“The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. If you’ve got to have a prayer session before raising the price by 10% then you’ve got a terrible business”
Warren Buffett Chairman & CEO Berkshire Hathaway
If anyone was to suggest to a law firm management team that they should hike their pricing by 10%; new clients with immediate effect and existing clients at the next review, the advice would be viewed with derision and opprobrium.
Many firms genuinely believe that their brand is so weak and their relationship with the bulk of their clients so brittle and so tenuous that the smallest increase in prices will result in a mass charge for the door.
Generally, this is based on little more than gut feel and intuition and whilst these are always helpful, they are no substitute for a more rigorous and analytical approach. Time therefore to introduce into the analysis a concept known as price elasticity of demand (PED).
The concept was pioneered by British economist Alfred Marshall in the early years of the 20th century. It is the most commonly used measure of consumers’ sensitivity to price changes. It is simply the proportionate change in demand given a change in price. The formula is usually written in its most basic form as;
So, if like me, the sight of something like the foregoing formula had you breaking out in a cold sweat at school, let's put some real numbers on it. Let's say you are in the habit of charging £1,000 for a certain type of job. You decide to increase the price by 25% which thereby becomes £1,250. If because of that price increase, demand drops by 10% then you end up with the following…
Reduction in demand (-10%)/Increase in price (+25%)
= price elasticity of -0.4
Put another way, if your starting point was 20 jobs at £1,000 each, you increase your price by 25% to £1,250, a PED of 0.4 would result in two of those jobs (10% of the 20 jobs) going to a less expensive competitor which would leave you asking the question, which would you rather do:
· 20 jobs at £1,000 each (£20,000), or
· 18 jobs at £1,250 each (£22,500)
Is it really that simple and in event, who says that the price elasticity of legal services is 0.4? The answer is ‘no’ it is rather more nuanced than that.
Prices of legal services (like all goods and services) are either highly elastic (price sensitivity means that volume will be affected by even minor changes in price) or highly inelastic (relative price insensitivity means that volume will be little affected by changes in price, at least initially).
Price sensitivity and therefore the correlation between price changes and demand are as one might expect, impacted by a range of variables including:
(a) Ease of substitution. The greater the availability of viable substitutes, the higher the elasticity (price sensitivity). There is a strong substitution effect where clients can easily switch at little or no cost or inconvenience.
(b) Necessity. The more necessary a specific service is and the more necessary the use of a specific firm or partner, the less elastic (price sensitive) the work.
(c) Brand loyalty and brand value. Attachment to a certain brand, either out of tradition or because of proprietary barriers can override sensitivity to price changes, resulting in more inelastic demand
(d) Who pays. People tend to be more price sensitive with their own money than with others.
The net result is that individual practice areas, firms, geographical locations, practice teams and individual partners will all have different price elasticity coefficients.
While we have not been able to locate more contemporary research, analysis undertaken in 1997 by Harvard University (Anderson, McClellan, Overton and Wolfram) concluded that the price elasticity of demand for legal services is -0.4. We would question that figure, not only because supply and demand of legal services has changed dramatically in the following 20 years but because when one considers the matters we identified in the preceding paragraph, it is obvious that no single figure tells the whole story. It is nonetheless insightful.
You might be reading this and thinking to yourself, ‘they've just taken some 750 words to tell me what I already know and what I already engage in and that is that ‘I charge what the market will stand’. Quite true but we think it is nonetheless worth spelling it out for three reasons:
(a) A homogenous approach to individual fee earner hourly rates is fundamentally flawed resulting in either overpricing and the resulting loss of profitable work that could otherwise have been secured, and ‘leaving money on the table’.
(b) Gut instinct alone is no way to manage a pricing strategy. Not understanding rudimentary elements of the science of pricing puts firms at risk of very costly pricing mistakes, and
(c) An understanding of price elasticity can give firms a lot more confidence about implementing strategic price increases in the knowledge that if they have assessed their PED correctly, they should hit the ‘sweet spot’ - optimising profitability in both percentage and in absolute terms, even if it means losing some clients and some work.