Mastering Dynamic Pricing in E-Commerce Part 1: The Pricing Problem
A good pricing strategy should maximize profitability while preserving a company’s competitive edge and delivering value to customers. Pricing strategies are essential for businesses to achieve their financial objectives and sustain growth. Key objectives of pricing include:
1. Maximizing Long-Term Profitability
Pricing strategies aim to generate maximum revenue and profit margins for products or services. They take into account factors like production costs, demand elasticity, and market conditions.
| 💡 Demand elasticity measures how much demand for something varies depending on a certain factor. Often, this factor is the price. For example, necessities, like simple food, have inelastic demand. On the other hand, the demand for luxury goods or entertainment is more elastic. |
2. Maintaining Competitiveness
Pricing decisions need to be aligned with the company’s positioning within the market. It involves assessing competitors’ prices and ensuring that the company offers comparable or superior value to customers at a competitive price point.
3. Meeting Customer Value Perception
Pricing should reflect the customer’s perceived value of the product or service. Companies need to understand their target market’s preferences and willingness to pay. Plus, it is important to know what value your offering brings.
The Pricing Dilemma: Setting Goals
Before delving into pricing tactics, a company must determine its goals and initial steps. Thus, you need to
- Select the direction you want to pursue
- Evaluate your current situation
- Determine expected steps
This section was partially inspired by Philip Kotler and his famous book “Principles of Marketing”. Undoubtedly, pricing is a fundamental aspect of marketing, and the two can often work together to achieve the final goal.
So, let’s discuss some common pricing goals that a business might have:
This goal becomes crucial for businesses when they realise they are operating in an aggressive and competitive market. Furthermore, customer needs can change dramatically over time, and these risks must be taken into consideration. In such a scenario, businesses may need to decrease prices for all items and maintain lower profitability levels.
For example, imagine you own a small local coffee shop. Initially, you have many local customers and few competitors, allowing you to set prices as you please. You might not have much concern for the quality of your beans and other factors. However, when a new Starbucks and a new Costa Coffee open nearby, both well-known brands with more attractive prices, the sales of your local coffee shop decline. You face the possibility of closing your business. In this situation, your primary goal is survival rather than expansion or profit maximisation. Therefore, you may need to decrease your prices and offer various discounts to mitigate the negative impact of the increased competition.
The main idea of this goal is not to thrive, but to endure, avoiding the worst-case scenario of having to shut down your business.
Companies with this goal focus on increasing the number of sales. They want to grow their share of sales in the market compared to key competitors. A company can choose this goal for one of three reasons:
Market Saturation or Market Growth
The company views market saturation or market growth as an essential step toward controlling the market and achieving stable revenue. By expanding its presence and market share, the company aims to solidify its position in the market and establish a reliable revenue stream.
Maximising the Number of Sales
The company prefers to maximise the number of sales and is willing to accept a reduction in revenue per unit to achieve a larger total revenue. Decision-makers prioritise volume over unit profitability. This helps the company to capture a larger portion of the market and increase its overall revenue.
Cost Reduction Through Increased Sales
The company believes that a larger number of sales allows them to reduce relative costs. By increasing sales volume, the company may benefit from economies of scale, lower production costs, and operational efficiencies. This, in turn, leads to improved cost-effectiveness and profitability.
This goal is popular among companies operating in highly competitive markets. For them, the optimal choice is often to implement penetration pricing.
💡 Penetration pricing means setting prices low to attract new customers and quickly capture a market share for a product or service. |
The penetration pricing is particularly suitable when:
Consumers Are Price-Sensitive
This means that small price changes significantly affect customers’ purchasing behaviour. In other words, consumers’ price demand is elastic, and they are more likely to respond positively to lower prices.
There Is a Significant Consumer Market
There is a substantial consumer market with high demand for the product or service. By offering competitive prices, the company aims to attract numerous customers and establish a strong foothold in the market.
The benefits of this strategy include:
Cost Reduction with Increased Sales
The sales volume increases due to the penetration pricing strategy. This often reduces the relative costs of offered products or services. This is because higher sales volume typically leads to economies of scale, lower production costs per unit, and improved operational efficiencies.
Entry Barrier for Competitors
Low prices act as a deterrent for existing or potential competitors from entering or expanding their presence in the market. The aim is to discourage competitors from undercutting prices or entering into price wars.
For Walmart, one of the main goals is to maximise sales. The company offers everyday low prices, bulk discounts, seasonal promotions, and clearance sales. This approach focuses on driving high sales volume and capturing a larger market share. The company attracts customers with competitive pricing and incentivizes increased purchasing.
To sum up, the company uses a penetration pricing strategy to increase its market share and sales volume. This involves setting prices low to attract a significant number of customers and deter competitors. By maximising sales volume, the company seeks to benefit from economies of scale and reduced costs, despite lower revenue per unit. This strategy is particularly effective in competitive markets with price-sensitive consumers and high demand for the product or service.
For some companies, the main goal is to achieve consistently high levels of profit over several years. It can be expressed in several ways:
Stable Profitability
The company aims to maintain a consistent level of profit year after year, indicating financial stability and reliability.
Average Rate of Return
Establishing a stable income based on the average rate of return provides a reliable measure of profitability. Plus, this ensures consistent financial performance.
Increased Capital Investment
The company seeks to increase prices and profits through strategic capital investment, such as expanding operations, improving efficiency, or investing in innovation.
For instance, Apple employs a profit maximisation pricing strategy for its products, like the iPhone. They price them at a premium, limiting discounts, and focusing on product differentiation. The company also has efficient supply chain management. Plus, they emphasise upselling and cross-selling. All of this further contributes to maximising profits. These strategies help Apple maintain its position as one of the most profitable companies worldwide.
Profit can be understood in both absolute and relative terms:
Absolute Profit
Absolute profit is calculated as total revenue minus expenses. It represents the total monetary gain derived from business activities. Absolute profit can be determined by multiplying relative profit (profit per unit) by the number of units sold.
Relative Profit
Relative profit refers to the profit calculated per product or unit sold. It measures the profitability of individual products. Relative profit can vary based on factors such as product category, demand, and quality. Products with high demand or prestige may have higher relative profits. At the same time, essential goods may have lower relative profits.
Market retention pricing focuses on maintaining a company’s existing market share and customer base. Companies with this goal set prices that keep current customers satisfied and loyal. The primary goal is long-term customer retention and stable revenue. Key aspects include:
Customer Loyalty: stable pricing and loyalty programs to encourage repeat business.
Competitive Pricing: matching competitors’ prices and emphasising product value.
Customer Satisfaction: high-quality service and responsiveness to feedback.
This strategy aims to build and sustain long-term customer relationships, ensuring steady revenue and a strong market position.
When considering an example of this goal, Netflix comes to mind first. Netflix uses market retention pricing strategies by keeping subscription fees relatively stable. They prioritise customer satisfaction through personalised recommendations and user-friendly interfaces. At the same time, the company avoids price wars to promote market stability. This approach helps Netflix retain its existing subscriber base and attract new customers, ensuring steady revenue in the competitive streaming market.
Choosing the Right Goal
We have identified four distinct pricing goals. “Surviving in the market” is primarily a reactive measure. Aside from this, companies frequently opt for a combination of the mentioned three main goals rather than selecting a single objective. The choice depends on factors such as:
- Product Category
- Market conditions
- Companies stage of development
Selecting the appropriate goal is a crucial initial step in formulating a pricing strategy.
After selecting the optimal goal, the company moves to the next step. Now, they need to choose their pricing approaches. In this section, we will discuss the most popular approaches without delving into complex algorithmic solutions.
All pricing approaches fall into two main categories: dynamic and static. The difference between them is in the frequency of price adjustments:
Static Pricing is an approach where you do not need to regularly update your prices. They are fixed for a long period of time. Examples of businesses that prefer static pricing are supermarkets, cinemas, museums, and theatres. There, decision-makers do not tend to adjust prices frequently. The reasons for this are high demand and the costly nature of price updates. Let’s take the example of being the owner of a local supermarket. You probably don’t have much time to rewrite price tags during your working hours due to the influx of customers. Of course, if you realise towards the end of the day that you have many items approaching their expiry date, you might decrease their prices. Yet, overall, your pricing remains static.
Dynamic Pricing is well-suited for businesses that need to regularly update their prices, often several times per day or more. This approach is most popular in the online sphere, including marketplaces and flight tickets. Another good example is taxi services. In these cases, optimal prices depend on numerous external factors, necessitating constant adjustments.
Undoubtedly, dynamic pricing is more common in the digital sphere. Adjusting prices online is easier than remaking paper price tags. However, offline retailers are increasingly adopting electronic price tags to implement dynamic pricing. In general, this can help businesses be more competitive, but one should also consider the technical costs of such changes.
The dynamic approach offers flexibility in terms of pricing perception. It allows companies to capture the most optimal price. This is why dynamic pricing is widely recognised as superior regardless of business type.
Cost-plus pricing is still extremely popular. In this approach, the selling price of a product is determined by adding a specific fixed percentage to the product’s unit cost. This percentage is called “markup”. Let’s take the following numbers as an example:
Total product cost = €10
Markup percentage = 20%
Markup price = (Total product cost * markup percentage) = €10 =* 0.20 = €2
Sales Price = Total product cost + markup price
Sales Price = €10 + €2 = €12
This approach is straightforward for both the business and the consumer. It is also convenient from a technical perspective because it involves fewer input factors. Generally, the markup depends on the category and type of product.
💡 The cost-plus approach is typically associated with static pricing and is often considered to be the initial step in transitioning from static to dynamic pricing strategies. |
This approach can be enhanced by incorporating various multipliers into sales prices, such as country or brand coefficients. This makes pricing more differentiated.
The downside is that this approach does not take into account demand specifics or any unique characteristics at the item level.
Another approach is to prevent warehouse overload. Most warehouses have some capacity limitations. Ideally, businesses should always have enough goods at hand to satisfy demand, but without keeping excess stock. So, they aim for frequent sales and the continuous emptying of the warehouse. If you do encounter warehouse overload, you might need to discount some items. This makes pricing less optimal, but given the limited time, you must find certain trade-offs.
It helps if you can accurately predict demand. There are various ways to do it, depending on your business model. For example, supermarkets often incentivise customers to use apps. The customer receives a discount, and the supermarket gains data on what they buy and how often. This allows the company to improve demand prediction and optimise stock levels.
Section Takeaways
Pricing strategies can be broadly categorised into dynamic and static based on the frequency of price adjustments. Dynamic pricing is common in online markets and services. It offers flexibility and optimization opportunities. Static pricing is popular in traditional retail settings. It prioritises stability. The cost-plus approach is a common static pricing strategy, involving a straightforward markup on product unit costs. Negotiating with suppliers and managing warehouse capacity are additional tactics that can impact pricing and enhance overall business performance.
💡 Each approach has benefits and considerations, requiring careful evaluation to align with business objectives and market dynamics. The optimal approach can vary for different items, even within the same company.
As you can see, pricing is a truly complex topic. There is no single solution that will help you and your company drive revenue, sales, and profit. The strategy you should follow fully depends on your goals. In this article, we have considered four main directions:
- Surviving in the Market
- Maximising Sales
- Maximising Profit
- Market Retention
Apart from these, there are also numerous other goals. For example, some companies aim to gain leadership in terms of product quality. We cannot highlight the best or the worst strategy, as each has pros and cons. The choice should depend on factors like product category, market conditions, and the company’s stage of development.
Moreover, only after formulating a precise and clear goal can you move on to selecting the optimal pricing approach. In this article, we discussed that pricing can be either dynamic or static. We also examined various useful pricing strategies:
- Cost-Plus
- Negotiations with Suppliers
- Avoiding Warehouse Overload
Undoubtedly, the number of pricing approaches is enormous. We have not mentioned several well-known strategies like setting a price based on the perceived value of a product or other advanced strategies.
💡 The main idea we want to emphasise is that dynamic pricing is more powerful than static pricing. And in the current dynamic world, you should always be moving forward.
In an upcoming article, we will delve into various advanced dynamic pricing algorithms. We will examine several families of approaches, each with its pros and cons:
Market-Based
This means adjusting prices base on competitor signals. This approach helps businesses to reach the most attractive price. If they are already the cheapest, they can enhance gross profit.
Demand-Based
This set of approaches is often divided into two parts: Calculating elasticity at the item level and Maximising a key metric through a pricing optimizer with known elasticity.
Elasticity estimation can be done with or without machine learning.
Reinforcement Learning
This means selecting prices without any prior knowledge of history or the current environment to maximise a key metric. Several methods are used for this, including Multi-Armed Bandits or more advanced techniques like Q-Learning.
Stay with us to expand your knowledge about the pricing optimization problem. Let’s explore various technical solutions together!
Author of the article – Denis Shvedov, Leader of Pricing Inteligence, analytics ambasador in the Pricing Department at Autodoc
Co-author – Vladyslav Chekryzhov, Head of Data Science at Autodoc
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