one word: elasticity.
by august j. aquila
price it right
economists define demand as a schedule of the various amounts of an item (a good or service) that buyers will purchase at different price ranges during a given time period.
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according to the theory of price elasticity of demand, there is an inverse relationship between price and the quantity of an item bought. in other words, as the price of a service decreases, the quantity demanded increases and as the price of a service increases, the quantity demanded decreases.
it’s very difficult for professional service firms to increase demand by offering special pricing. for example, if a law firm offered a discount divorce, would happily married couples look for a divorce, or if an accountant offered a lower price for an irs tax examination, would people who did not receive a notice be at all interested? in short, it has been difficult for most cpa firms to accurately estimate the demand for their services.
a critical aspect of pricing is the elasticity of demand or the responsiveness of your clients to a change in the pricing of your services. demand can be either elastic or inelastic. if demand is elastic, a decrease in your fees will result in an increase in demand and an overall increase in total revenue. if demand is inelastic, a decrease in your fees – even a significant decrease – may have little positive effect on the demand of your services, thus resulting in a decrease in overall total revenue. inelasticity also exists when the price increase times the quantity demanded results in an increase in total revenue.
in the accounting profession, it appears that the demand for most services is inelastic. for example, many firms that have raised fees have found that the quantity has decreased slightly, but that overall revenue has increased. a firm could determine the market size for a given service and then price that service according to the increased demand for its service at a given price.
in other words, you find out that 300,000 corporate tax returns were filed last year in your market. if you think you are in an area with elastic demand you will want to lower your fees. this may increase demand for the service and give you a great total revenue. if you believe that you have inelastic demand then you will want to raise your fees, which, in turn, would lessen the demand but provide you with overall greater revenue.
obviously, demand will be completely different in each market and for each service. for example, the demand for compliance work in accounting shrinks in direct proportion to the number of mergers that take place each year. conversely, if the economy in your area is growing and new businesses are being formed, then you will experience a greater demand for those services.
the figure below demonstrates the elasticity of demand. in other words, if the price of your service (p) is lowered and that results in a more substantial change in the quantity purchased (q), the demand for your services is elastic. the elasticity of demand for accounting services usually depends on three factors:
- if your service is perceived as something that would be nice to use, but is not necessary, then the demand will be elastic. examples of such services include consulting projects that are not critical to the operations of the business and other kinds of services, such as estate planning, that can easily be put off.
- if your service is an important part of your client’s and prospect’s budget, the demand will be elastic. the more important it is to your client’s operations and the greater the cost of the service is to your client’s overall budget, the more responsive the demand will be.
- finally, if there are few acceptable substitutes for your services then the demand will be inelastic.
elasticity of demand
many times, clients postpone the purchase of a service that is not critically necessary. by lowering the fee for these services, you may increase the demand. many businesses try to stimulate demand by offering some sort of discount or special offer.
if, as my experiences have shown, the demand for most accounting services is relatively inelastic, then accountants must use other marketing tools such as service differentiation, direct sales and promotion to increase and stimulate sales. non-price, rather than price competition is the most effective way to increase sales of a service when the demand for the service is inelastic.
one response to “how demand affects pricing”
frank stitely
it can be misleading to talk about demand curves without talking about supply curves as well. what a client is willing to spend (demand curve) isn’t what he / she may actually have to spend based on the supply of providers and substitutes such as tax prep software and low cost tax shops.