What is price sensitivity?
Price sensitivity is a measurement of how much the price of goods and services affects customers’ willingness to buy them.
For example, imagine you sell cupcakes. If you add $0.10 to the price of a cupcake and your customers immediately start to visit the bakery across the block instead of yours, they’re exhibiting high price sensitivity.
Price sensitivity varies a lot. It’s influenced by the kind of goods and services you sell, the kind of customer you have, and the wider market factors, such as social and economic trends.
In economics, price sensitivity is described in terms of elasticity of demand – a numerical figure that’s worked out using the following equation:
Price elasticity of demand = % change in quantity demanded / % change in price
The relationship between elasticity and price sensitivity is important to understand. Essentially, when there is high elasticity, you can increase the price without seeing much of a corresponding decrease in demand. When there is low elasticity, when the price goes up, demand goes down.
Why is price sensitivity important?
Keeping track of price sensitivity is vital because it allows you to understand the impact an increase or decrease in price will have on your profits, and how to time any pricing changes you have planned to best take advantage of the current mood among your customers.
There are multiple, ever-changing factors that drive price sensitivity, meaning it’s wise to track it on an ongoing basis so that you have the necessary information to hand whenever you need it.
When setting prices, the ideal is to achieve the perfect balance (equilibrium) where your price is as high as you can make it without adversely affecting demand from your customers. Hitting that precise point and staying there is likely impossible, but careful price sensitivity analysis can help make sure you get as close as you can to your goal.
What factors affect price sensitivity?
Price sensitivity drivers vary, but here are some of the most common factors involved.
Type of product or service
Certain classes of goods and services are by nature more sensitive than others. Examples include things like bread, milk, gasoline, toothpaste – the items people need to live life and do their jobs. You can expect to see demand for these kinds of goods holding steady no matter the economic climate. However, when times are tough, price sensitivity may increase as people try to get the best possible deal on these essentials.
On the other end of the scale, there are things that show high price elasticity of demand because they’re less essential, and demand for them is more affected by other factors such as quality, brand, or style. These might include things like trips to the movies, vacations, designer clothing and luxury cars.
In a crowded marketplace, customers can shop around among competing vendors to find the best deal. They will hold in mind a price reference – a general understanding of the “going rate” for something based on their observations and comparisons. When there are a lot of companies offering the same kind of thing, provided what is offered is sufficiently like-for-like, they may be more willing to switch suppliers on the basis of price.
Businesses can play a role in setting the reference point by harnessing the power of price anchoring. This is a form of cognitive bias where the price of something seems large or small relative to the prices around it. If you’ve ever purchased a subscription or service that’s presented in a tier of offerings, you’ll have seen this in action: compared to a “Gold” or “Platinum” package at $100, your “Basic” $25 subscription seems cheap, even if you hadn’t intended to spend any money when you started out.
Uniqueness of product
If a business has cornered the market, for example with a patented device or recipe that nobody else can replicate, a customer may be more tolerant of price increases. This is especially true in the case of essentials, such as medicine or healthcare provision. If only one business offers it, you will pay what it costs because there’s no real alternative.
Uniqueness also comes into play when the brand associated with a product is very strong. Brand-based uniqueness makes it harder to compare items and assess a fair like-for-like reference price. A pair of Nike trainers, for example, is less likely to be substituted for a generic pair of sneakers than a quart of milk from Supermarket A is to be traded for a cheaper one from Supermarket B.
Ease of switching
Sometimes price sensitivity level stems from practical concerns about switching from one supplier to another. There may be fears and doubts associated with moving from one broadband provider to another. If for example your current supplier is a known and trusted brand and the alternative is a newcomer, you may have worries about security, support, and consistency of supply. That might make you choose to stick with your original provider despite a rise in rates.
When there is less money in the bank, price sensitivity is bound to increase, especially for more expensive items. This factor can be seen on a person-to-person level, and at a societal one, for example during a recession.
Price sensitivity varies a lot between individuals. Where one person makes a decision based primarily on price, another might also take into account quality, looks, durability, and brand reputation and be less price-sensitive as a result. The importance of other demand factors will affect price sensitivity according to that person’s temperament, values and life experiences.
Price is one of several factors that influence purchase decisions, and price sensitivity always exists as part of a wider matrix of factors affecting demand.
Ways to reduce pricing sensitivity
We can use our knowledge of other demand factors as levers, upping those influences in order to reduce price sensitivity – or even undermining them to increase it, if price is our main differentiator. (If your product is the cheapest on the block, your messaging approach might be along the lines of “Why pay more?”)
Increasing brand strength, improving customer experience, using marketing and messaging to ease concerns about change and switching, making products obviously unique, and emphasising quality are all ways of reducing the power of price in your customer’s decision-making.
How to measure price sensitivity
You can arrive at a measure of price sensitivity using the equation for price elasticity of demand we covered earlier:
Price elasticity of demand = % change in quantity demanded / % change in price
But this is data about what has happened in the past and how much price sensitivity has moved over time. It doesn’t explain why price sensitivity has changed, or help you decide what to do about it.
To understand price sensitivity drivers, we need to delve into the experience data around price and go deeper into a customer’s mindset around price, value, and desirability of goods.
One of the most useful tools for doing this is Van Westendorp’s Price Sensitivity Meter. It’s a set of questions that allow you to gauge price sensitivity from real customers and understand how much they will pay for a given product, even before you put that product up for sale. As well as an optimum price point, the method provides an acceptable price range so you can decide how to proceed.
Another valuable method is the Gabor Granger pricing technique, which helps you to analyse price sensitivity and elasticity of products already in the market, clarifying the relationship between price and demand.
How to form the best pricing strategy
Setting the price point for your products and services is one of the most important decisions you’ll make before going to market, so it makes sense to invest time and resources in price sensitivity analysis, thoroughly researching your market, your customers, and your competitors ahead of time.
Using a research platform like Qualtrics, you can run in-depth research to develop a pricing strategy that’s unique to your business and your market.