasticity of Demand
One reason market dynamics are changing for many companies is the radical changes to demand. When demand is extremely low or extremely high the normal relation between price and demand can break. At either extreme, changes in price can have little impact on demand. On the right of the distribution, when demand is extremely high, there are opportunities for surge pricing, or price gouging. Be very careful here. If the price gouging will damage your community or put vulnerable people at risk then don’t do it.
Segment your customers using market dynamics
Most companies have customers in all four quadrants and smart businesses have already used this as a way to segment their customers. For these companies the question becomes how is my market segmentation changing. Two companies that were in the same segment might each move in different directions. For example, a vendor of small fans might see its restaurant business collapse while demand from medical devices makers explodes. With so many different companies working to make ventilators there may be many new customers entering the market.
The most important thing to do today is to get close to your customers and understand three things.
What quadrant was the customer in before the COVID 19 crisis?
What quadrant are they in now?
What will happen after the COVID 19 crisis?
Only by answering these three questions will you know how to change your pricing.
