Price elasticity is a poor angle for looking at demand planning

Published on by Joannes Vermorel.

Lokad regularly gets asked to leverage an approach based on the price elasticity of demand for demand planning purposes; most notably to handle promotions. Unfortunately, statistical forecasting is counter-intuitive, and while leveraging demand elasticity might feel like a “good” approach, our extensive experience with promotions indicates that this approach is misguided and nearly always does more harm than good. Let’s briefly review what goes wrong with price elasticity.

A local indicator

Price elasticity is fundamentally a local indicator - in a mathematical sense. So while if it is possible to compute the local coefficient of the price elasticity of demand, there is no guarantee that this local coefficient has any similarity with other coefficients that would be computed for alternate prices.

For example, it might make sense for McDonald’s to assess the elasticity coefficient for, say, the Big Mac moving from $3.99 to $3.89 because it’s a small price move - of about 2.5% in amplitude - and the new price remains very close to the old price. And given McDonald’s scale of activity, it’s not unreasonable to assume that the function of demand is relatively smooth in respect to the price.

At the other end of the spectrum, promotions, especially promotions in the FMCG (fast moving consumer goods) and general merchandize sectors, are completely unlike the McDonald’s case described above. A promotion typically shifts the price by more than 20%, which is an entirely non-local move, yielding very erratic results, which is completely unlike the smooth macro-effects that may be observed for McDonald's and its Big Mac.

Thresholds all over the place

The price elasticity insight is fundamentally geared towards smooth differentiable functions of demand. Oh yes, it is theoretically possible to approximate even a very rugged function with a differentiable one, but in practice, the numerical performance of this viewpoint is very poor. Indeed, markets are full of threshold effects: if customers are very price sensitive, then being able to offer them a price just a little bit lower than any competitors can alter the market share rather dramatically. In such markets, it’s unreasonable to assume that demand will smoothly respond to price changes. On the contrary, demand responses should be expected to be swift and erratic.

Hidden co-variables

Last but not least, one fundamental issue with using price elasticity for demand planning in the context of promotions, is that the price elasticity puts too much emphasis on the pricing aspect of demand. There are other variables, the so-called co-variables, that have a deep influence on the overall level of demand. These co-variables too often remain hidden, even though identifying them is very much feasible.

Indeed, a promotion is first and foremost a negotiation that takes place between a supplier and a distributor. The expected increase in demand does certainly depend on the price, but our observations indicate that changes in demand primarily depend on the way a given promotion is executed by the distributor. Indeed, the commitment on extra volume, a strong promotional message, additional or better-located shelf space and the potential temporary de-emphasis of competing products typically impact demand in ways that dwarf the pricing impact when it's examined on its own.

Reducing the promotional uplift to a matter of price elasticity is frequently a misguided numerical approach standing in the way of better demand planning. A deep understanding of the structure of promotions is more important than the prices.

Categories: Tags: promotion forecasting