The Pitfalls of Dynamic Pricing

Dynamic pricing is more than simply adjusting a price. Merchants have changed prices due to supply or competitive shocks for millennia. What makes pricing dynamic is the, well, dynamism with which prices change.

In my upcoming book, The New Invisible Hand, I’ll explore the most important technological trends affecting pricing and commercial strategy. One chapter will focus specifically on this issue: unpacking the promise and perils of dynamic pricing.

There are many different ways to categorize the types of dynamic pricing. I’ll focus here on a categorization based on the information inputs that inform the pricing:

• Customer Behavior
• Customer Characteristics
• Blended

Customer Behavior

Customer behavior-based dynamic pricing is a method that adjusts prices according to explicit customer-agnostic rules.

Happy hours are a common example in some cities. Certain food and drink items are discounted for everyone during a certain time period, often right after work on a typically slow day (e.g., Tuesday).

Some merchants, such as gas stations, may charge you different amounts for paying by cash or credit card. The different prices are clearly listed and reflect to some degree the extra cost to the merchant of processing a credit card payment.

Some loyalty programs can also be thought of as a form of dynamic pricing if a long-time buyer receives a special discount due to their participation.

You will notice that such rules-based pricing mechanisms are both visible and non-exclusionary.

By visible, I mean that the pricing mechanism is communicated to the customer. The purpose of a happy hour is to get customers to come, so customers must know about the happy hour in order to adjust their behavior. Customers know that if they do X, they get Y.

By non-exclusionary, I mean that, at least in theory, the special pricing is available to anyone who follows the rule. Customers know that Y is available to anyone who does X.

Customer Characteristic

Customer behavior-based dynamic pricing has to do with how the customer acts. Customer characteristic-based, on the other hand, has to do with who the customer is.

Many movie theaters offer a senior discount. Age, for better or worse, is an immutable part of who we are. We cannot adjust our behavior to receive such a discount.

Zip codes correlate with income and therefore with willingness to pay, so some online services may use such information to present customers in the same metro area with a different price. The goal is to match the willingness to pay of the customer, not any particular buying pattern.

Some online services will track your browsing history and use that to adjust what price they display for a product or service. If you have looked at a certain product before, a system may determine that you are already committed to buy and slightly increase the price. Or, a system may decide that you’re on the fence and need just a little discount to purchase.

You’ll notice that some customer characteristic-based pricing schemes, such as a senior discount, may be advertised to the customer. Others, like zip code or browsing history, almost certainly are not.

Blended

Obviously, there isn’t a bright line separating customer behavior from characteristics. Some methods of customer segmentation and pricing share aspects with both—so they’re what I call blended.

Let’s consider a hypothetical pricing scheme where customers with iPhones are charged more for a product. Such a scheme is a simple rule, of course, and one might argue that customers could change their smartphone and therefore adjust their behavior to avoid the hypothetical surcharge. Therefore would it be behavior-based?

On the other hand, we’ve already discussed how behavior-based pricing is explicit to the customer because one of the goals is to change customer behavior. Do you think a merchant that charged iPhone users more would make that known? Probably not. We also know that the goal of charging by mobile platform would be to get at underlying characteristics of the person. Therefore would it be characteristic-based?

I think it’s best to accept that some schemes are blended rather than trying to fit them plainly into behavior- or characteristic-based.

Well, What’s Best?

Unfortunately, there’s no easy answer to that. There are advantages and disadvantages to using behavior and characteristics to adjust your pricing and segment your market. Much can come down to notions of fairness.

A customer behavior-based approach like a happy hour is easy to understand, simple to implement, and widely accepted by customers. It can also, crucially, drive customer behavior in ways that are profitable to the merchant.

However, giving a blanket discount to everyone who walks into the bar at a certain time means that almost certainly many people who would buy at full price are not. The merchant is leaving money on the table.

A customer characteristic-based approach like a zip code scheme is a bit harder to implement, but may give merchants a better approximation of willingness to pay. Therefore, they can collect more money from customers who don’t mind at the same time as offer discounts to other customers who otherwise would be priced out completely.

On the other hand, you may have felt a little uncomfortable reading about the hypotheticals in the characteristic-based section. As a customer, being charged more simply because of your browsing habits doesn’t engender much brand loyalty with the company acting in that way.

Market norms are co-created between merchants and customers. They are different between industries and over time. Whereas most customers don’t bat an eye at a senior discount, other characteristic-based methods of pricing can trigger deeply held feelings of injustice.

In an infamous example from 2012, it was found that Staples and other companies varied online prices based on zip code. Customers felt tricked. While it may be the norm for many sites to do so, other companies, such as Groupon, have taken a stand against such practices in order to provide the best customer experience they can.

There isn’t one right answer, but it goes to show how tied up pricing strategy is with branding and larger corporate strategy. It takes careful planning to ensure that any dynamic pricing schemes a company utilizes are in line with their other priorities. Tread carefully.