How to Reap Higher Profits With Dynamic Pricing

More and more companies are now able to change their prices in real time to capture the full possible value of goods and services. Here’s how to do dynamic pricing right.

Sun Microsystems Inc. chairman Scott McNealy forecast that “With recent advances in wireless and information technology, even our cars could … call for bids whenever the fuel tank runs low, displaying a list of results from nearby gas stations right on the dashboard.”1

It sounds far-fetched. But dynamic pricing — where prices respond to supply and demand pressures in real time or near-real time — is making inroads in many different sectors, including apparel, automobiles, consumer electronics, personal services (such as haircuts), telecommunications and second-hand goods. The advent of the Internet led to cost transparency, decreased search costs and ease of price comparison. Some observers concluded that as a result, prices would decrease and equalize across different channels, and that fixed prices would continue to be the norm.2 However, price dispersion continues to be widespread and dynamic pricing is entering new sectors. EBay Inc. used auctions to sell more than $20 billion worth of goods in 2005. Ford Motor Co. sold more than $50 billion worth of automobiles in North America with demand-based DP in 2003, exceeding profit targets by $1 billion.

Fixed prices are, after all, a relatively recent phenomenon — a product of mass manufacturing that came about after the Industrial Revolution. Before that event, fixed prices were the exception; DP was the norm, with both buyer and seller able to benefit in many DP transactions.

However, apart from airlines and hotels, which employ DP routinely, most companies still use relatively simple strategies for determining prices: competitive pricing (pegging prices to competitors’ prices) or cost-plus pricing (calculating the cost of a good or service and adding profit). Now dynamic pricing optimization offers companies in many other sectors the alternative of raising average realized prices in the face of increased pricing pressures.

Four principal reasons are driving the increasing use of DP today:

  • More companies can now access and deploy the technology for DP at affordable prices in new product and service categories.
  • Recent research shows that with the right approach, consumers will accept DP even if they are currently buying using fixed prices.
  • Increased pricing pressures and supply constraints in different industries are driving companies to look at new ways of extracting value and reallocating demand.

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References

1. S. McNealy, “Welcome to the Bazaar,” Harvard Business Review 79 (March 2001): 18-19.

2. R. Kuttner, “The Net: A Market Too Perfect for Profits,” BusinessWeek, May 11, 1998, 20.

3. M.J. Ashworth, “Revenue Management Builds Higher Profits,” Electric Light & Power 75 (November 1997): 4; and W. Zhao and Y.S. Zheng, “Optimal Dynamic Pricing for Perishable Assets with Nonhomogeneous Demand,” Management Science 46, no. 3 (March 2000): 375-388.

4. W. Baker, M. Marn and C. Zawada, “Price Smarter on the Net,” Harvard Business Review 79 (February 2001): 122-127.

5. A. Sahay, “Consumer Reactions to Dynamic Pricing,” working paper, Indian Institute of Management, Ahmedabad, India, 2005.

6. M. Maynard, “Will This Idea Fly? Charge Some Travelers $10 for Showing Up,” New York Times, August 25, 2004.

7. D. Welch, “Ford Tames the Rebate Monster,” BusinessWeek, May 5, 2003, 5-6.

8. I. Merson, “Reverse Auctions: An Overview,” Acquisition Directions Advisory, July 2000.

9. K. Belson, “Digital Dealmakers Meet in the Middle,” New York Times, Sept. 11, 2003, sec. E, p 1.

10. “Amazon.com Varies Prices of Identical Items For Test,” Wall Street Journal, Sept. 7, 2000, sec. B, p. 19.

11. E. Brynjolfsson and M.D. Smith, “Frictionless Commerce? A Comparison of Internet and Conventional Retailers,” Management Science 46, no. 4 (April 2000): 563-585.

12. M. Marn, C. Zawada, D. Swinford and W. Baker, “Internet Pricing: A Creator of Value — Not a Destroyer,” McKinsey Marketing Practice, September 2000, 2.

13. D. Levy, M. Bergen, S. Dutta and R. Venable, “The Magnitude of Menu Costs: Direct Evidence From Large U.S. Supermarket Chains,” The Quarterly Journal of Economics 112, no. 3 (August 1997): 791-825.