March 1, 2019 Growing & Complex Businesses en_US Learn how to let the market—not your margins—determine pricing. Understand how price skimming and variable pricing strategies directly impact your revenue. Dynamic price models: strategy, examples, and yields
Growing & Complex Businesses

Dynamic price models: strategy, examples, and yields

By Susan Payton March 1, 2019

When an article on BuzzFeed listed dozens of solutions to sweaty feet, the writer put Remodeez at the top of the list. The increased exposure and ensuing sales would’ve been great news for any retailer to hear, except for one thing…

The BuzzFeed article may have listed the price at $9.99, but many visitors and would-be buyers would’ve seen Amazon’s pricing was closer to $15 when they clicked through. The stats on Amazon price tracker shows the price rise in 2017, with pricing spikes happening every time Remodeez got coverage in media.

The price rose because Amazon uses a mechanism called dynamic pricing. When a product is sold with dynamic pricing, its price changes based on supply and demand. That might mean the price for a product changes daily, or even hourly. Happy hours at your local bar, airline pricing on travel websites, and Uber’s surge pricing are all examples of dynamic pricing at work.

“Consumers think they’re getting gouged—and they think it’s me,” Remodeez founder Jason Jacobs said to CBS News. He said there’s no benefit to the price increases, as he lost out on sales volume.

In theory, one can make a case for pricing to match rising demand (and prevent a shortage of supply). In practice, it’s a controversial topic and one that people feel strongly about. Advocacy Group Consumer Watchdog called attention to Amazon in particular in 2017, and Amazon is being investigated by the FTC for deceptive pricing.

Yet despite Jacobs’ experience, Amazon optimization company Feedvisor reports this software is growing more popular with Amazon sellers—especially with those selling between $250K-$2M per year, with 15% more merchants using it than the year before.

Not every business can use dynamic pricing as frequently as Amazon does. For example, it would be difficult for a brick-and-mortar store to change prices every hour, given the task of manually changing price tags. However, some physical retail brands are using AI to come up with dynamic pricing they implement through promotions and discounts.

Dynamic pricing strategies work well for products that are in high demand at certain times (like Saturday night with Uber) and for seasonal products: during Christmas, you may be able to sell more if you employ dynamic pricing to sell higher priced products to people willing to pay more to ensure they get the perfect gift for a loved one. The force that drives dynamic pricing is one of perceived value—the worth a customer assigns to your product. There are several variations of these advanced pricing models to consider when determining prices for your products.

Types of dynamic pricing

Each of the following dynamic pricing strategies are built on one fundamental principle: they rely on supply and demand. However, each method has its own characteristics.

Price discrimination

Price discrimination (also called variable pricing) occurs when a business sells the same products at different prices through different channels. There are three degrees of pricing discrimination:

First-degree price discrimination: Also known as perfect price discrimination, this is when a business prices each product they sell at the maximum price they sell.

Second-degree price discrimination: When a business charges different prices based on quantity sold, like giving discounts for bulk purchases.

Third-degree price discrimination: When a business charges different prices to different types of consumers. An example of this would be senior discounts or lower prices for children.

You can justify doing this if there’s a benefit to the customer: take online versus offline sales, for example. You might offer “free” shipping on your website and charge a slight premium for products purchased there over what you charge in the store, or vice versa. Customers will gladly pay a little more for the convenience of ordering online.

However, Canada’s largest bookstore chain, Indigo, does the opposite: the retailer charges less for orders that are shipped from its warehouse rather than purchased in-store because there are fewer costs associated with processing an order.

Price discrimination also works when there is a captive audience. Airlines also use price discrimination, changing the price for airline seats with demand-based pricing. People who need to fly a particular route will have to pay more during peak season.

Advantages and disadvantages of price discrimination

One reason to consider price discrimination is that it ensures that your products are profitable across all channels. Cost varies for you to sell a product, depending on the channel (like in the Indigo example above). If you use a third party ecommerce site to sell, then you can take into account the fact that they charge a fee for the privilege and charge accordingly.

And because not all customers are willing to pay the same price for your product, you can segment to optimize sales. For example, college students don’t have a lot of money, so they’re often overlooked as a market. Offering student pricing for movie tickets ensures a movie theater fills seats, even if it’s at a lower price.

The drawback is that some people may find the periods when prices rise to be unfair and may go to the competition for a better price.

Price skimming

If you have a new-to-market product, you first need to attract customers so they’ll see the value-based pricing of your product and tell others. With price skimming, pricing starts high to attract early adopters and people who see more value in your product because of its higher price.

Think of every piece of technology you have ever purchased. A VCR. A DVD player. An MP3 player. Mobile phone. Tablet. Computer. Chances are if you bought it shortly after the new product arrived in the marketplace, you paid significantly more than people paid for the same product even a few months later.

Advantages and disadvantages of price skimming

The clear advantage of price skimming is that your initial price can help you see a hefty profit margin.

In terms of disadvantages, price skimming can’t work long-term: before long, your competition will flood the marketplace with lower-priced alternatives to your product.

Yield management

Yield management, also known as revenue management, can be seen as a price/market discovery tool: lowering prices based on low demand can attract new customers. It’s also used for inventory like hotel rooms that, if they aren’t sold, mean no revenue collected.

A room might be listed for $200 a night several months out, but when the day arrives, if the room hasn’t been booked, the hotel might release it to a third party travel site to sell at a steep discount. Selling the room at a lower profit margin is better than letting it go vacant.

Advantages and disadvantages of yield management

Selling a product or service, even if it is at a reduced price, keeps revenue flowing and helps provide an ROI (albeit a lower one) for time-sensitive items like airline seats and hotel rooms. It also provides an opportunity to turn a one-time buyer (swayed by price) into a loyal customer.

A disadvantage develops if customers expect those last-minute deals, which may lead them to wait for deals instead of buying early at full price. While they may recoup losses in the short-term, they are also training customers to expect a discounted rate (making them more reluctant to pay the standard full rate) in the long-term.

Final thoughts

There are several pricing models to consider when you’re going through the process of assigning, or reflecting on, prices for products. According to McKinsey, dynamic pricing strategies can help you see 2-5% in sales growth and a 5-10% increase in profit margins, especially when demand is high.

If supply and demand impact your product significantly, dynamic pricing may be the best strategy to ensure a steady flow of sales. However, be careful not to take dynamic pricing too far, with swings in prices your customers won’t appreciate. When you anticipate big swings in demand, do some small pricing experiments to see how your customers react. Customer behavior during these experiments can reveal the perceived value of your products during times of atypical demand, providing valuable info for optimal pricing levels.