What’s in a Price? — In the End, It’s Perceived Value
Price elasticity is the percentage change in quantity demanded in response to a 1 percent change in price.
Elasticity of gasoline is 0.2 short-run — 1 percent price increase leads to 0.2 percent decrease in quantity demand. The reason for the small change is that gas has few substitutes, and people will pay a high price for it. Even when price increases dramatically, demand remains fairly stable.
Elasticity of gas long-run is 0.7. Here, people have time to adjust (i.e., take fewer shopping trips, drive a car with better mpg, etc.) and change in demand is greater with a price increase.
Another example is cell phones where price changes rapidly. A new smartphone sells for $400, next year $200, and year after that for $80 on eBay. Consider Google Glass, Internet connected eyeglasses with a screen to keep people connected to e-mail, networks, and other information without gazing down at the small screen on a smartphone.
Google Glass is being tested by 8,000 people, who had to win an essay-writing contest and pay $1,500 for the glasses plus incur the expense of traveling to New York, Los Angeles, or San Francisco to pick up the device. In other words, these folks are paying Google $12 million for the privilege of consumer testing. What does this say about elasticity of this product in the short run?
Goods with more substitutes have higher elasticities. Elasticity for new cars is 1.5 and for fresh-picked veggies it’s 4.6. Substitutes are used vehicles and canned or frozen veggies.
Change in price has quantity/price effects. Price increases tend to result in fewer units sold while price decreases lead to more. Increase in the price of inelastic goods increases revenue while decrease in price has the opposite effect. The effect is reversed for elastic goods.
However, since car wash operators want to know how change in price may affect the bottom line, the answer would not come from using economic theory.
Volume levels normally associated with express exteriors charging $3 base suggest low price leads to more units sold. However, economic theory that may seem to work on paper does not necessarily extend to the real world.
If supply of product X goes down and its price goes down as well, we would infer that demand for X decreased as well, relative to supply. This inference comes from the law of supply and demand but it solves nothing because you have to try and find out what caused the decrease in demand.
Consider an area with total car wash sales of $2 million (see Table 1, below). The market consists of wash A, B, C, and D each has 25 percent share, washing 62,500 vehicles at an average $8 for total sales of $500,000. The market is in equilibrium.
Next, someone comes in and builds an express wash. The wash is priced like a commodity: $3 base, $4 average. The $3 price and convenient location reduces economic distance for certain consumers and gravity effect allows the new wash to pull 25 percent share, which comes from wash B and wash C.
The outcome is that consumers gain, wash B and wash C don’t, and more capital is deployed for less return. This is the result from an economic analysis because the system is closed. In the real world, the system is not closed.
There is no wall to stop people from going outside the area or to stop people coming in from the outside. If B and C have no mortgage, the owners could lower their price to pull customers back until the new-wash owner is unable to cover its debt and the market returns to equilibrium.
If B, C and the new wash have similar cost, the new wash could use differentiation. In economics, differentiation is using algebra to solve inequalities. In marketing, differentiation is a strategy to establish positional advantage. We earlier mentioned the advantage of a convenient location.
Sales promotion is another differentiator. Competitors may be selling good, better, and best, while the new guy is selling clean, shine, and protect.
Another way to differentiate is to change the product in a creative way, such as adding new functional features to make the product more appealing. For example, with the “freemium” model, ancillary products (e.g., vacuum) is provided free, but money is first charged for features/functionality (exterior wash). Freemium can be used to build a consumer base when marginal cost of producing extra units is low like computer software.
Assume the new wash sweetens the deal by also providing free prep, towels, and window cleaner to thwart the competition’s own differentiating ways. This adds $0.25 per car to cost of goods.
In the final analysis, what is in a price is perceived value, which can have little to do with literal interpretation of supply and demand. For example, if Coca-Cola lowered the price of Coke by 50 percent, I still wouldn’t buy it because I simply like the taste of Pepsi better.
Bob Roman is president of RJR Enterprises – Consulting Services (www.carwashplan.com). You can reach Bob via e-mail at firstname.lastname@example.org.