The Pros and Cons of Dynamic Pricing: What You Need to Know

The Pros and Cons of Dynamic Pricing: What You Need to Know

Krzysztof Suwada - August 9, 2022

Dynamic pricing is a term that has been gaining popularity in recent years as businesses have looked for new and innovative ways to increase their profits. But what is dynamic pricing, exactly? And more importantly, is it right for your business?

In this article, we will explore the pros and cons of dynamic pricing models and help you decide if this type of pricing strategy is right for you.

The Concept of Dynamic Pricing Models

The principle behind dynamic pricing is simple – replace the fixed prices with dynamic ones in order to maximize profit. In order to estimate different prices, it is necessary to constantly reevaluate the relevant variables.

dynamic pricing model how it works

How dynamic pricing model works

The variables differ depending on what is being sold. Different rules apply to products and services, and within each category, hundreds of combinations are possible. Those who decide to implement dynamic pricing may adopt different strategies depending on the specifics of their business and the industry.

Fixed price strategy (with single price point) vs. dynamic pricing (with multiple price points)

Fixed price strategy (with single price point) vs. dynamic pricing (with multiple price points)

In general, they divide into two categories:

  1. target-oriented
  2. time-oriented

The first strategy type focuses on segmentation based on the target groups in order to find the maximum price a particular user is ready to pay. The second strategy, on the other hand, takes advantage of the time opportunity. In this case, the companies may determine their prices based on seasonal peaks or periods of increased demand.

Aside from demand, the competition aspect is also essential in dynamic pricing software. The models take the prices set up by the competitors into account as well as the availability of the competitors’ products. If the company strongly relies on these aspects, it may go for competitor pricing – a strategy that gives priority to these variables. That is often the case of e-commerce retailers, who offer widely available products produced by numerous brands.

Dynamic pricing is not a new concept, but companies have started putting it into practice quite recently. There are a few reasons for that. First, without advanced technological tools, recurring price estimation would be a daunting task. We needed tools that could draw conclusions from extensive datasets and process numerous variables that impact the price. With the development of data science and machine learning, this is now easily achievable.

The second reason has little to do with technology, but with consumer behavior. Throughout centuries, we have grown accustomed to the fixed price model. Before the rise of e-commerce, we would visit a shop and buy the products for the same prices unless they were discounted – because of a defect, short shelf life, seasonal sale, or any other reason.

The changing prices, particularly based on the target group, may thus cause some criticism, as some customers consider it unfair. That explains why some companies would long be hesitant towards adopting this technology. We will dive deeper into this topic in one of the following paragraphs.

Examples of Dynamic Pricing Across Industries

The best way to understand the strong and weak sides of dynamic pricing is through practical examples. Some industries embraced dynamic pricing faster and with much more enthusiasm than others because of their specifics. The ones that base their functioning on the long-term relationship with the customer and are more vulnerable to fraud – like banking or insurance – tend to maintain a cautious approach towards this strategy. The others, like all sectors linked to tourism, are made for time-based pricing due to their seasonality.

Currently, dynamic pricing is most present in hospitality, events, transport, and e-commerce. Aviation has paved the way for the other branches of the logistics sector to use real-time pricing strategies. The practice of using dynamic pricing by airlines in the US dates back to the 80s, when the industry got deregulated.

In Europe, it has started being used extensively with the airline industry and the popularization of low-cost flights, contributing to the growth of the low-fare carriers such as Ryanair, Wizzair, and EasyJet that have mastered both surge and segmentation pricing. Today, it is common across the transport sectors to switch from fixed prices to dynamic.

Some, like the carsharing industry, had an easy start - the dynamic pricing was turned into a standard when their niche was only shaping. The case of Uber and the carsharing apps that came after is fascinating, exposing the best and worst sides of this strategy. It proves how quickly the customers can get accustomed to dynamic pricing and how helpful it can be in managing demand.

We have already published an article exploring the dynamic pricing use cases across industries. We recommend it if you are interested in diving deep into this topic.

What Are the Benefits of a Dynamic Pricing Strategy?

Dynamic pricing is profit-oriented, which is the main factor that draws companies to it. However, the spectrum of benefits this strategy can provide them with is much broader. We have gathered some examples of the ways dynamic pricing can contribute to the company’s success.

Increased Profits

Dynamic pricing models always aim at finding the highest price the customer is ready to pay. Traditional pricing strategies lack the flexibility to find that sweet spot – the companies always have to search for a middle ground, losing a chance to increase their markup without losing the customer.

In practice, dynamic pricing may sometimes seem to work against the favor of the company’s profit. At times, the algorithms lower the prices to extreme levels. That is particularly visible when booking airline tickets or car-sharing rides. However, that move is always an outcome of thorough calculations and is backed by data. If the model is designed and trained in the right way, the pricing decisions it makes increase profit.

Increased Flexibility and Control Over Pricing

Dynamic pricing fits the pace at which the market is evolving. We are living in times of rapid and radical changes caused by the climate crisis, geopolitical situation, and technological revolution. All that affects the consumption habits, supply chains, the availability of the materials and products, and the demand for them.

Fluctuations in costs and demand call for a dynamic pricing strategy that helps the companies keep their prices more adequate to the market variables. By employing the machine learning models that estimate prices based on different variables, the businesses gain control over their profit margins with minimum engagement.

Dynamic Pricing Can Be Tailored to Specific Customers or Markets

We have already mentioned that dynamic pricing models can base their estimations on the target group. By combining the company’s historical customer data with the information regarding the particular customer, they can find the highest price to offer without risking that the transaction will not be fulfilled.

Such segmentation can also apply to markets. That is particularly useful for companies that sell their products or services internationally. Every market has its own rules, but these rules are hard to discover for the company, even if it is not new to them. Here it is worth employing a deep learning algorithm that can find multilayered correlations between the purchasing decisions and particular variables.

Dynamic Pricing Encourages Competition and Innovation

Dynamic pricing has the power to change the whole sector, as the example of car sharing services proves. Instead of using it as a tool to adjust their prices to the competition standards, the businesses can pave new standards among the competitors. That undoubtedly helps them gain a competitive edge.

Dynamic Pricing Helps When You Want to Avoid Unsold Merchandise

The flexibility of dynamic pricing enables companies to manipulate prices in a way that stimulates sales in periods of lower market demand. For businesses that sell seasonally-oriented products, that’s a great way to reduce the stock.

Here’s an example: the company sells barbecue equipment. In the north temperate zone, its sales boom around the springtime, when the days start getting warmer and the customers feel the summer coming closer. Early fall, it drops.

To get rid of the unsold merchandise, the company can use dynamic pricing to find the maximum price the customers are willing to pay for the equipment after or before the season. Based on customer data, they are able to identify the “early birds” that tend to do their shopping in advance, and those who are intentionally looking for seasonal bargains, adjusting the price to each target group.

What Are the Disadvantages of Dynamic Pricing?

Dynamic pricing is by no means a perfect solution for any case. Even though it brings all the benefits listed above, it has some flaws, too. Let’s take a look at the other side of the coin and the disadvantages of dynamic pricing to see what the businesses have to take into account.

Dynamic Pricing Strategies Can Be Difficult to Implement and Manage

In order to successfully implement a dynamic pricing strategy that brings profit, the companies have to understand their product, market, and target groups very profoundly. Otherwise, they may end up choosing the wrong variables. And that can make their models estimate inadequate prices, affecting the sales.

Another aspect worth mentioning is the data itself. There is no dynamic pricing without training the algorithm with an extensive historical dataset and access to current market trends in order to produce real-time pricing. In some strategies, like surge pricing, it is enough to rely on an open-source dataset as the most-important feature impacting prices is seasonality (e.g., in the tourism industry, when higher prices are set for the peak season or when special events, like concert dates, are held within a particular destination). Segmentation-oriented strategies, although very effective, require customer data that the business has to store and process.

Price optimization software can be harder to implement in industries where multiple features and pricing trends impact the final pricing strategy. A great example here would be solutions designed for the transportation sector - in such a competitive market dominated by manually produced quotes, automation software can increase revenue, but it has to be implemented thoroughly to utilize the big data. In these scenarios, not only a careful calculation of the base price has to be covered, but also a 360-degree view of the logistics network and other factors need to be considered to produce a quote that can improve gross margins.

A Dynamic Pricing Strategy Requires Careful Analysis of Market Conditions

Before introducing dynamic pricing, any business should test the ground with extensive research. Maybe some other company in their niche has already tried to implement this model and failed? That, of course, would be a red flag. But it could also mean that company has picked the wrong time or used a poorly designed dynamic pricing model that did not reflect the product’s value and market conditions.

Being a pioneer may pay off, but it does not have to – and not every company can afford to risk a pioneering strategy. So, it is worth first researching the attitude of the particular market towards dynamic pricing and its particular types, as well as its effectiveness in maximizing profit.

Dynamic Pricing May Cause Customer Confusion or Resentment

Dynamic pricing is not always welcomed with enthusiasm. Quite contrarily – some customers are skeptical towards it, considering the fluctuating prices unfair. In reality, however, this strategy creates an opportunity for the customer to choose. Otherwise, they would have no choice, having to either pay the fixed price or resign from the purchase. The flexibility of the time-based opportunity model allows them to find an affordable “purchase window.”

It is a bit trickier with the target-oriented price estimation, which puts the habits and preferences above the demand and other variables. That model, even though it maximizes the profit, may have bad reception from the customer side.

Still, some companies have doubts about whether to implement dynamic pricing because of that risk factor. However, we believe you can avoid the negative outcomes with education and transparency.

Dynamic Pricing Can Be Less Profitable in Some Cases

The power of dynamic pricing is most visible in the sectors that sell goods or services with at least double-figure prices and that rely on seasonality. It can still be profitable for the businesses that sell first-need products with steady demand, but not to such an extent. The industries with stiff price standards and heavy reliance on trust and long-term relationships with clients, like banking, may end up risking a lot.

With the Right Dynamic Pricing Software, You Can Maximize Profits

The safest strategy is to create your custom software or plugin that is 100% adjusted to the specifics of your company and industry. We can help you with that - drop us a line to talk about your project! We have already helped companies from different sectors introduce AI solutions, and we are ready to embrace another challenge in this field!

About the author

Krzysztof Suwada

Krzysztof Suwada

Data Science Expert

Linkedin profile

Krzysztof is a data scientist who applies machine learning and mathematical methods to solve business problems. He is particularly interested in developing end-to-end solutions for companies in various industries using deep learning and NLP techniques.
Mathematician, software developer, and trainer. Krzysztof's expertise in machine learning earned him a Google Developer Expert title. A fan of Albert's Einstein quote: "If you can't explain it simply, you don't understand it well enough."

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