What is Dynamic Pricing?
In short, dynamic pricing is a pricing strategy which applies variable prices instead of fixed prices. New and optimal prices are calculated and recalculated periodically, every day or even every hour. The essence of dynamic pricing is offering the right price to the right customer, at the right time, for the right product to increase the company's sales and margin.
In the past, pricing was a manual task where a person determined what the price of a product should be. The actual price was mainly based on factors as demand: How many people like to buy the product? and supply: How much inventory is left and how fast do we have to sell this before its perishes, gets old-fashioned, gets replaced by a new version?
With dynamic pricing, prices are changed based on automated processes. Apart from demand and supply, other factors can be included as well, such as:
- Local demand & supply: instead of looking at overall demand within the nation, prices can be adopted on local (state, city, street) demand and supply.
- Time: this factor is actually strongly tied to demand. Some restaurants are, for example, cheaper during the week than during the weekend, as demand is less.
- Weather forecasts: rain, snow and sun can all influence the future demand of the product. With rain coming, people care less about the prices of umbrellas.
- Competitors' prices: at what price does the competitor offer the same product? Should we match the price or even go lower?
- Customer behavior: if a customer comes back several times, the chance that he will buy the product increases. Increasing the price may even entice the customer to buy the product faster.
- Customer attributes: in-store, if a customer looks wealthy, you may want to try to sell at a higher price. Online the same concept can be applied using data like the location/zip code of the computer accessing the website or the device used (iPhone owners on average are more wealthy than Android users).
Key element in applying dynamic pricing is price elasticity: what will happen to the customer demand if prices are increased or decreased? Typical behavior is that customers buy more or less products (Q) if the price (P) decreases or increases. The objective of dynamic pricing is to use mathematical models to find the optimal price (P*) which maximizes the total revenue of a company (P * Q). Alternative is not to focus on maximizing revenues, but maximizing margins.
Dynamic pricing has been around for a while and is common practice in several industries, like the hotel, airline and event ticket industries. These industries are actually selling perishable goods. When the room or seat is not booked before the night, flight or the event, the product becomes worthless. Therefore, companies in these industries tend to lower prices as the deadline nears. However, the consumer knows prices drop when the deadline nears so some will gamble that prices will drop and delay their purchase. Still, if all potential buyers delay their purchase, demand may suddenly peak again and increase prices. Hence, the term dynamic pricing.
Amazon is one of the leading examples of dynamic pricing in the retail space. They are adapting their prices millions of times per day based on many factors.