Every academic pricing book will tell you, pricing is well understood. Simply plot your demand curve which is the quantity you sell at each price. Use that information to plot your profit Qty*(price – variable cost). If you’ve done this right, your profit looks like an upside down U. Now select the price that correlates with the top of the U. That is your profit maximizing price. Easy, huh?
As Lee Corso would say, “Not so fast my friend.”
There are two huge reasons why this is completely impractical. First, who knows their demand curve? It is almost impossible to know the demand at any given price with any certainty at all. There are many market research methods, based on statistics, to make estimates, and these estimates are probably better than guessing, but not very accurate. Besides, they still don’t account for the second huge reason.
Reason 2, your demand curve doesn’t include competitive reactions. How will your competitors respond to your price changes? If you lower your price, and they don’t change theirs, you gain more share, sell more units, and probably increase profits. However, if they lower prices too, you probably don’t gain any unit sales, and what you do sell is at a lower price, so profits certainly decrease. Demand curves do not explicitly take into consideration competitors’ responses. In other words, demand curves aren’t overly useful in figuring out what price to set.
This is good news! You don’t have to estimate a demand curve.
So what do you have to do? You must have a set of beliefs about how your competitors and customers will respond when you change prices. Then, playing mental “what if” games possibly combined with price testing, you will make decisions on how to best set your prices.
You’re probably thinking, “But that doesn’t sound easy.” You’re right. I never said pricing is easy, I just said you don’t have to create a demand curve.
A demand curve is a great theoretical tool for economists, but it’s not practical for people who have to actually run a business. This reminds me of one of my favorite quotes: “In theory, theory and practice are the same. In practice, they are not.” – Yogi Berra
If you enjoy my writing on pricing would you please do me a favor? Recommend my book, Impact Pricing, to a friend. Evelyn said, “I spent an entire Saturday afternoon reading Impact Pricing–and discussing its lessons and insights–with my entrpreneurial son-with-the-small-business. We were both fascinated at the clarity of ideas and workable solutions to his business model.”
Mark Stiving, Ph.D. – Pricing Expert, Speaker, Author