Benefits of Dynamic Pricing
Dynamic pricing (yield management or revenue management) is a price discriminating method where customers are divided into two or more groups, and each group is charged a different price for goods or services are similar. Resources prices are adapted according to the demand function and the demand which is currently prevailing. It is pricing system that sellers will use and will be based on the customer’s behavior to yield maximum revenue.
Recently, dynamic pricing has become prevalent with internet retailers and in the airline industry. In a survey (McFee and Velde) American Airlines has about half a million different prices per day. The pricing method will be successful where two conditions coexist. One that the product or service in question will expire at a specific time and two the capacity is fixed.
The airline industries such as American Airlines will apply dynamic pricing by charging different prices for refundable and nonrefundable tickets, the timing of the flight, if it’s a business or leisure flight and even offering different prices depending on the origin of the customer (for example, different prices to and from Los Angeles to Phoenix will vary depending on whether the customer is from Los Angeles or from Phoenix).
Dynamic pricing has the benefit of optimizing revenue since pricing is flexible. Prices are not fixed and if demand is high, a company will increase the prices, if demand goes down, the company will reduce the prices accordingly. The method has the advantage of forewarning the management on the market trend and act accordingly.
One of the disadvantages of dynamic pricing is the unpredictability and lack of comfort in knowing that a product will be bought at a certain fixed price and therefore it would be easier to predict and budget on these sales predictions. Again, for optimum success, the success of dynamic pricing requires expensive software.
Dynamic pricing is the modern way of maximizing revenue. Profitability of a company should not be affected by the forces of supply and demand. It is the responsibility of the management to work out on prices that yield maximum profits during different market seasons.
Supply and demand is the relationship between the availability of the product and how many customers are available to purchase the products. Suppliers will base their prices on the demand of the product and the availability of suppliers for the same product. Thus, if there are several suppliers for the same commodity, suppliers will fight to gain the customers by offering lower prices. Again, when demand for the commodity goes up and the supply remains constant, the suppliers will increase the price of the commodity, thus adjusting the prices to the law of supply of demand. Thus, price becomes a reflection of demand and supply.
According to the law of demand, while all other factors being constant, if the price of the product goes up, fewer customers will buy the product, thus demand goes down. This is because the consumers will consider the opportunity cost of buying the product at a higher price and decide if it is worth giving up the alternative item or buy this particular product. The relationship between demand and price is said to be negative as the higher the price increases, the lower the demand for the product. The law of supply on the other hand states that if the prices of products are high then the supply is high as well.
When the price goes up the suppliers will supply more in order to earn more from these suppliers, thus the relationship between the supplier and price is said to be positive. However, the suppliers will have to act quickly before the market becomes overcrowded with the supply, adjusting the prices downwards. This happens when the supply exceeds the demand for the product; the supplier will have to adjust the price downwards to compete for the customers. All other factors being constant, the laws of supply and demand will meet at an equilibrium point, where the demand and supply are equal. At this point, suppliers are selling all their products and consumers get the goods that they need.
In applying the rules of supply and demand organizations will base their production on the demand. The management in organizations should be active in maximizing profitability with minimal costs and proper utilization of the available resources. It would be uneconomical to produce goods that will not be sold immediately as this will lead to tied up capital. Tying up capital has negative effects as the cash spent on the inventory and production costs can be reinvested in another area within the organization. There are other costs that are also incurred on overproduction including storage costs and insurance costs.
The demand and supply strategy in determining prices and production assumes that unmet demand will be lost, there is limited production capacity and sales are discretionary (Chan, Levi and Swann, 2001). The strategy recognizes the importance of inventory in determining the price of an item. The managers will delay the production and the pricing of the product until when there is demand for the product. Delayed Production and Pricing work in such a way that the production and the pricing will be decided upon at the start of the period where customers start to demand and when their orders have been received. This is demand-based pricing strategy.
Demand-based pricing strategy is based on the consumer behavior and how much value they put on the product (Berends, 2004). The managers will select the best strategy which will also depend on their products. There products which are in demand throughout the year, while others will have low and high seasons. For the goods that are all season, the demand for the product is almost similar throughout the year. Production is easy to predict by comparing the demand for several periods and considering other factors like competition and the quality of the products.
For products whose demand is seasonal, managers can use the partial planning models (Chan, Levi and Swann, 2001) where decisions are made at the start of the season. This will use the forecasted demand for the product, and if there is any product that is left over, it can be used as sale for the next period or to make part of sales during the low season. Depending on the durability of the product, production can be maximized during the low season. This will have the advantage of reducing production costs which may be higher during the high season as skilled labor and raw materials will be on higher demand and cost may be higher then. This is mass market pricing (Berends, 2004) where standard products are produced in high volumes.
In delayed and partial pricing methods, prices are determined at each period and this will be determined by the production cost which in turn will be determined by the inventory that was brought forward from the prior season, the current cost of inventory, the labor costs plus the profit margin that has been set by the management.
In conclusion, it is up to the management to decide the strategy that will maximize on profits at all seasons. When the demand for a product is high, the prices and production can be adjusted to meet the demand and maximize on sales at this particular season. Sales can also be maximized during the low seasons by adjusting the prices downwards.