Dynamic pricing is one of those buzzwords that gets thrown around so much that it barely means anything anymore.
That’s why we decided to ask a seasoned retail and e-commerce expert to spell out what you really need to know about dynamic pricing (hint: there are no more vague buzzwords involved). Let’s jump right in!
Arhi Kivilahti is a retail strategy consultant with 15+ years of experience in academia, retail consulting, developing digital services for one of the biggest grocery retail chains in Finland, and running his own e-commerce business. It’s safe to say he knows a thing or two about pricing in retail and e-commerce.
In this blog post, we’ll cover the following topics:
- What is dynamic pricing, really? A simple definition
- How dynamic pricing works
- More than just discounts — 4 practical examples of dynamic pricing in retail and e-commerce
Watch our 'Dynamic pricing' webinar instead
1. What is dynamic pricing, really? A simple definition
So, what does it actually mean to have a dynamic pricing model?
Let’s start with the very basics (rather than throwing in more buzzwords).
A product’s price consists of different building blocks: profit margin, logistic costs, product-related costs, admin costs, and so on, but on top of all these, time can be one factor, too.
At the core of dynamic pricing is how your product’s price relates to time. In its strictest interpretation, dynamic pricing is the opposite of static pricing, which simply means that you have one price, and that’s the price until the end of the world.
So technically speaking, you’d only have to change a price once for the price to be considered dynamic instead of static, but in reality, that’s rarely how dynamic pricing works (let alone a good idea).
2. How dynamic pricing works
Dynamic pricing has been around since the existence of markets.
If you were to buy an apple some 500 years ago, you would go to your local market, and you would always have to haggle the price.
There was no one set price for apples that all sellers would put in their price tags — quite the opposite: the cost of goods varied by each seller’s negotiation leverage, day and time, and your haggling skills.
While the same basic principles of dynamic pricing still hold in the 2020s, the rise of online shopping and new technologies like electronic shelf labels allow us to take advantage of more predictable and consistent pricing strategies than haggling based on your degree in kitchen sink psychology.
In the picture above, you have a timeline going from left to right and a customer who makes a choice. The customer can choose between having a higher price now (T1) or a discounted price later (T2).
If they choose to wait, they also risk some uncertainty because a shirt can go out of stock in their size or color, or apples may run out entirely.
The elasticity of intertemporal substitution (EIS) measures consumers’ willingness to substitute future consumption for present consumption. In simple terms: how many customers are willing to buy the shirt now (T1) and how many are willing to take a risk and wait until a later point in time (T2) – and if we increase or decrease the price, how will the customer’s preferences change?
(The way consumers respond to changes in price is measured by price elasticity.)
In addition to the point in time, dynamic pricing is always related to some product or market-related factors (such as stock levels or competitors’ prices).
For instance, there’s also a potential consumption window after which apples and other perishable goods are not edible anymore. With clothes, this consumption window is slightly more vague, but a shirt can also go out of fashion, after which you might not want to buy it anymore.
To sum it up: you can add different time points and features to this model, but the same underlying mechanism still holds.
Read our e-book "AI in pricing" to learn more about this topic
3. More than just discounts — 4 practical examples of dynamic pricing in retail and e-commerce
So, what does dynamic pricing look like in practice?
Aside from the fact that dynamic pricing helps optimize for the right price point and different consumer preferences (e.g., cheaper vs. faster home delivery), there are other, less obvious benefits that retailers sometimes fail to consider.
Benefit 1: Better optimized inventory turnover
Limited stock exclusivity has dictated airplane tickets and hotel night prices for as long as we can remember. Still, there are a lot of other potential real-life applications beyond the obvious ones.
Most grocery stores today put a lower price tag on expiring items during the last hour or two. What if you could optimize this even further and reduce prices gradually based on the willingness to pay, rather than reducing prices incrementally based on a gut feeling?
With a dynamic pricing strategy, this is possible.
Typically, grocery retailers only have one static price for, let’s say, a pack of chicken breast until they reduce the price by 30% or 50% closer to the expiry date.
With a dynamic pricing strategy, you could gradually decrease the price over a longer period of time (e.g., 7 days), starting from the full price seven days before the expiry date and then progressively lowering it to a very low discounted price closer to the expiration date. In brick and mortar, this is also possible with electronic shelf labels.
Dynamic pricing is not exactly a new thing in supermarkets, but very few retailers take full advantage of its possibilities.
This type of “tiered” pricing for groceries allows consumers to choose if they would rather want a longer expiry date and pay the full price, or get a pack of chicken breast cheaper and use it sooner. It also enables a more efficient inventory turnover with less perishable food ending up in waste. Tying the price point back to the expiry date would also provide more transparency, which also helps consumers make better-informed decisions.
The very same logic could work in any other industry, too. Instead of dropping the old phone model’s price when a new model is launched, they could get real-time information on how much consumers are willing to pay for it and then gradually change the old model’s price based on those insights.
Benefit 2: Optimal balancing of peaks and lows
Peak-load pricing is a well-established dynamic pricing strategy in the hospitality sector, but it can also work wonders in e-commerce and retail.
Especially in the grocery industry, some days of the week tend to be quieter than others: for instance, people just don’t typically do their groceries on Wednesdays. With dynamic pricing, consumers can be incentivized to do their groceries on quieter times by offering lower prices on Wednesday mornings, and in turn, increasing prices on Friday evenings.
Not all industries experience changes throughout the week or day like the grocery industry. Some other industries have a strong seasonality element, so nudging people to make purchases during the off-season is one way to balance high and low demand.
Additionally, some retailers already offer overnight deliveries, where the benefit is that almost everyone is at home in the morning and can simply pick up their package from their door in the morning. This allows retailers to make good use of a prolonged delivery window and avoid rush hours entirely.
Benefit 3: Avoiding unnecessary discounts with the optimal price point
Sometimes you might have to decrease the price of your product for it to sell more. In some cases, it’s okay to give a hefty discount, but in some other cases, you might want to be more discreet about it to avoid damaging your brand image.
In these cases, dynamic pricing can help you find the right price point where the product sells as much as it possibly can. (In fact, our AI-based price optimization tool has been able to increase profit margins on average 10% more compared to traditional methods of calculating price elasticity.)
Benefit 4: More efficient (and greener) deliveries
Dynamic pricing can help retailers optimize their delivery routes for better efficiency, and as an added bonus, it can also mean more eco-friendly deliveries.
To stick with our grocery example, retailers can suggest prioritized delivery slots to consumers based on scheduled grocery deliveries in the same area.
If someone in my neighborhood is getting a delivery, I might as well get mine at the same time to prevent a half-empty delivery van driving around the city just to come back to the same area two hours later. These ‘green slots’ or quieter days can also be offered with discounted delivery fees to nudge for preferred consumer behavior.
The keyword is controlled experimenting
Pricing is not a set-and-forget type of business decision — and this is especially true online where competitor data is widely available and controlled experiments are easy to conduct in a continuous manner. Just like your product portfolio, business strategy, and competitive landscape change over time, also your pricing strategy should be constantly evolving.