The practice of dynamic pricing is not a new concept. Some see the origin in the airline Industry where its use started in the 1980s. But even beforehand it was common practice in small grocery stores to discount perishable products like bread over time. At its core, dynamic pricing simply means that a company sells a product at different prices.
Drivers of dynamic pricing in retail
Today, dynamic pricing is widely used in retail and especially online retail. Its use becomes more common and popular with pricing managers as the driving factors of its application spread to other industries (e.g. B2B sales). Most recently, leading retailers started to use machine learning technology for dynamic pricing with great success. There are many different ways to conduct dynamic pricing. It is important to look out for pitfalls as some companies experienced backlash from customers or others even suspected them to have violated anti-price discrimination laws. So what are the factors that drive the use of dynamic pricing in retail? And what are the different types of dynamic pricing?
There are four main factors that drive the significance of dynamic pricing for retail businesses:
- Importance of Pricing: Product Pricing strategy is a crucial aspect for retail companies that directly affects profitability and growth. Pricing decisions have direct impact on the main business activities such as marketing and supply chain management. Price changes can be used to reflect and complement changes in these business departments.
- Data explosion: Over the last years we saw an explosion in the generation of data and it is likely that the growth rate of data collection will increase even more. Especially in retail, customers leave a data trail each time they make a purchase on the web, use their credit or loyalty card. This data can be used to adapt prices quickly to a change of customer behavior.
- Rising complexity & transparency: Selling through online channels has increased price and information transparency dramatically. Changes of external factors (e.g. competitor prices) have immediate impact on one’s business. To stay competitive companies need to be able to adapt their prices quickly to a changed market environment.
- Enabling technologies: Online prices can be changed easily with a few strokes on the keyboard. Simple pricing software enables automatic price changes e.g. based on competitor prices. More recent developments in artificial intelligence allow an even higher degree of automation with additional increase in performance.
Types by input factors
One can differentiate forms of dynamic pricing by the main input factors that influence price changes and the technology or main methodology in use. In practice, most companies use a combination of different types to tap the full potential of pricing. Various factors can trigger price changes.
The most commonly used factors are the following:
- Supply: This is very common in industries with a large share of fixed cost like hotels, airlines or ride sharing. Moreover, with a decreasing amount of available supply (seats, free rooms) prices regularly increase. In retail, supply plays a major role for stock items especially if they are perishable or cannot be sold after a certain time frame (e.g. fashion products). In this case, retailers often use mark-down pricing where they reduce prices to the end of the season.
- Demand: An increased interest for a product can trigger a price increase. Following this strategy, retailers try to capture a larger part of the willingness-to-pay of their customers. A good example is a popular kind of sneaker. In an extreme form, we can sometimes observe price gouging where sellers try to take advantage from demand surges. One example was the increase of prices of face masks during the corona crisis.
- Competitor prices: Competitor prices are one of the main factors to trigger price changes. Especially if competitors sell exactly the same product it is easy for customers to compare prices. Here the difficulty is to determine which products are really price comparison products and at which price difference the customer will change vendor.
- Characteristics of customer: In business they refer to this practice as personalized pricing. Here the price varies for different kinds of customers. The idea is that different customers have a different willingness-to-pay and can therefore one can charge them different prices. A simple example is a price discount for senior citizens for a museum visit. In online retail personalized pricing is usually put into practice with coupons. Companies that use this form of dynamic pricing need to look out for a potential backlash of their customers that feel that this kind of pricing is unfair.
Types by methodology and technology
Even though some of these factors seem common sense like supply and demand. Companies rarely act in a perfect test environment where retailers change their prices while other demand influencing factors stay the same. Furthermore, often many things change at the same time (e.g. competitor prices, marketing spend, seasonality). That is where technology and methodology comes into play. Here we can differentiate between two types of dynamic pricing:
- Rule-based pricing: This is the most commonly used method of dynamic pricing. In this case, a fixed formula determines prices and price changes. One example is a rule to set a minimum margin of 20% or to directly match prices of competitors. There are two main shortfalls of this methodology: It takes a lot of manual effort to administer the price formulas and the price rules are often based on parameters that are easy to measure but entail only limited information about customer behavior. Often companies only reach suboptimal results using this kind of pricing method.
- Machine Learning based pricing: Machine learning technology is a huge enabler for price optimization and automation. Machine learning models can measure price elasticities for different price points or even model the whole price demand curve for each product. Next generation software solutions based on this technology run price optimizations towards company goals automatically without the setting of price rules.