Intelligent Enterprises of the 21st Century

Real Time/Dynamic Pricing

Real time or dynamic pricing mechanisms occur on the Internet when buyers and sellers negotiate the final transaction price for the exchange of goods or services. These mechanisms are used in online auctions and name-your-own-price formats, for example. Right pricing often involves a careful consideration of costs, customers and competition. When any of these change, the best possible price may also change. Understanding price sensitivity factors can help meet fluctuating conditions. Rather than having a fixed price, it is sometimes better to resort to the techniques of real-time pricing. The Internet assists in customizing the price or real time pricing based on volume discounts/past buying behaviour/changes in demand and/or supply and so forth.

Proper pricing requires information. In a rapidly changing and complex, highly competitive market, it can be difficult and sometimes almost impossible for a firm to calculate and forecast its demand accurately. Due to the changing internal/external characteristics in the environment, the demand continues to change and the Internet causes high price sensitivity.

Another problem that online vendors face is that different customers pay different prices. Many markets offer discount coupons to repeat buyers, discounts, or special deals. Pricing in these markets must account for differences among these customer segments and somehow encourage proper buying by these groups.

Using a fixed price when electronic markets are involved is especially difficult. Electronic markets change swiftly. Online price sheets become the only method for checking the right prices. The traditional methods disappear and the entire pace of pricing accelerates.

Companies are using real-time pricing, and the power of real-time markets, instead of setting the price themselves. This partly stems from efficiency and partly it is caused by necessity. When conditions change so quickly, only real-time pricing approaches may be feasible. Zhao and Zheng (2000) discuss a dynamic pricing model for selling a given stock of a perishable product over a finite time horizon is considered. Customers, whose reservation price distribution changes over time, arrive according to a non-homogeneous Poisson process. It is shown that at any give time, the optimal price decreases with inventory. A sufficient condition is identified under which the optimal price decreases over time for a given inventory level. This sufficient condition requires that the willingness of a customer to pay a premium for the product does not increase over time.

Three models of real-time pricing are growing on the Internet (Greenstein & Feinman, 2000; Hanson, 2001):

• The first is an expansion in the use of auctions.

• The second is the growth of rental markets for consumer and industrial products.

• The third is the mixture of auction and capacity planning known as yield management.

Each model is discussed in the following sections.

Auctions

Online auctions are powerful methods of real-time pricing. Auctions work well on the Internet because in-depth information is available to bidders. Bidders can call or e-mail for more information. Participants can join in from anywhere on the planet. Managers responsible for pricing will increasingly choose not to set prices but to schedule auctions instead.

Auctions are an effective pricing method even when face-to-face selling and negotiations are feasible, e.g., the city of Melbourne, Australia, has been a pioneer in real estate marketing by permitting both traditional negotiated sales of houses and auctions of houses. This combination allows a direct comparison of auction against negotiation. It was observed that on average sellers got 8 percent more for their houses when they auctioned them. Auctions are also flexible since there are various types of auctions such as English, Dutch, Sealed Bid, Double; and there are a variety of auction strategies general consumer auctions, specialty consumer auctions, business-to-business Web auctions, seller-bid (reverse) auctions and group purchasing auctions (Schneider, 2002). Kaufman and Wang (2001) study the dynamics of one instance of dynamic pricing— group-buying discounts—used by MobShop.com, whose products' selling prices drop as more buyers place their orders. The research collects and analyzes changes in the number of orders for MobShop-listed products over various periods of time, using an econometric model that reflects the understanding of bidder behaviour in the presence of dynamic pricing and different levels of bidder participation.

In the pre-Internet era, the biggest problem with auctions had always been the expense of getting enough bidders together in the same place at the same time. The Internet helped overcome this limitation since bidders no longer have to be physically present. This factor reduces participants' cost and increases the total number of bidders. It also raises the auction price paid and the profitability of the auction to the seller.

Online sites improve the power and efficiency of auctions in two main ways. The first is information. In-depth information improves bidders' understanding of the items being sold. Auction theory has shown that it is profitable to both the buyers and sellers. Buyers are more comfortable and they feel that they can correctly evaluate the items being sold. Their bids reflect this comfort level. On average, sellers will receive higher winning bids and bidders will more often get items that they truly value. The second benefit of online auction sites is that they expand the number of bidders. This benefits the seller, leading to a higher winning bid. It also works to avoid an auction failure, when no one bids higher than the reservation price or the lowest price that the seller is willing to accept. Increasing the number of bidders it is more likely that this reservation threshold is surpassed.

Online Art Auctions

The art world online provides an example of the progressive steps a company can use to take advantage of online auction capabilities. The first step for many is consignment selling. The gallery may never take actual possession of the art and simply act as a broker. The gallery earns its commission by bringing buyers and sellers together adjusting it's pricing appropriately. The gallery can set up an auction and let buyers' current level of interest determine the prices. Consignment becomes more like an auction if prices decline for slow moving objects (e.g., www.artbrokerage.com).

Online Auction Types

Once a company has decided to use an auction to set price, it can choose the auction type. The most popular auction type, both online and traditional, is the English auction. This is the familiar kind of auction whereby an auctioneer calls out the bids until no one is willing to top the last bid. The high bidder gets the item and pays his or her bid. Less common, but still in use, is the Dutch auction. In a Dutch auction, the price starts high and gradually declines. The first bidder gets the item.

FirstAuction.com, OnSale.com, and eBay.com are three leading auction sites on the web. In India, www.baazee.com is a popular auction website. Each uses the English auction style. A number of auctions never start because no one bids the minimum. A few weeks later, these unsold products maybe re-auctioned, with a lower minimum bid.

The Dutch auction works in the opposite direction from English auctions. The initial price is set high and it falls at regular time intervals. The first customer willing to bid gets as many of the items as he or she wants at that price. The remaining items continue to have their prices cut. An item starts out at full price. After a certain number of weeks, its price might fall 20 percent, then 30 percent, or even 50 percent. Dutch auctions have remained common for flowers and other perishable items. The site www.priceline.com is an example of a Dutch/reverse (i.e., seller-bid) auction.

Online Rental Markets

Real-time pricing is especially valuable when there is real-time use by consumers. When consumers rent a product, what matters are their immediate needs. On one hand, renting can also be much more efficient than buying for the following reasons: A rental car does not sit around on weekends. Professionals can do maintenance. The only insurance needed is for the rental period. The renter avoids long-term parking and storage costs.

On the other hand, the rental car market also shows why rentals can be a problem. Consumers may abuse rental cars. When a car is immediately needed for an emergency, it may not be available. The daily charge for a rental car may make it an expensive way for regular access to a car.

Online rental markets are emerging for digital products/services. Digital products and/or services avoid most of the problems of rentals, while taking advantage of the benefits. With digital products, inventory costs disappear. There is no need to stock a copy for each user since copies can be generated whenever needed. Likewise no "user abuse" or depreciation problems occur. Finally, sophisticated new pricing techniques are possible.

A futuristic version of software rental has been dubbed super distribution. Super distribution relies on the Internet to collect the rental price for software every time it is used. The basic idea is simple. The creator of a digital item makes it widely available online. Each digital item contains a piece of code that can collect a tiny price. Copying is always free but use results in collection of a fee. Super distribution prices may be fixed at the time of distribution or may be based on the currently prevailing charge. The latter approach blurs the distinction between the rental market and an auction.

Yield Management

Every business traveler is familiar with yield management. Yield management is the sophisticated matching of price and available capacity. It is the system that lets airlines charge much lower prices to tourists. Low cost fares are subject to restrictions and means of separating low willingness-to-pay tourists from high-willingness-to-pay travelers. Other travel amenities, such as hotel rooms and car rentals, have copied these yield management ideas. Yield management has been successful for companies that have been able to implement it.

Several critical characteristics must be present for yield management to be effective. These are most common in service industries. The first is fixed and perishable capacity. Unsold airplane seats are forever lost as soon as the plane takes off. The same holds true for cargo and freight companies. A ship that sails with spare room has a revenue opportunity that later trips cannot recover.

A high level of fixed costs is also important. The cost of adding an additional guest to a hotel with space is small compared to the total cost of maintaining the hotel. The costs of supplying the gas, electricity, or telephone calls are mostly fixed. Additional customers impose minimal costs compared to the up front costs of creating the capabilities and signing the customer base.

The second characteristic is a customer base with identifiable segments. The core idea of yield management is to give price sensitive customers a price break to encourage them to fill up the seats without causing a loss of customers willing to pay the regular price.

A final fundamental of yield management is demand uncertainty and enough sophisticated information technology and systems to deal with that uncertainty. The Internet is making revenue management available to a much wider range of companies. By combining revenue management to a web site, many additional industries are able to use these capabilities. The next step in the evolution of yield management is to apply it to a range of small business services.

Bundling

Bundling is a combination of products into larger packages. While bundling is simple in concept, it can have large effects on competition and consumers. Online suppliers are aggressive users of bundling. Bundling seems to be everywhere online, rather than price online activities separately, many online providers charge a single fee that gives access to everything.

The most important guideline for online bundling is margin spread bundling. Margin spread bundling shows that it is profitable to bundle items that have a high contribution margin ratio.

The second important bundling guideline for the online world is aggregation bundling. When bundling is profitable, the bundle should be targeted toward the average consumer. Unusual and specialty items can be kept separate and priced higher, but the main product should be bundled toward average taste. The goal is to expand sales to the average consumer.

Bundling is so common online because these two guidelines often reinforce each other. If a company has a high contribution margin for online products and consumers value the bundle more than they do individual items, comprehensive bundles become profitable. In this case, the total value of the bundle is a little less than what the consumer would pay individually for these items. The small cut in price is more than made up for in volume.

If the incremental cost of online material is high, bundling is not profitable and standalone sales are best. Margin spread bundle creates the incentive for increasing volume and aggregation bundling increases the volume.