The 8 do’s and don’ts of dynamic pricing

July 31, 2018

The 8 do’s and don’ts of dynamic pricing

Dynamic pricing is one of the most exciting topics in the pricing world right now, with digitalization providing many great opportunities for companies to be more responsive with their pricing. But despite its technological underpinnings, dynamic pricing requires strong human oversight directed by a clear strategy.

Dynamic pricing is certainly not new, having been pioneered by airlines in the ‘70s and now widely used by hotels, airlines, and car rental and tour operators. Taking cues from the travel industry, we’re seeing more and more players outside travel moving towards dynamic pricing, such as entertainment providers and major online retailers like Amazon.

And it’s not only being used in online environments. Traditional bricks and mortar companies are also revolutionizing how they monetize, finding new ways to tap into customers’ willingness to pay.


Related insights: The 5 pricing models companies need to consider when innovating



Empowered by digital

This shift has been largely enabled by digitalization; data is becoming more richly available, processing power is increasing and new technologies like electronic price tags are emerging that make it much easier for companies to adjust prices quickly and effectively.

Dynamic pricing can be located within a broader move towards customization and personalization with the emergence of data – companies now have the power to learn more about their customers and differentiate customer segments by price sensitivity, linking this insight with key market variables, such as supply and demand, timing and perishability.

The potential of dynamic pricing is huge. Companies have newfound ways to maximize monetization, reduce waste and balance supply and demand. Dynamic prices allow businesses to respond more nimbly to market trends.

However, dynamic pricing is not embraced by all consumer groups nor is it appropriate to every situation. Dynamic pricing, when used blindly or in isolation – devoid of human oversight and a clear strategy – can at worst destroy reputation and erode consumer trust, while many will only choose to accept it begrudgingly.
 

We’ve seen many cases where dynamic pricing has worked and where it’s gone very wrong. Here are 8 do’s and don’ts of dynamic pricing:

  1. Do be dynamic when the inventory is perishable or there’s a clear capacity constraint.

When you have a perishable fixed inventory or capacity constraint and you have a varied willingness to pay among your customer segments that is actionable, then you should consider dynamic pricing.  Just think of the airline industry – there is a fixed capacity in terms of seats available on a flight and, at the same time, there is varying willingness to pay that is actionable as early bookers are typically price sensitive, whereas late bookers are typically business customers with higher willingness to pay. Consequently, airlines traditionally offer cheaper prices for earlier bookings that tend to increase as you book closer to departure. At the same time, the capacity constraint (finite number of seats on a plane) means that for very popular flights and dates, the airline can monetize excess demand through higher prices – this is exactly why peak travel dates tend to have higher prices than off-peak ones.
 

  1.  Do be dynamic when you can use it to balance supply and demand.

Dynamic pricing can be used effectively to balance supply and demand in two-sided marketplaces. The classic example is Uber, which uses dynamic pricing to incentivize supply in supply-scarce situations through higher prices, while at the same time reduce demand to maintain acceptable waiting times for the customers willing to pay a premium. Through dynamic pricing, the marketplace is able to balance supply and demand and ensure long wait times are avoided, so customers are happy, the drivers are happy as they get paid more per trip, and Uber is happy as it is able to generate more revenue by balancing the marketplace.
 

  1. Don’t be dynamic if it doesn’t align with your strategy.

Just because your competitors are using dynamic pricing doesn’t mean you have to follow suit. Take Uber competitor Addison Lee as an example, who clearly states on their website “our prices stay the same when you book, no surge charges at peak times”. They have decided not to use dynamic pricing as a strategic decision, choosing instead to focus on the quality of their service. Each ride they offer guarantees the same price, same type of car, Wi-Fi, charging of your mobile phone, and so on.  Their choice not to use dynamic pricing has become their unique selling proposition. And it has paid off – their revenue has increased by 31% in the past year.
 

  1. Do be dynamic when your price is fluid, you’re elastic and it’s cost-efficient.

Who would have thought 10 years ago that supermarkets would move to dynamic pricing? Now it’s possible with the use of digital price tags. And it works because so many of their products have an expiry date – they have perishable inventory and thus a supply constraint. So, while there is a revenue benefit by way of increased sales, there’s also a cost benefit because supermarkets can now minimize waste. Firms are able to effect 90,000 price changes a day, and German supermarkets using dynamic pricing have achieved a 2.5% increase in revenue and an astounding 30% drop in waste.
 

  1. Do use dynamic pricing when there’s seasonal demand.

In these cases, there need not be a supply constraint or perishable element, there’s no need to match supply and demand, but there’s some urgency. Online retailing giant Amazon has been using dynamic pricing on various products that exhibit seasonality in demand. One example is Pumpkin Pie Spice, an American product which is very popular during Thanksgiving and Christmas, which is normally sold for $4.49 on Amazon. But before Christmas, it has been listed for as high as $8.49. This is purely driven by demand during the holiday period, impacting customers’ willingness to pay. Because customers need the product now and it’s not a frequently bought product, there’s limited price recollection and customers are less price-elastic – they’ll accept the higher price more willingly. Dynamic pricing can allow for effective monetization of seasonal demand and urgency when price sensitivity drops.
 

  1. Don’t use dynamic pricing when there’s no seasonality or urgency but there’s full comparability.

Dynamic pricing, however, should never be taken too far, and even a market leader like Amazon sometimes gets it wrong. Prices on Amazon and other online retailers can be fully compared using best-price tracker websites. Unlike flights, products sold online can usually be found elsewhere in exactly the same format, and there is usually no supply constraint. Customers can simply buy the product at another retailer if they don’t like the price, or they can buy it at a later date if they believe the price will drop. In fact, savvy shoppers have learned to look out for bargains and are quite happy to shop around online. Dynamic pricing in such circumstances can shift demand from when consumers wished to purchase an item to when they expect the price to be cheaper, which is clearly revenue sub-optimal for online retailers.
 

  1. Don’t over rely on algorithms and neglect the human element.

While dynamic pricing can be greatly assisted by data and algorithms, these should neither be used blindly nor in isolation, devoid of a clear strategy. Amazon made headlines when a book, The Making of a Fly, was listed on the platform for several million dollars – and it wasn’t a bestseller by any means. In this case, two booksellers were listing the same book and were tracking each other. So, as one raised their price, the other soon followed without anyone checking, until the price reached $23.7 million. This case emphasizes how important it is to track dynamic prices and apply checks to ensure prices remain reasonable, in line with broader company and pricing goals. Forgetting the human element in dynamic pricing is a guarantee for failure.
 

  1. Don’t use dynamic pricing in situations that can be deemed insensitive or as profiteering.

Unfettered dynamic prices can create bad publicity. When Whitney Houston passed away, the price of her Ultimate Collection album increased from $4.99 to $7.99 on Apple’s iTunes Store only hours after her death, bringing Sony Music under fire. This 60% increase was driven purely by algorithms sensing higher demand for her music. While price hikes due to high demand make perfect sense, to consumers this can come across as pure profiteering, especially in sensitive situations. Customer trust is one of the key factors in the success of any business so always make sure that prices are explainable.

 

Walking before running

These lessons underline how important it is to know your customers, your market and the particular variables pertaining to your business – product perishability, supply and demand changes, price elasticity and constraints.

While digitalization has empowered companies by opening up new and creative ways to monetize their business – having powerful data and algorithms now at their disposal – the human element should never be forgotten. In fact, dynamic pricing, while reliant on technology, also requires fundamental business process changes to succeed, making human input ever more important. Dynamic pricing must be led by a step-by-step approach, embedded within broader company and pricing goals, and built upon a thorough understanding of your product and market.