Dynamic Pricing

Price Setting (Pricing)
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A Kahnesky
Analyst, Denmark

Dynamic Pricing

WHAT IS DYNAMIC PRICING? INTRODUCTION
Dynamic Pricing or Surge Pricing or Demand Pricing or Time-based Pricing is a pricing strategy. It is used when a company or store continuously wants to adjusts its prices throughout the day. The goal of these price changes is mainly two fold: on one hand, companies want to optimize for margins, and on the other they want to increase their chances of sales. It is based on Discriminatory Pricing, which allows changing prices based on the supply and demand, time, competitor's prices, customers, or other external factors. Dynamic Pricing typically uses computers and business analytics to model and forecast these factors to change the prices of products & services dynamically. A popular example of Dynamic Pricing is ride-hailing services such as Uber, which changes the price for a route based on the demand and time of the day. But airlines are well known to sell seats at dynamic prices for many years.
Dynamic pricing used to be a normal pricing mechanism in human history. However, the invention of 'price tags' in 1861 saw a transition to Fixed Pricing, due to the sheer complexity in changing the prices of thousands of goods being sold. Due to technological innovations and computational ease, firms can now use Dynamic Pricing for earning a little extra revenue which was earlier being left on the table.

Dynamic Pricing uses the Latitude of Price Acceptance the price range within which changes to the price have little or no impact on the customer's buying decision. Firms typically try to alter the prices within this range, without invoking a backlash from the customers; firms may attempt to widen this range by varying prices across channels and regions with proper communication to the customers.

WHEN CAN DYNAMIC PRICING BE USED?
  • Fixed capacity on resources, which can't be scaled up or down rapidly (e.g. limited number of rooms in a hotel or seats in an airplane).
  • Perishable products or services whose value drops sharply (either to zero or certain salvage value) after a period of time (e.g., flight tickets, flowers, vegetables, meat).
  • If variable costs form a small percentage of the total cost of the product or service.
  • Brand consciousness is low (this is typically seen when customers are price sensitive).
  • When price flexibility is possible, i.e. options to avail a similar albeit cheaper product (e.g., customers have an option to either purchase a brand, new car or a pre-owned car).
  • The firm has a large market with a huge number of customers and transactions (e.g., Stock Exchanges).
  • When firms face a need to sell excess inventory, the use of Dynamic Pricing helps to increase the recovery and reduce the write-offs.
TYPES OF DYNAMIC PRICING STRATEGIES

Price Discovery Mechanisms: Customers determine the prices thought their own actions in the transactions, i.e. the price changes during the transaction.
  1. Auctions: Customers bid up to purchase their desired product (e.g., old Artifacts' auction)
  2. Reverse Auction: Sellers bid down to sell goods (e.g., firms bidding for Government contracts)
  3. Dutch Auction and Yankee Auction: Seller solicits bids from multiple buyers for several identical items (e.g. Initial Public Offerings or IPO)
  4. Group Buying: A community of small buyers combines their purchases for availing a limited-time discount offer (e.g., websites like Groupon)
  5. Negotiations: The buyer and the seller transact via direct or automated settlement.
Posted Price Mechanisms: Customers are able to see the posted price, which changes across transactions:
  1. Yield Management: Maximizing revenue for the sale of a product or service which has a fixed supply and whose value diminishes to zero over a period of time (e.g., flight tickets)
  2. Demand-based Pricing: Prices vary according to the demand for a product/service whose value diminishes over time to certain salvage value. (e.g., pre-owned cars)
ADVANTAGES OF DYNAMIC PRICING. BENEFITS
  • BOOSTS REVENUE AND PROFITS: Setting multiple price levels helps the firm in getting more revenue. Reducing prices helps in boosting the sales volume.
  • BETTER INVENTORY MANAGEMENT: Prices are often hiked for fast-moving goods to get additional revenue, which lowering the prices for slow-moving goods helps to get rid of excessive inventory.
  • IMPROVED MARKET UNDERSTANDING: Huge data collection and use of predictive models helps the firm to understand the market trends better.
  • ENHANCED FLEXIBILITY: Flexibility offered by dynamic pricing helps firms to target specific goals such as increasing revenue, profits, market share, etc.
DISADVANTAGES OF DYNAMIC PRICING. PITFALLS
  • PERCEIVED AS UNJUST PRICING: The discriminatory nature of dynamic pricing (based on customer, time, location, etc.) may portray it as an unjust pricing strategy.
  • BACKLASH FROM CUSTOMERS: The firms may face backlash from customers if their dynamic prices appear as unjust to them. This might be due to prices falling outside the Latitude of Price Acceptance range, inadequate transparency from the firm's side on the pricing policy, or if the dynamic pricing is based on the customer's past buying behaviour or their willingness to pay.
  • LOGISTIC ISSUES IN IMPLEMENTATION: Dynamic pricing of physical goods requires the extensive use of electronic tags instead of paper-based price labels.
  • PRICE WARS: The prices of products adjusting dynamically to face the competitor's price, might lead to price wars, in case of a drastic decline in prices.
APPLICATIONS OF DYNAMIC PRICING
  • Automobiles (Pre-owned)
  • Apparels
  • e-Commerce (Retail)
  • Transportation (Airlines, Railways, Buses, Cab/Taxi)
  • Restaurants & Hotels (Lodging)
  • Educational institutions
  • Cinema halls or Multiplexes
  • Gyms and Health clubs
  • Tickets for shows, concerts or other events
⇒ What is your opinion about the fairness of dynamic pricing? Any other remark?

Sources:
Sahay, Arvind (2007) "How to Reap Higher Profits With Dynamic Pricing", 2007, MIT Sloan Management Review
Metcalfe, Luke (2017) "What is Dynamic Pricing and Why is it Important?", 2017, Crealytics
Melanie (2019) "Dynamic Pricing Strategy: The Good and the Bad", 2019, Unleashed

  Jaap de Jonge
Editor, Netherlands
 

Dynamic Pricing is not Price Gouging

Price gouging occurs when a seller increases the p (...)

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