Price elasticity is a microeconomics concept that explains the relationship between a product's price and demand for that product. Professionals that understand the trends driving price elasticity in their industries are masters of pricing strategy. It's more important than ever to understand the nuances of elasticity, a concept that most of us learned in high school and probably haven't thought about since.
Lower prices for hotel rooms drive significantly higher demand but for other products like insulin (diabetes medication), different prices rarely lead to large changes in demand since those patients will always need their medicine.
Why is it so important to understand the price elasticity of demand?
Ask yourself the following questions. How much does the introduction of a platform like AirBnB cause hotel industry supply and demand curves to move in opposite directions? What does that say about how we should think about price of a product like a hotel room?
Modern pricing strategy and revenue management is all about understanding and acting on these elasticity changes before your competition does. In an industry like hotels, higher prices have a massive impact on demand even when it's just a small change. Revenue management is all about finding the perfect mix of both room rates and occupancy. Consequently, without understanding price elasticity it's almost impossible to identify the optimal price point for hotel rooms that will drive the highest absolute value or revenue for your hotel on any given night.
What is Price Elasticity?
Even if you’ve never taken an economics class, you likely encounter price elasticity on a regular basis. In short, price elasticity measures how changes in supply and demand impact an item or service’s price. This impact can be represented in a graph, with quantity demanded on one axis and price on the other axis. When you draw a line through the data points, the line that relates the two is called the demand curve, and the slope of the line shows if the relationship is elastic or inelastic. Many factors impact price elasticity, including the availability of substitutes, time, and whether the product is a luxury or a necessity.
Price Elasticity of Demand (PEoD) = % Change in Quantity Demanded / Percentage Change in Price
What does price elasticity of supply look like in real life? Gasoline prices provide a stylized example. Since people rely on gasoline to fuel their cars, a necessary mode of transport for many people, we will still buy gas even if the prices rise. If the price increases, the quantity demanded will stay pretty much the same, so gasoline prices demonstrate inelastic demand or inelasticity. On the other hand, strawberry prices are elastic. If the price of a container of strawberries skyrockets, people will likely purchase other fruit instead like blueberries or raspberries, thus purchasing fewer strawberries. As the strawberry price increases, the quantity of strawberries demanded will decrease, which shows that the relationship is elastic.
More Substitutes Emerge Every Year in the Lodging and Hotel Industry
As demonstrated in the strawberry example, a key factor in price elasticity is the availability of substitutes. If strawberry prices surge, people will buy less expensive produce, like apples, bananas, or oranges - or even different varieties of berries. There is no shortage of strawberry substitutes. More substitutes leads to more price elasticity.
Similarly, in the hotel industry, the number of substitutes is high. In a given market, one property can have substitutes with the same star rating, amenities, price range, location, and brand identity. Even hotels within your competitive set are substitutes for each other.
But in addition to hotels, alternative lodging is becoming increasingly available as a substitute for traditional accommodation. Not only are more travelers adopting alternative lodging, the growth of the short-term rental industry is explosive. In just nine years, Airbnb has listed more rooms on its platform than the top 5 hotel chains combined have in their portfolios. Short-term rental companies like Stay Alfred and The Guild provide hotel-style services and amenities in their apartment listings, which make them even closer substitutes for hotels, and management company Sonder hit $100M in revenue within only 5 years of operation. These trends show that alternative lodging is a true substitute for hotel rooms, which over the last few years has begun to make the demand curve for hotel rooms even more elastic.
The Hotel Booking Window is Shifting
In addition to the availability of substitutes, timing plays a role in price elasticity. We’ve all heard the phrase “the right place at the right time,” and this idea applies perfectly to pricing trends. For example, in the middle of a rainstorm, an umbrella vendor could raise prices, because people don’t want to wait around before buying an umbrella. They want to stay dry - right now. In this case, the short timeframe of the rainstorm makes umbrella prices more inelastic, because even if prices increase, people will still buy.
Timeframe is increasingly important in the hotel industry because booking windows are getting shorter, which makes the room rate demand curve less elastic. Leisure travelers aren’t booking as far in advance as they used to, and groups are also booking closer to their arrival date. We often don’t realize the difference that this shift has on elasticity until it’s too late. Each minute that the booking window shifts up drives the elasticity curve with it. As mentioned in a Virginia Polytechnic Institute and State University study:
“Travel booking behavior has changed substantially over the past two decades. The emergence of new technology and online intermediaries has provided travelers with the flexibility to book up until the date of stay. This has created a fast-paced, dynamic booking environment that disrupts traditional revenue management strategies focused on pricing and allocating rooms based on the time of purchase.”
If you feel like you’ve seen “Limited Time Offer!” taglines everywhere, you’re right. Besides traditional booking sources, apps and websites dedicated specifically to last-minute reservations, like HotelTonight, are becoming more popular. These apps not only provide a massive convenience to travellers but have also unexpectedly shifted the entire timeline and booking window for hotel rooms. The ability to easily book last minute rooms has changed the psychology and behaviors of those in search of hotel rooms. Those who book a room while they’re in destination will have less price sensitivity because they fundamentally need a room and that spectrum draws out incrementally all the way through a booking made years in advance.
An Inevitable Recession Will Turn Necessity Into Luxury
Is the product a luxury or a necessity? Whether the item or service is a “want” or a “need” plays a part in the overall price elasticity. Products that are everyday necessities, like food and transportation, tend to be less elastic because people will still buy them, even if the price increases just like the gasoline example we used above. On the other hand, the quantity demanded of products that aren’t truly necessary, like luxury goods, tends to decrease when the price rises.
While travel is sometimes a necessity, tough economic times can push travel into the “luxury” category, thus increasing the price elasticity. When budgets get tighter, leisure travelers will look for less expensive vacations (or not go on vacation at all) and companies will cut back on business travel expenditures. Out of the U.S. travel market, business travel accounts for $327B and $761B for leisure travel, but these numbers can change as in-person business meetings would likely shift to digital platforms like high-definition video conferencing or Slack during a recession. It’s important for revenue managers to plan for changing price elasticity in a recession because revenue management software cannot anticipate these long term cyclical dips.
How Can My Hotel Adapt To a Changing Marketplace?
If you feel overwhelmed by all of these changes, that’s only natural. The demand curve for hotel rooms changes constantly - by day, by market, by segment - which is far too much for a person to calculate and forecast. A strategic hotelier will implement revenue management software, such as IDeaS G3, to find optimal pricing based on data. IDeaS G3 gathers competitor prices, historical trends, guest review scores, search engine trends, and more to power its continuous pricing model, which then publishes the ideal rate for each room type and each channel. The system can even optimize rates for meeting and event space, so the entire property is operating at peak profitability.
Revenue management software enables you to spend less time on repetitive tasks and more time on strategic decisions. Let your RMS handle the number crunching while you focus on positioning your hotel in the market and reacting to hospitality industry trends. Hire revenue managers who are strategic and give them the tools to focus their time on high level strategic questions rather than mundane and repetitive calculations.
There’s never a dull moment in today’s ever-changing hotel industry. In order to react to the changing hospitality landscape, a volatile economy, special events, weather patterns, and more, a strong revenue management strategy is necessary for any hotel to succeed when your competitors are implementing price changes hourly. Sophisticated revenue management tools like IDeaS G3 are readily accessible with insightful data and time saving productivity tools, but a forward-thinking hotelier must still understand the concept of price elasticity and the underlying themes that impact the demand curve in order to execute a successful revenue management strategy.