Understanding the Demand Curve (And How It Works)
By Hotel Tech Report
Last updated January 26, 2022
5 min read
Property owners commonly rely on their revenue management tool to “do the work” for them, using their RMS to find the ideal mix of room rates and occupancy. It’s easy to fall into the trap of using your revenue management tool blindly without understanding how it works. As a result, however, you may be missing a strategy that will drive the absolute highest value for your hotel.
Revenue management systems like BEONPRICE automate much of the revenue management tasks that would previously occupy much of your time. These systems do the bulk of the manual labor, but stop at providing strategic revenue management. This is where revenue managers need to focus their effort: and returning to the basics of the demand curve can help your team be more strategic in maxing out your property’s revenue potential.
Understanding the demand curve gives decision-makers a way to anticipate how demand affects the pricing of your hotel rooms. The demand curve allows you to model travelers’ decisions and price your rooms accordingly to gain the most possible revenue from those seeking accommodation at any given time. Revisiting the basics of the demand curve can help you develop a more intelligent revenue strategy to gain more customers and beat out the compset.
What is a Demand Curve?
The demand curve is a graphical illustration of the law of demand. It represents the relationship between the price of a good or service and the amount (quantity) demanded over a given period of time. The x-axis charts the quantity demanded; the y-axis charts the price. The demand curve allows you to predict the quantity demanded when you price your rooms at a specific dollar amount.
There are two main types of demand curves: the elastic demand curve and the inelastic demand curve. Elasticity refers to the degree to which an increase in price results in a decrease in demand. When a demand curve is elastic, a price decrease causes a significant increase in the quantities purchased. For instance, when the price of paper towel drops by 15%, a shopper might buy extra knowing they’ll use it eventually. A perfectly elastic demand curve looks like a flat, horizontal line.
Inelastic demand curves map what happens when a price decrease doesn’t increase the quantity purchased. Fruit, for instance, has a relatively inelastic demand curve; because fruit spoils in large quantities, a shopper can’t buy more of it just because the price falls by 15%. A perfectly inelastic demand curve looks like a vertical straight line.
There are many variables that impact demand elasticity, especially in the hotel industry. Before we dive into those, we’ll cover a basic understanding of the law of demand to provide background your hotel can use along with a revenue management tool to improve profitability.
What is the Law of Demand?
In macroeconomics, the law of demand is a principle that states that as the price of a good decreases the quantity demanded of that good will increase (and vice versa). The phrase “quantity demanded” is an important part of this definition. Quantity demanded refers to the discrete amount of a product or services – e.g., available hotel rooms, or hours of labor. Most people just refer to this as “demand,” but in macroeconomics, demand refers to the entire demand curve.
The law of demand holds true as long as four key factors that influence demand don’t change. These factors include:
The prices of related goods or services (e.g., airline tickets)
The income of the buyer
The tastes or preferences of the buyer
The expectations of the buyer (e.g., about future prices)
These factors, among other things like the state of the economy and regulatory changes, can shift the entire demand curve as the relationship between price and quantity changes.
Demand Curve Shifters
When the entire demand curve for a product shifts to the right, that indicates that the product has become more commercially desirable and that a larger quantity will be sold at a given price. If the entire demand curve shifts to the left, the opposite is true: the good or service is less desirable and fewer items will be sold at a given price.
What causes a demand curve to shift? The demand curve graph can shift to the left or right depending on changes in income, population, and consumer preferences. Here are some examples of how this works.
Income: when income goes up, so does demand. Consumers who have more disposable income are more likely to spend it. When the economy expands and paychecks go up, consumers tend to spend more on desirable goods, leading to a shift in the overall demand curve to the right.
Population: if population goes up, so does demand – shifting the curve to the right. There are more people who want an item at any given price point, so the curve moves.
Consumer preferences: there are all kinds of things that can influence consumer preferences. Consistently negative reviews of a hotel property, for instance, can cause the demand to drop. Movements in taste change the quantity of a good at every price point.
Remember, when the demand curve shifts, it indicates a shift in overall demand – not just in quantity demand. A shift left or right does not mean that the quantity demanded by every individual buyer changes by the same amount. For instance, not everyone who has a higher income will, therefore, buy an additional car. A shift in a demand curve shows a pattern for the market as a whole.
Hotel Demand Curves
What does the law of demand mean for pricing at your hotel?
There are many variables that increase or decrease demand, meaning the hotel industry is pretty elastic. These independent variables include average daily rate (ADR), income, change in employment, seasonal trends (i.e., demand during spring break or holiday travel periods), and rooms sold. ADR has a negative relationship to demand while the rest can positively shift the curve to the right. “For example, as ADRs increase, consumers purchase fewer hotel rooms, hence the negative sign. As income and employment increase, consumers have greater abilities to purchase hotel rooms, hence the positive direction of these relationships,” reported one analysis.
However, different types of properties also have different degrees of elasticity. General price elasticity data shows that luxury rooms and high-end properties are by far the most elastic. Because these rooms are considered a luxury good, travelers are more price-sensitive to spending on expensive vacations; they’ll seek “value” when incomes are down, unemployment is up, or news headlines predict a recession. The following table indicates how elastic demand curves are for each type of property.
What do the numbers in this table mean? If the quantity demanded increases by 7% when price decreases by 10%, the price elasticity of demand is -7/10 or -0.7. In this case, expect expenditures to decrease by 3%.
By understanding how guest income, employment, seasonal trends, and ADR can change your demand curve, revenue managers can price rooms effectively to capture the highest possible quantity demanded. This is where a revenue management software platform comes into play.
Revenue Management Software is the Key to Optimizing Demand
Revenue management software such as BEONPRICE can help gather data points necessary to properly price your hotel rooms. Revenue management software helps your team sell the right room to the right customer at the right price, incorporating demand curve variables along with channel and timing to maximize profitability. BEONPRICE will factor in historical and market data with forecasting and predictive analytics to recommend rates for each customer segment and room type.
The algorithms in an RMS help hotels set an ADR depending on real-time supply and demand information. Accurately pricing rooms with better data leads to an increase in RevPAR and Net RevPAR (RevPAR after operating costs are deducted), as well as the RevPAR Index (a measure of revenue in comparison to competitors in the market). When a spike in demand is predicted for a seasonal, such as university spring break, BEONPRICE can help set prices that account for the right shift in the demand curve.
Hotels that use revenue management systems save between 20 - 40 hours each month by streamlining manual workflows. The AI built into BEONPRICE and similar platforms can free up your team to do more strategic thinking. Leave supply and demand analysis to the robots – and get your pricing on the right track by returning to demand curve basics.