This is an excerpt from the ebook “Predictive Analytics for Business”. Download full text here.
Dynamic pricing is a pricing strategy in which companies apply variable pricing instead of traditional, fixed pricing. Prices are set in accordance with current market demands and as data is analyzed, the right prices are calculated. In dynamic pricing, different users can be charged a different amount for similar goods.
Dynamic pricing is a must for e-commerce retailers to increase sales and generate more profit. With machine learning, companies can monitor and adjust prices more effectively. To make accurate pricing recommendations and sales predictions, algorithms analyze historical and competitive data. Dynamic pricing can boost profits by 25% on average.
And how does it work? The pricing of airline tickets is a great example to illustrate that. When you’re buying a flight ticket online, you can sometimes notice that the price of the ticket changes, the very same ticket, same plane, same time, same seat. It can go up or down, depending on various factors. Airlines price tickets differently based on customer status and demand. It’s now obvious to us that some time is more expensive for travel – so flight tickets will cost more around Christmas, or even on a Friday evening compared to Wednesday morning. We’ve already learned that this is how it goes, but sometimes the price can change in an instant – like when you add the ticket to cart. But airlines are not the only segment making more profit with the use of dynamic pricing; so do hotels, gas stations, financial institutions, and retailers. Dynamic pricing allows businesses to remain competitive while still capitalizing on market demand.
There are different types of dynamic pricing based on different factors.
Segmented pricing is a pricing strategy that offers different prices for different customers, for example in different geographical regions.
Competition-based pricing is a process of selecting appropriate price points in reference to the prices charged by competition. This strategy is often used by companies selling similar products.
That’s a pricing strategy often used by airlines or hotels. The prices are changing depending on the availability of products or services.
Peak pricing is a strategy where customers pay more during the period of higher demand. Peak pricing is most frequently implemented by utility companies.
Penetration pricing is a strategy used to attract customers to a new product or service. It means setting a low initial price for a product or service, often below the market rate. This strategy relies on the concept of low prices attracting a large portion of customers.
Dynamic pricing can analyze a number of factors that you consider important to your pricing strategy. For some companies, analyzing just one aspect like the supply, demand or competitors’ prices is sufficient, but in other cases, pricing may rely on a number of factors to set the best possible price.
There are good and bad reasons to increase prices, and sometimes higher demand is not the only factor that should influence the decision to make prices higher.
Stay competitive. Dynamic pricing helps you be competitive 24/7. If you want to make sure you’ve got the best offer in town, you don’t have to spend hours going through the offers of your competition.
Motivate customer behavior. You can encourage more customers to use your service during off-peak hours. This way, you can distribute the activity more evenly throughout the day and help avoid experiencing heavy surges.
Be transparent about your pricing. Don’t use your pricing strategy against your customers. Make sure you let them know that the prices may change. You may be afraid of saying “the price may go up if …” – and sure, users can wonder why they may be paying more than someone else. But in this case, they know the rules and they accept them, while keeping people in the dark would be much like lying. And imagine your customers finding out that they’re charged differently for the same product or service without knowing it. They may get angry.
Avoid too much price discrimination. It may be hard to tell where the line is, especially when the prices are calculated based on the actual demand. However, you need to make sure that your pricing strategy doesn’t hurt your customers and ruin your company’s image. And it can if it’s unfair.
Uber uses a surge pricing model in their business. When demand for rides increases, prices go up. Riders wanting to order an Uber know about that – they can see a multiplier to the standard rates on the map. For example, if the multiplier is 1.8x, a ride that normally costs $10 will then cost $18. The rates are updated based on real-time demand, so the surge can change quickly. It’s a fair deal in general – on a Friday night, there may be more people who want to take an Uber than actual Uber drivers. That’s a good reason for prices to go up. However, there was a time when there was a snowstorm in New York, and taking an Uber was for many the only option to get back home. The surges were reportedly around the level of 4x, which is expensive but given the circumstances – acceptable. However, rides were even more expensive than that and some riders requested refunds. Though it was all due to higher demand, Uber was largely criticized for making profit on exploiting its customers.
We’ve grown used to the fact that every passenger on a plane may have paid a different price for the same standard. As shoppers, we may experience moments of frustration when we see that prices go up just when we’ve made up our mind to buy something, or that the price drops just a day after we’ve bought it. “Can they even do that?”, we may ask, and that’s a reasonable question – to which the answer is… that depends.
Price discrimination can be illegal is it’s based on impermissible factors such as race, gender, nationality, or religion. No company is allowed to offer a higher price for the exact same product based on these factors. Dynamic pricing can also be illegal if it violates antitrust law. However, good dynamic pricing strategies analyze factors such as location, demand, customer profile, and competition to generate price recommendations – and in such a case, it’s perfectly legal. However, not everything that’s legal is acceptable for consumers. When designing a dynamic pricing strategy, it’s good to consult experts – other companies using this solution, business professionals, or a lawyer. Make sure that your pricing strategy is transparent and doesn’t hurt your customers. As long as it works for them, it works for you, too.
More and more companies implement dynamic pricing, so there needs to be a reason, right? And naturally, there is: other pricing strategies fail. The most common pricing strategy, still, is fixed pricing. It can mean low or high prices, depending on the company and the product or service, but it’s often fixed – you set a static price based on your costs and desired profit margin. However, there’s an important assumption there: your sales volume should be big enough to generate the right profit margin and cover the costs. This way, you can’t use your pricing strategy to influence customer behavior and sales volume. And remember, your customers are dynamic, too. They’re well aware of acceptable prices, they shop around, they choose from too many options. You need to adjust – or you’re out. To keep up with the competition, demand, and other factors, you need a dynamic approach. A good dynamic pricing system will consider all the data points relevant to your business and make data-driven decisions. As always, a strategic approach and the right data plan a key role in the process so you make sure you’re turning towards being a data-driven organization, and not basing your actions on unverified assumptions.