Dynamic pricing

"August bank holiday is coming up. I need to book flights and hotel for the holidays as soon as possible", said John to his wife, Seema. John googled famous locations in Spain, shortlisted some hotels, and made a travel itinerary, including flights to book. Well, he couldn't go further without discussing it with Seema. They both worked out a plan and agreed on a budget. John jumped on his laptop to make bookings. To his disbelief, all prices he saw an hour ago had now increased by almost 10%. John witnessed a dynamic pricing strategy. 

Dynamic pricing Dynamic pricing

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Table of contents

    Dynamic pricing has become increasingly popular in today's business world as companies seek to optimize their revenue and stay ahead of their competitors. However, it's important to understand both the advantages and disadvantages of this pricing strategy and its potential impact on a business's profitability. By exploring real-world examples of successful dynamic pricing implementation and following some key rules, you can effectively leverage this strategy to boost your bottom line and keep your business ahead of the curve.

    Dynamic Pricing Definition

    Dynamic pricing (DP) is known by many names, like time-based pricing, surge pricing, and demand pricing. Dynamic pricing has different definitions depending on the focus of the research.

    An initial definition of dynamic pricing is as follows:

    Dynamic pricing is a tool used to maximise revenue by "selling a suitable product, to a suitable client, for a suitable price in a suitable time".1

    On the other hand, a definition focused on supply is:

    "Dynamic pricing is the form of resources management where supply is controlled manipulating useful life and price."2

    Yeoman and Kimes (1999) claimed a "universally accepted definition of dynamic pricing" sounds like:

    "The allocation of resources and inventory to a suitable client for a suitable price to maximise revenue and profitability".2

    Based on these different definitions, we can conclude that dynamic pricing means offering different prices to customers per external factors such as demand, availability, purchasing capacity, and competitor prices. As you might have experienced, flight tickets are always expensive for last-minute bookings.

    Dynamic Pricing Plane Tickets StudySmarterFig. 1 - Flight tickets are always expensive last minute

    Factors Affecting Dynamic Pricing

    Dynamic pricing is affected by many factors, such as:

    • Customer behaviour - By analysing past data, companies can divide customers into two broad categories according to their behaviour. These categories are myopic customers and strategic customers. Dynamic pricing strategy concentrates on myopic customers. For example, supermarkets offer perishable goods at reduced pricing if products are reaching expiry.
    • Customer characteristics: generally dictate buying patterns, customer base size, and segment. Prices of products vary depending on whether customers are regular or not. Customers willing to buy a standard loaf of bread are high in number as compared to customers willing to purchase a gluten-free one. If a customer is from a higher-income class, as per their purchasing history, they might have to pay a premium value for a product.
    • Fair price: Price fairness is defined as "consumer's evaluation and understanding whether the difference between seller's and other party's prices is reasonable, acceptable or justifiable" (Maital, 2004; McFadden, 1999). If consumers think the price is unfair, they may feel cheated and will not pay.
    • Market structure: In a monopoly market, a product's dynamic price depends on consumer demand, not competitor pricing. On the other hand, in an oligopoly, competition plays a vital role in deciding the price of a product - for example, Tesco's promise of a price match with Lidl and Aldi. Product demand: The price of a product will increase if demand is high. This principle of economics holds in this case too. Digital technologies allow companies to determine when the demand for any product is high or low. Anticipating demand as per festivals or seasons is easy. But digital technologies today can help companies identify demand during a particular hour of the day.
    • Perception of product value: A consumer thinks about not only the price they are paying but also the quality of the product. If a high-quality product is offered at a discount but still higher than fair value, consumers may still buy it because of their perception of the product's value.
    • Availability of product: Mangoes are seasonal fruits available only in certain months of the year. If the supply of mangoes decreases, the price of mangoes will increase. Availability and seasonality influence the price of the product. Consider limited-edition Jordan sneakers. As a limited number of shoes are available, prices will be high at launch and further increase as more pairs are sold.

    Myopic customers purchase the product if they feel the offered price is less than the usual price. Strategic customers understand the company's strategy and wait longer for the company to bring prices down even further.

    Dynamic Pricing Strategy

    Dynamic pricing strategy is a pricing strategy where the price of a product or service fluctuates based on market demand, supply, and other external factors. The first step of the dynamic pricing strategy process is to identify the reason for changing the pricing strategy. There can be many reasons for a business to implement dynamic pricing, such as attracting more customers, improving profits, competing with other brands, or penetrating the market.

    Once the business has determined its objectives, the second step is to identify a strategy to implement. Dynamic pricing can be time-based, segmented (different prices for a similar product), peak, and market-based. Businesses may also use a combination of these strategies.

    • Time-based dynamic pricing: The pricing of a product or service changes throughout the day. For example, Uber - prices may change as per the demand and availability of vehicles in the vicinity.

    • Segmented pricing: Segmented pricing is also called price discrimination. Some businesses offer discounts on bulk purchases or sell at lower prices for members of loyalty programmes. In segmented pricing, different segments of customers receive different prices. For example, some customers receive birthday discounts.

    • Peak pricing: Peak pricing refers to the pricing offered when demand is highest. The business's peak pricing can be lower or higher than the usual selling price.

    • Market-based pricing: In this strategy, price is determined by competitors' pricing. Certain market conditions influence pricing, like a sudden supply fall or an increase in demand. Due to the war in Ukraine, the oil supply has decreased, resulting in a surge in fuel prices.

    Once the strategy is finalised, businesses need infrastructure to apply and monitor the strategy. Organisations must decide on key performance indicators and regularly test a strategy's success. The strategy must be flexible, meaning that the business may adjust the strategy in response to market conditions. Hence, a business must follow four basic steps to implement dynamic pricing:

    1. Decide the aim of the dynamic strategy.

    2. Choose the right strategy or a combination of strategies.

    3. Set up the infrastructure to implement strategy and decide on KPIs.

    4. Implement the strategy and monitor it regularly, making adjustments as required.

    Effect of Dynamic Pricing on Profitability

    Dynamic pricing increases the profitability of the business. But there is a very fine line. Dynamic pricing allows businesses to sell products at a lower margin, but too many pricing variations may alienate customers from the product. Consider the graphs in Figure 1. The first graph is for static pricing, and the second graph is for dynamic pricing.

    Dynamic pricing, Static Vs Dynamic pricing, StudySmarterFig. 1 - Static Vs Dynamic pricing

    In a static pricing strategy, goods are sold at a fixed price. Hence, the revenue of static pricing is limited. On the other hand, for dynamic pricing, as demand decreases, the product price is reduced. Therefore, there are multiple pricing points. Even though prices are reduced, the company is still selling goods that otherwise might be wasted. In doing so, the company is earning some profit. As the saying goes, "something is better than nothing". Dynamic pricing allows companies to make extra profit. Hence, it increases the profitability of any business.

    Dynamic Pricing Advantages and Disadvantages

    A dynamic pricing strategy has multiple benefits for businesses and consumers. But like any strategy, it has some drawbacks. Let's address the advantages and disadvantages of dynamic pricing for businesses and consumers.

    Advantages and disadvantages of dynamic pricing for businesses

    Advantages

    1. Increased revenue: Businesses implementing dynamic pricing create more revenue than businesses operating on a single pricing strategy. Profit is earned at a low margin when demand is low or at high margins when demand is increased.

    2. Better market understanding: By implementing dynamic pricing, businesses gather and analyse more customer behaviour and characteristics data. Businesses accurately understand customers' willingness to pay and product demand patterns.

    Disadvantages

    1. Customer alienation: Customers do not like being played. Customers may feel cheated if they feel a business overcharges them. Businesses may lose their loyal customers.

    2. Price wars: Dynamic pricing is often affected by competitor pricing. If a competitor offers a high discount, the business has to match that; otherwise, it may lose market share. Such a situation gives rise to price wars as companies keep reducing rates to attract customers. This, in turn, reduces profits and risks the survival of businesses.

    3. Lost sales: Businesses may lose their sales if the dynamic pricing strategy goes wrong. Many buyers prefer checking quotes from different providers before making a purchase. If a business charges more considering the demand for a product, the buyer will prefer another business selling at cheaper rates.

    Advantages and disadvantages of dynamic pricing for customers

    Advantages

    1. Strategic customers: Customers who understand dynamic pricing try to wait out the price rise caused by high demand. Many customers know businesses track their activities via cookies and other digital tools. Hence, they choose to use private browsing (incognito mode) or do the same search on different devices.

    2. Showrooming: Showrooming is checking products in-store and ordering them online for cheaper rates. Hence, physical stores are used just as showrooms. Customers practice this to take benefit of reduced pricing offered by online retailers.

    Disadvantages

    1. May have paid more: Customers may pay more for a product in case of urgency. Customers may also misinterpret high prices as high quality.

    2. Panic situation: High prices may reflect the high demand for the product and cause panic.

    Dynamic Pricing Example

    Airlines introduced dynamic pricing. Following the success of this pricing strategy, hotels, car rentals, communications, and the travel industry implemented it too. As a result, other sectors like retail, production, telecommunication, and energy suppliers use it to maximise profits. Here are some examples of dynamic pricing.

    Ride-hailing services: The ride-hailing services Uber and Bolt use dynamic pricing. Uber offers ride prices considering demand, time of the day, area, and distance.

    Budget airlines: Budget airlines like Ryanair offers prices depending on the number of tickets sold and the time remaining for the flight. It offers some tickets for a high price and examines whether customers are buying them. If demand persists, prices will increase and vice versa. Other airlines set prices based on competitor prices and customer behaviour.

    E-commerce stores: Dynamic pricing strategy has been a major contributing factor to the success of Amazon. Amazon uses an AI-driven pricing strategy that considers many factors such as customer browsing, purchase history, competitor prices, market condition, and demand.

    Dynamic pricing is a valuable strategy for businesses to earn more profit. But when used extensively, it may make customers feel irritated with the constant price change.

    Dynamic pricing - Key takeaways

    • Dynamic pricing means offering different prices to customers as per external factors such as demand, availability, purchasing capacity, and competitor prices.
    • Dynamic pricing depends on factors like customer behaviour, customer characteristics, fair price, market structure, product demand, perception of product value, and availability.
    • Dynamic pricing can be time-based, segmented, peak, or market-based.
    • The advantages of dynamic pricing for businesses include increased profitability and market understanding.
    • The disadvantages of dynamic pricing for businesses include the possibility of customer alienation, price war and loss of sales.
    • The advantages of dynamic pricing for customers are showrooming and a strategy to save money.
    • The disadvantages of dynamic pricing for customers are the possibility of paying more and a potential panic situation.

    References

    1. Weatherford, Lawrence R., and Samuel E. Bodily. A taxonomy and research overview of perishable-asset revenue management: Yield management, overbooking, and pricing. Operations research. 1992.
    2. Yeoman, Ian, Anthony Ingold, and Sheryl E. Kimes. Yield management: Editorial introduction. Journal of the Operational Research Society. 1999.
    Frequently Asked Questions about Dynamic pricing

    What is dynamic pricing?

    Dynamic pricing is known by many names like time-based pricing, surge pricing, and demand pricing. It is a tool used to maximise revenue by selling a suitable product to the right client at the right time. 

    What is one benefit of dynamic pricing?

    One of the benefits of dynamic pricing includes its ability to increase revenues. Additionally, by implementing dynamic pricing, businesses gather and analyse more data about customer behaviour and characteristics. Businesses accurately understand customers' willingness to pay and product demand patterns.

    Does dynamic pricing typically benefits consumers?

    Dynamic pricing typically benefits certain types of customers. Customers who understand dynamic pricing try to wait out the price rise caused by high demand as they know it will eventually decrease. However, customers might end up paying more for a product in case of urgency. 

    What factors affect dynamic pricing?

    The factors that affect dynamic pricing include customer and market characteristics, the market structure, product demand, perception of product value, and availability of the product. 

    How to implement dynamic pricing?

    Every business must decide on certain things before implementing a dynamic pricing strategy. The first step is to identify the reason for changing the pricing strategy. Once the business has figured out its objectives, the second step is to identify a strategy to be implemented. Dynamic pricing can be time-based, segmented, peak pricing, or market-based pricing. Businesses may also use a combination of these strategies.

    Test your knowledge with multiple choice flashcards

    Dynamic pricing does not depend upon

    Which of the following factors affect dynamic pricing? 

    Which of the following is NOT a type of dynamic pricing?

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