Dynamic pricing

Dynamic pricing, also referred to as surge pricing, demand pricing, or time-based pricing is a pricing strategy in which businesses set flexible prices for products or services based on current market demands.[1] Businesses are able to change prices based on algorithms that take into account competitor pricing, supply and demand, and other external factors in the market.[2] Dynamic pricing is a common practice in several industries such as hospitality, tourism, entertainment, retail, electricity, and public transport. Each industry takes a slightly different approach to dynamic pricing based on its individual needs and the demand for the product. Dynamic pricing is unpopular with some consumers as it favours the wealthy, who are less likely to be priced out of a market when there is high demand, such as the electricity market during a heat wave or the food industry during a famine.[3][4]

Not to be confused with Variable pricing.

History of dynamic pricing

Dynamic pricing has been the norm for most of human history. Traditionally, two parties would negotiate a price for a product based on a variety of factors, including who was involved, stock levels, time of day, and more. Store owners relied heavily on experienced shopkeepers to manage this process, and these shopkeepers would negotiate the price for every single product in a store. Shopkeepers needed to know everything they could about a product, including the purchase price, stock levels, market demand, and more, to succeed in their jobs and bring profit to the store.

As retail expanded in the Industrial Revolution, storeowners faced the challenge of scaling this traditional haggling system. As assortments expanded and the number of stores grew, it quickly became impossible for shopkeepers to keep up with the store. The negotiation model quickly proved inefficient within an economy of scale.

The invention of the price tag in the 1870s presented a solution: one price for every person. This idea harkened back to a traditional Quaker idea of fairness: Quaker store owners had long employed a fixed-price system in the name of egalitarianism.[5] By charging the same price of all shoppers, Quakers created a system that was fair for all, regardless of shoppers' wealth or status.

Unlike the Quakers, who used fixed pricing as a way to maintain fairness, retailers used fixed pricing to reduce the need for highly skilled shopkeepers and smooth out the shopping experience within a store. The price tag made it easier to train shopkeepers, reduced wait time at checkout, and improved the overall customer experience. This fixed-price model with price tags would dominate retail and commerce for years to come. Dynamic pricing (as we know it today) would re-emerge in the 1980s, aided by technological innovation.

Dynamic pricing in air transportation

Dynamic pricing re-appeared in the market at large in the 1980s airline industry in the United States.[6] Before the 1980s, the airline industry’s seat prices were heavily regulated by the United States government, but change in legislation during the decade gave airlines control over their prices. Companies invested millions of dollars to develop computer programs that would adjust prices automatically based on known variables like departure time, destination, season, and more.

After seeing the success of dynamic pricing in selling airline seats, many other verticals within the travel and tourism industry adopted the practice. Dynamic pricing is now the norm for hotels, car rentals, and more, and consumers have largely accepted the practice as commonplace. The practice is now moving beyond the travel and tourism industry into other fields.

Dynamic pricing in rideshare services

The most recent innovation in dynamic pricing—and the one felt most by consumers—is the rise of dynamic pricing in rideshare apps like Uber. Uber’s “Surge Pricing” model, where riders pay more for a trip during peak travel times, began as a way to incentivize drivers to stay out later in Boston, according to Bill Gurley, former board member of Uber. The incentive worked, and the number of drivers on the road in the early morning hours increased by 70%-80%, and the number of unfilled Uber requests plummeted.[7]

Dynamic pricing today

Dynamic pricing has become commonplace in many industries for a variety of reasons.

Hospitality

Time-based pricing is the standard method of pricing in the tourism industry. Higher prices are charged during the peak season, or during special-event periods. In the off-season, hotels may charge only the operating costs of the establishment, whereas investments and any profit are gained during the high season (this is the basic principle of long-run marginal cost pricing: see also long run and short run).

Hotels and other players in the hospitality industry use dynamic pricing to adjust the cost of rooms and packages based on the supply and demand needs at a particular moment.[8] The goal of dynamic pricing in this industry is to find the highest price that consumers are willing to pay. Another name for dynamic pricing in the industry is demand pricing. This form of price discrimination is used to try to maximize revenue based on the willingness to pay of different market segments. It features price increases when demand is high and decreases to stimulate demand when it is low. Having a variety of prices based on the demand at each point in the day makes it possible for hotels to generate more revenue by bringing in customers at the different price points they are willing to pay.

Transportation

Airlines change prices often depending on the day of the week, time of day, and number of days before the flight.[9] For airlines, dynamic pricing factors in different components such as: how many seats a flight has, departure time, and average cancellations on similar flights.[10]

Congestion pricing is often used in public transportation and roadways, where a higher price at peak periods is used to encourage more efficient use of the service or time-shifting to cheaper or free off-peak travel. For example, the San Francisco Bay Bridge charges a higher toll during rush hour and on the weekend, when drivers are more likely to be travelling.[11] This is an effective way to boost revenue when demand is high, while also managing demand since drivers unwilling to pay the premium will avoid those times. The London congestion charge discourages automobile travel to Central London during peak periods. The Washington Metro and Long Island Rail Road charge higher fares at peak times.

Dynamic pricing is also used by Uber and Lyft.[12] Uber's system for "dynamically adjusting prices for service" measures supply (Uber drivers) and demand (passengers hailing rides by use of smartphones), and prices fares accordingly.[13]

Professional sports

Some professional sports teams use dynamic pricing structures to boost revenue. Dynamic pricing is particularly important in baseball because MLB teams play around twice as many games as some other sports and in much larger venues.[14]

Sports that are outdoors have to factor weather into pricing strategy, in addition to date of the game, date of purchase, and opponent.[15] Tickets for a game during inclement weather will sell better at a lower price; conversely, when a team is on a winning streak, fans will be willing to pay more.

Dynamic pricing was first introduced to sports by a start-up software company from Austin, Texas, Qcue and Major League Baseball club San Francisco Giants. The San Francisco Giants implemented a pilot of 2,000 seats in the View Reserved and Bleachers and moved on to dynamically pricing the entire venue for the 2010 season. Qcue currently works with two-thirds of Major League Baseball franchises, not all of which have implemented a full dynamic pricing structure, and for the 2012 postseason, the San Francisco Giants, Oakland Athletics, and St. Louis Cardinals became the first teams to dynamically price postseason tickets. While behind baseball in terms of adoption, the National Basketball Association, National Hockey League, and NCAA have also seen teams implement dynamic pricing. Outside of the U.S., it has since been adopted on a trial basis by some clubs in the Football League.[16] Scottish Premier League club Heart of Midlothian introduced dynamic pricing for the sale of their season tickets in 2012, but supporters complained that they were being charged significantly more than the advertised price.[17]

Retail

Retail is the next frontier for dynamic pricing. As e-commerce grows in importance and the size of assortments expands, retailers are turning to software to help track product prices and make pricing updates.

Retailers, and online retailers in particular, adjust the price of their products according to competitors, time, traffic, conversion rates, and sales goals.[18][19] Dynamic pricing is quickly becoming a best practice within the retail industry to help stores manage these factors in a fast-paced market. Dynamic pricing software allows retailers to easily understand what happens in their assortments at a glance and act proactively on market changes. There are another of other benefits as well, including greater efficiency, increased consumer trust, and better overall strategy setting.

Some retailers will build their own dynamic pricing software, but many more will outsource to a software vendor. Retailers in all categories use dynamic pricing software including sporting goods, beauty, fashion, do-it-yourself and hardware, baby and family, auto parts, home care, fast-moving consumer goods (FMCGs) and more. Dynamic pricing can even be used by brick and mortar stores with the help of electronic shelf labels (ESLs).

Brands and Dynamic Pricing

In recent years, more brands have launched direct-to-consumer sales channels to capture more consumer data and control brand perception. [20] Many brands turn to dynamic pricing to help manage this sales channel and follow the market.

With dynamic pricing, brands can more easily control their market perception and create a direct relationship with consumers. However the most interesting benefit to a direct-to-consumer strategy is the market data that brands can collect on their customers.

Some third-party sellers in the Amazon Marketplace use software to change prices more frequently than would be feasible for people to do, in order to compete for business on price.[21][22]

Dynamic pricing methods

There are a number of ways to execute a pricing strategy with dynamic pricing software, and they can all be combined to match any commercial strategy. This section details some of the most well-known and popular pricing methods and explains how they change in a dynamic pricing engine.

Cost-plus pricing

Cost-plus pricing is the most basic method of pricing. A store will simply charge consumers the cost required to produce a product plus a predetermined amount of profit.

Cost-plus pricing is simple to execute, but it only considers internal information when setting the price and does not factor in external influencers like market reactions, the weather, or changes in consumer value. A dynamic pricing tool can make it easier to update prices, but will not make the updates often if the user doesn’t account for external information like competitor market prices.

Pricing based on competitors

Businesses that want to price competitively will monitor their competitors’ prices and adjust accordingly. This is called competitor-based pricing. In retail, the competitor that many companies watch is Amazon, which changes prices frequently throughout the day. Amazon is a market leader in retail that changes prices often,[23] which encourages other retailers to alter their prices to stay competitive.

Competitor-based dynamic pricing can increase sales, especially if they take advantage when other retailers run out of stock. But without proper boundaries, it can also lead to a race to the bottom where stores fiercely compete for sales and drive the price to the ground. A quality dynamic pricing software will have boundaries that protect markets from this.

Pricing based on value or elasticity

Ideally, companies should ask the price for a product which is equal to the value a consumer attaches to a product. This is called value-based pricing. As this value can differ from person to person, it is difficult to uncover the perfect value and have a differentiated price for every person. However, consumer's willingness-to-pay can be used as a proxy for the perceived value. With the price elasticity of products, companies can calculate how many consumers are willing to pay for the product at each price point. Products with high elasticities are highly sensitive to changes in price, while products with low elasticities are less sensitive to price changes (ceteris paribus). Subsequently, products with low elasticity are typically valued more by consumers if everything else is equal. The dynamic aspect of this pricing method is that elasticities change with respect to product, category, time, location and retailers. With the price elasticity of products the margin of the product, retailers can use this method with their pricing strategy to aim for volume, revenue or profit maximization strategies.[24]

Conversion rate pricing

Conversion rates measure how many browsers on a website turn into buyers. When conversion rates of viewers to buyers is low, dropping the price to increase conversions is standard with a dynamic pricing strategy.

Time-based dynamic pricing

Time-based dynamic pricing is popular in several different industries where demand changes throughout the day or where suppliers want to offer an incentive for customers to use a product at a certain time of day.

Time-based retail pricing

Many industries change prices depending on the time of day, especially online retailers. Most retail customers usually shop the most during weekly office hours between 9AM-5PM, so many retailers will raise prices during the morning and afternoon, then lower prices during the evening.[25]

Time-based utility pricing

Time-based pricing of services such as provision of electric power includes, but is not limited to:[26]

  • Time-of-use pricing (TOU pricing), whereby electricity prices are set for a specific time period on an advance or forward basis, typically not changing more often than twice a year. Prices paid for energy consumed during these periods are preestablished and known to consumers in advance, allowing them to vary their usage in response to such prices and manage their energy costs by shifting usage to a lower cost period or reducing their consumption overall (demand response)
  • Critical peak pricing whereby time-of-use prices are in effect except for certain peak days, when prices may reflect the costs of generating and/or purchasing electricity at the wholesale level
  • Real-time pricing whereby electricity prices may change as often as hourly (exceptionally more often). Price signal is provided to the user on an advanced or forward basis, reflecting the utility's cost of generating and/or purchasing electricity at the wholesale level; and
  • Peak load reduction credits for consumers with large loads who enter into pre-established peak load reduction agreements that reduce a utility's planned capacity obligations.

A utility with regulated prices may develop a time-based pricing schedule on analysis of its cost on a long-run basis, including both operation and investment costs. A utility operating in a market environment, where electricity (or other service) is auctioned on a competitive market, time-based pricing will typically reflect the price variations on the market. Such variations include both regular oscillations due to the demand pattern of users, supply issues (such as availability of intermittent natural resources: water flow, wind), and occasional exceptional price peaks.

Price peaks reflect strained conditions on the market (possibly augmented by market manipulation, as during the California electricity crisis) and convey possible lack of investment.

Conversion rate pricing

Conversion rates measure how many browsers on a website turn into buyers. When conversion rates of viewers to buyers is low, dropping the price to increase conversions is standard with a dynamic pricing strategy.

Controversy

Some critics of dynamic pricing, also known as 'surge pricing', say it is a form of price gouging.[27][28]

Dynamic pricing is widely unpopular among some consumers.[29][30][31]

Amazon.com

Amazon.com engaged in price discrimination for some customers in the year 2000, showing different prices at the same time for the same item to different customers, potentially violating the Robinson–Patman Act.[32] The company stopped and apologized after it was discovered.

Uber

Uber’s surge pricing has also created controversy, notably with increased pricing during hostage situations, hurricanes, and more.[33] Beginning in 2015 the company started placing caps on how high the surge pricing can go during times of emergency.[34]

See also

References
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  3. Neil Irwin (October 14, 2017). "Why Surge Prices Make Us So Mad: What Springsteen, Home Depot and a Nobel Winner Know". New York Times.
  4. Ashley Clements (April 26, 2011). "Yemen's other crisis – the daily struggle for food". The Guardian.
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  13. Decker, Susan; Saitto, Serena (2014-12-19). "Uber Seeks to Patent Pricing Surges That Critics Call Gouging". Bloomberg L.P. Retrieved 2015-12-19. Uber applied for a U.S. patent last year for 'dynamically adjusting prices for service' using mobile devices. The system measures supply (Uber drivers) and demand (passengers hailing rides with smartphones), and prices fares accordingly.
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  17. "Hearts fans cry foul over ticket deal 'own goal'". Edinburgh Evening News. 24 March 2012. Retrieved 20 October 2012.
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  25. http://business.time.com/2012/01/09/why-monday-is-e-retailers-favorite-day-of-the-week/
  26. Partially reworded from United States Energy Policy Act of 2005, sec. 1252. Smart metering
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  28. Aimee Picchi (September 6, 2017). "Amazon faces complaints of price gouging ahead of Irma". CBS News.
  29. "A Fair Shake". The Economist. May 14, 2016.
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  34. "Uber, learning from Sandy, caps surge pricing during blizzard". Christian Science Monitor. January 26, 2015. Retrieved August 30, 2019.
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