The elasticity of price

Gas prices are scooting over $4/gallon here in the states and yet consumption has not shown signs of significant reduction. How can that be?

That’s the question that reporter Gail Rosenblum of the Minneapolis Star Tribune posed to me late last week. Her article, Paying a lot for gas, changing lifestyles a little" appeared in Friday’s edition of the Star Tribune.

While I know this specific topic (gas prices) is on everyone’s mind, it seems to me that the conversation Gail and I had is even more interesting when you step back and look at consumer attitudes about prices in general.

Two years ago, we were in a tizzy over gas prices. We couldn’t believe they were going to be $2/gallon. We were outraged. We were going to cut back. (Of course, we didn’t) Fast forward to today. Imagine if I stopped people on the street and asked them what they would think of paying $2/gallon for gas. They would weep for joy. In fact, it would sound too good to be true and they’d ask me "what’s the catch?"

Ahhh, the elasticity of price perception.

Why do I think this is worthy of some thought? A few things to note:

The elasticity of price is a one-way street (we are never happy about going higher in price after the marketplace reduces costs.)

The elasticity of price is fast-acting (we get used to the higher price pretty quickly.)

The elasticity of price works best for necessities (we can cut back on stuff we don’t "need" but endure price hikes on stuff we think we do need.)

So how could you apply this thinking to how you set prices? If everyone in your industry is lowering prices because of the recession — how will this hold them back when they’re ready to re-raise their prices? How will it affect you if you resist the urge to lower prices now?