Dynamic pricing: What it is and how you can you use it

Dynamic pricing refers to charging different prices for a product or service, depending on who is buying it or when it sells. Dynamic pricing is sometimes called demand pricing, surge pricing, or time-based pricing. And it’s a reaction to changes in competition, supply, demand, and other market forces.

In 2020, dynamic pricing made headlines when the prices of everyday goods such as toilet paper and hand sanitizer changed dramatically. More common examples are happy hours at your local bar, airline pricing on travel websites, and rideshare surge pricing.

In this article, we’ll explore whether dynamic pricing is an effective strategy for your business.

What is dynamic pricing?

Dynamic pricing is a strategy that involves setting flexible prices for goods or services based on real-time demand. Algorithms and machine learning help facilitate this real-time pricing strategy. Companies can factor in things like supply and demand changes, competitor pricing, and other market conditions to help set product prices.

Dynamic pricing decisions won’t work for every business or industry. But industries that often use dynamic prices include

• Hospitality
• Travel, including the airline industry
• Entertainment
• E-commerce businesses
• Retail
• Electricity
• Public transportation

Generally, dynamic pricing favors wealthier consumers. Wealthier consumers have the means to handle price adjustments. Consumers with more limited funds may find themselves priced out of the market when prices increase. They may wait for lower prices or sales to purchase goods or services.

What is an example of dynamic pricing?

Sometimes, dynamic pricing results in unintended consequences for business owners. Let’s take a look at a recent example of how real-time price changes impacted a small business selling on Amazon.

Dynamic pricing e-commerce case study: Amazon

In May 2017, a BuzzFeed article recommended Remodeez shoe deodorizers on a list of popular foot remedies. The increased exposure and the ensuing increase in sales would’ve been great news for any retailer. But the article listed the price at $9.99.

At the time, would-be buyers went to Amazon to see the price was closer to $15 because Amazon uses dynamic pricing. The Amazon price-tracking website camelcamelcamel shows the price increased in 2017 each time Remodeez got media coverage. And that’s had an impact on the business.

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

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 relies on supply and demand. However, there are a couple of other variations that you’ll want to consider, as each method has its own characteristics. Below, we’ll detail popular dynamic pricing variations.

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 price discrimination.

1. First-degree price discrimination: Also known as perfect price discrimination, this is when a business prices each product at its maximum value.
2. Second-degree price discrimination: This is when a business charges different prices based on quantity sold—think discounts for bulk purchases.
3. Third-degree price discrimination: This is 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 price discrimination if it presents a customer benefit. Take online versus offline sales, for example. You might offer free shipping on your website but charge more for products purchased online than you do in the store, or vice versa. Some customers will 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 they ship from their warehouse because it costs less to process the request.

Price discrimination also works when you have a captive audience. Airlines use price discrimination when they use demand-based pricing to change the price of airline tickets. People who need to fly a particular route will have to pay more during peak times.

Advantages and disadvantages of price discrimination

Price discrimination can ensure your products are profitable across all channels. Product costs vary, depending on the channel, like in the Indigo example. If you use a third-party e-commerce site to sell, consider that they charge a fee and increase your price accordingly.

And because not all customers are willing to pay the same price for your product, you can segment to optimize sales. For example, many college students have tight budgets, 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 to price discrimination is some people may find the periods when prices rise to be unfair. And they may go to your competition for a better price.

Price skimming

If you have a new-to-market product, you’ll need to attract customers who will 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 price.

Think of every piece of technology you have ever purchased: a VCR, DVD player, MP3 player, mobile phone, tablet, computer. If you bought it shortly after it hit the market, chances are you paid more than those who bought it 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 usually doesn’t work long-term. Before long, your competition will flood the marketplace with lower-priced alternatives to your product.

Yield management

Also known as revenue management, you might see yield management as a price and market discovery tool. It’s the process of lowering prices, based on low demand, that can attract new customers.

For example, hotels use yield management to manage their inventory of unsold rooms. A room might be listed for $200 a night several months out. But if no one books the room, 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 at a reduced price keeps revenue flowing and helps provide an ROI for time-sensitive items. It also offers an opportunity to turn a one-time buyer swayed by price into a loyal customer.

A disadvantage develops if customers wait for those last-minute deals instead of buying early at full price. You may recoup losses in the short-term. But you’re also training customers to expect a discounted rate, making them more reluctant to pay the standard price in the long-term.

How to use dynamic pricing

If dynamic pricing is compatible with your business model, it can be an effective strategy to boost revenue. It’s even more effective if your products or services are in high demand. Here are four steps to get the most out of dynamic pricing.

1. Define your goals

Before you price your products or services, define your goals. That includes defining why your business exists, what it stands for, and what your customers can expect from you. Implementing dynamic pricing without first addressing these questions can confuse your team, your audience, and your stakeholders.

2. Establish your pricing strategy

No two businesses are alike, so their pricing strategies shouldn’t be either. Before you dive into the tactics of dynamic pricing, consider your overarching strategy to attract and retain customers through pricing.

For example, if your goal is to capture as much traffic as possible while also making a good margin, you could follow the “high-runner” strategy. With the “high-runner” strategy, you price most of your products cheaper than the competition but price a few items higher to capture profits. The rationale behind this strategy is that once a visitor shops with you once, they’re less likely to look elsewhere for similar products.

Choosing the best pricing strategy for your small businesses serves as a compass for decision-making and sets you up for success.

3. Choose and implement your dynamic pricing strategies

Once you’ve established a pricing strategy, you need to implement the tactics to bring it to life. This is where the dynamic pricing strategies—price discrimination, price skimming, and yield management—come in. But these strategies aren’t mutually exclusive. You may want to use a combination to align pricing with your goals.

4. Test your dynamic pricing strategies

You can’t improve what you can’t measure. Before you put your dynamic pricing strategy into effect, it’s vital to have systems in place that monitor sales. Without monitoring sales, you can’t ensure that your strategy is accomplishing what you want. If you’re not seeing the results you want, consider reevaluating your strategy.

Using artificial intelligence (AI) for dynamic pricing

Not every business can use dynamic pricing as frequently as Amazon or eBay. 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 that they can implement through promotions and discounts.

Here’s how it works: Cloud software tests a subset of products at various stores, tracking factors like competitor pricing and customers’ shopping history. After about a week of evaluating a price’s impact on sales, the AI makes a suggestion. If the stores sell more of a product after a price change, AI prompts the store manager to make a permanent price change. The AI-manufactured price is then released to all customers.

Pros and cons of dynamic pricing

Depending on your industry, dynamic pricing could help you grow your business. That said, you should understand the pros and cons of the strategy before you go all in. There is no catch-all answer to how implementing dynamic pricing will impact your business. Ultimately, your decision comes down to whether you’re confident that the potential benefits outweigh the risks.

Dynamic pricing pros

1. Dynamic pricing allows you to set real-time prices based on the trends that impact your business the most. With dynamic pricing, you can remain competitive and maximize revenue.
2. A dynamic price can save your company money in the long run. Since software determines prices, you won’t need to allocate funds for market research or pricing strategies.
3. Dynamic pricing can grow your business. Dynamic pricing strategies can help you see 2-5% sales growth and a 5-10% increase in profit margins, according to McKinsey.

Dynamic pricing cons

1. Customers may become frustrated with inconsistent prices.
2. Businesses trying to stay competitive can start price wars where prices drop to unsustainable levels.
3. Customers may consider dynamic pricing unfair, particularly if prices fluctuate based on shoppers’ demographics.

Is dynamic pricing legal?

Yes, dynamic pricing is legal. But some organizations challenge its legality. The advocacy group Consumer Watchdog called attention to Amazon in 2017, and the FTC is investigating Amazon for deceptive pricing.

Businesses can adjust prices based on internal metrics or market. But it is illegal for businesses to adjust prices based on impermissible factors such as race, gender, religion, or nationality.

Is dynamic pricing fair?

In theory, one could make a case for pricing to match rising demand and prevent a supply shortage. In practice, it’s a controversial topic.

Consumers may feel as though businesses lied to them if they paid more for shoes, concert tickets, or airline tickets than their neighbors. However, proponents of dynamic pricing argue that it’s the consumer’s responsibility to find the best price.

Despite some negative feedback, Amazon optimization company Feedvisor reported that dynamic pricing software has grown more popular with Amazon sellers. Between 2017 and 2018, 15% more vendors selling between $250,000 and $2 million per year used repricing software.

If you implement dynamic pricing in your business, it’s in your best interest to always be upfront and transparent with consumers about your practices.

What’s the difference between dynamic pricing and price discrimination?

Price discrimination refers to price changes that are based on individual shopper demographics. Dynamic pricing is the practice of making prices flexible based on fluctuations like internal metrics, market factors, and competitor pricing.

Price discrimination is a subset of dynamic pricing, but one key difference separates the two concepts. Price discrimination provides different shoppers with different prices. Dynamic pricing changes the price for all shoppers.

One example of price discrimination would be an e-commerce brand creating two prices for the same product to see how shoppers respond. With dynamic pricing, an e-commerce brand adjusts the price of that same product for all shoppers to increase traffic.

Why is dynamic pricing important?

Although there may be a stigma around dynamic pricing, the reality is that it can maximize profits and track expenses. Using algorithms and machine learning, you’ll employ price optimization, ensuring you set your goods and services at the best price.

If supply and demand impact your product significantly, dynamic pricing may be the best strategy to ensure a steady flow of sales. What’s more, the data you gather after implementing dynamic pricing can reveal your products’ perceived value during times of atypical demand.

With insightful strategy and attention to detail, you’ll find that a dynamic pricing model can help take your business to the next level.