Measuring Price Elasticity And More

Price elasticity is a concept every business person should understand but I have found that many don’t.

Wikipedia defines price elasticity as:

a measure used in economics to show the responsiveness, or elasticity, of the quantity demanded of a good or service to a change in its price

Here is a chart that, I think, makes the concept easier to understand:

In it’s simplest terms, the lower the price of something the more demand there usually is for it. But every product and service has its own elasticity curve and it is important to understand what the price elasticity is of your product or service.

The good news is that it has never been easier to determine the price elasticity curve of a product or service.

Here is how you do it.

  1. offer the product or service on the web and make the purchase as easy as possible (Stripe and/or Paypal).
  2. establish the range of pricing you want to measure, start at a number higher than you can imagine anyone paying and end at a number that is equal to the cost to produce your product or service (the cost of good sold)
  3. set the price at the high end of the range
  4. buy some search traffic to your offering (Google Adwords)
  5. measure the traffic to your offer and the conversion rate (Google Analytics)
  6. lower the price
  7. repeat 4 & 5
  8. lower the price again
  9. repeat 4 & 5
  10. continue this process until you reach the low end of the range

Then plot conversion rate against price and you will have the price elasticity of your product or service. It is best to keep everything other than price constant as you move through this exercise. For example, don’t change the adwords campaign as you move through this process.

As you do this, you can also measure what it costs to acquire a customer (CAC) via search. That may not turn out to be the best way to acquire a customer but it’s a very helpful number to know.

You will want to consider this formula as you think about where to land on pricing:

Price > CAC + COGS

That means the price you charge must be greater than the cost you must pay to acquire a customer plus the cost you must pay to make or deliver the service.

If your product or service is sold on a subscription basis, then you must also know the amount and timing of churn to expect and the lifetime value of a customer (LTV). In a subscription offering, the above formula becomes

LTV > CAC + COGS

All of these concepts and math falls under the terminology of “unit economics” and you will often hear investors (including VCs) talk about “understanding the unit economics” of a business. If you don’t know what that means when an investor brings it up, you are unlikely to close that sale.

But I am not writing this to help entrepreneurs raise money. I am writing this post to help entrepreneurs understand how to build a profitable business.

You must know the price elasticity of your product or service. You must know how much it costs to produce. You must know how much it costs to acquire a customer. And if your model is subscription, you must know your churn and lifetime value. From all of that comes the data and knowledge that allows you to optimize price, margins, and profitability. Which, after all, is the goal of a business, all the other bullshit you read on the internet notwithstanding.