Pricing and the Internet

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EC427The Internet for Business Economists (IfBE)

• Lecture 6
• Pricing and the Internet

The Internet for
Business Economists Guy Judge, September 2004
2
Todays objectives

• to identify some of the issues raised in relation
  to Pricing and the Internet
• to focus specifically on questions relating to
  dynamic pricing on the Internet - and
  distinguishing it from differential pricing
  (which is essentially a form of price
  discrimination)

The Internet for
Business Economists Guy Judge, September 2004
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Reading and further references

• Some key references are given on slides at the
  end of this presentation
• For more details see the links6.html file -
  available on the IfBE web site

The Internet for
Business Economists Guy Judge, September 2004
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Preliminary Interactive Interchange Please
answer YES or NO to each of the following

• Do do you know what each of the following are?
• willingness to pay
• reservation price
• consumer surplus
• value-based pricing
• static, posted or menu-driven pricing
• reverse auctions
• pricebots

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Business Economists Guy Judge, September 2004
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Some issues concerning Pricing and the Internet

• Price competition on the Internet Frictionless
  commerce? - have shopbots and shopping
  comparison sites made online prices more
  competitive?
• Differential Pricing - how has the Internet
  enabled sellers to fight back? Is it always bad
  for consumers?
• Dynamic pricing - what is it and how is it being
  implemented?

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Business Economists Guy Judge, September 2004
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Price levels and price dispersion online and
offline (1)

• In the early years of e-commerce it was predicted
  that the Internet would lead to a frictionless
  economy
• Lower search costs and better information would
  increase competition and lead to lower prices and
  greater price convergence see e.g. Bakos (1997)
• There have been a huge number of empirical
  studies, mainly on homogeneous products such as
  books an CDs (see especially Brynjolfsson
  Smith) but other studies have looked at cars,
  consumer electronics, and also travel, life
  insurance
• A recent study of CDs and books in Italy by
  Ancarani and Shankar (2004) provides a full
  bibliography

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Business Economists Guy Judge, September 2004
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Price levels and price dispersion online and
offline (2)

• Ancarani and Shankar remind us that shopping
  comparison sites provide information not only
  about product prices but also on product
  characteristics and independent product reviews
  this can affect offline prices as well as online
• Most studies have found lower price levels online
  than offline, even when shipping and other costs
  are included (e.g. Brynjolffson Smith)
• Some studies distinguish three categories
  pure-play Internet, bricks-and-mortar
  (traditional shops) and bricks-and-clicks
  (multichannel retailers)
• But price dispersion remains as high online as
  offline various explanations for this

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Business Economists Guy Judge, September 2004
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Price levels and price dispersion online and
offline (3)

• Just having a web presence doesnt mean that a
  consumer will find your site. Haring has
  introduced the notion of a virtual location.
  Just as some physical stores are prominently
  located on the high street or shopping mall, in
  the virtual world some sites are highly visible
  while others are more difficult to locate. With
  the increasing importance of shopping search
  tools (e.g. Froogle) what Baye et al. call
  Information Gatekeepers it has become more
  important for e-tailers to advertisein order to
  establish brand awareness to foster consumer
  loyalty and to appear high up a list of search
  results
• This may explain why a well known company like
  Amazon has a greater volume of sales than some
  less well known but cheaper rivals
• But the issue of trust also comes into the
  equation consumers wary of scams may not be
  confident that less well known companies can be
  trusted to deliver, or to replace faulty goods,
  or to protect consumer confidentiality and
  security.
• All this tends to prevent the erosion of market
  power and allow companies to practice price
  discrimination

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Business Economists Guy Judge, September 2004
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Setting the scene 4 scenarios

• In a stable market for a uniform product - a
  seller who can segment the market can charge
  different consumers different prices
  (third-degree price discrimination) - e.g.
  computer software
• In the market for a perishable (time-sensitive)
  product the price can be varied over time to
  ensure that all the product is sold e.g. fruit,
  airline seats
• In a market with unpredictable demand and supply
  movements the price can be varied over time to
  keep track of these movements and to ensure that
  revenue is maximised - e.g. share prices
• In the market for a unique or rarely traded
  product the seller can use an auction to get the
  best price e.g. antiques

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Business Economists Guy Judge, September 2004
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Differential pricing and dynamic pricing the
essential differences

• Differential pricing relates the price to the
  customer (or group of customers)
• - variations across customers
• Dynamic pricing relates the price to changing
  market conditions (shifts in demand and supply
  curves - or changing customer preferences)
• - variations over time
• Both can be described as flexible pricing systems
  and both can be implemented using web-based
  software agents

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Business Economists Guy Judge, September 2004
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Dynamic pricing versus static pricing the
essential differences

• Static (posted, catalogue or menu pricing)
• The seller attempts to determine the best price
  for the product before selling - the price
  remains fixed (except in the face of severe
  demand or supply shifts)
• Dynamic pricing (responsive pricing)
• The seller constantly monitors supply and demand
  conditions and regularly modifies the price to
  respond to changing conditions - the aim is to
  minimise disequilibrium transactions

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Business Economists Guy Judge, September 2004
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Differential pricing - segmenting the market

• segmenting the market by objective customer
  characteristics - by age, demographic or other
  factor (e.g. business/consumer) - involuntary
  selection
• segmenting the market via voluntary
  self-selection - customer decides which version
  is worth it
• versioning - a form of customisation
  especially relevant for online information
  (digital) goods - the additional costs of
  producing different versions can be very small
  while the additional revenue extracted from
  consumers can be large
• by differentiating the products suppliers
  decrease their substitutability

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Business Economists Guy Judge, September 2004
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Differential pricing - other tactics

• product bundling - e.g servicing or training
  programmes
• loyalty programs - to increase switching costs

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Business Economists Guy Judge, September 2004
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Differential Pricing is it always a bad thing
for consumers? Varians view.

• Varian (1996) explains that differential pricing
  can sometimes be good for consumers, in that it
  can lead to the supply of products that would
  remain unprofitable and therefore unavailable if
  the producer was forced to charge all consumers
  the same price.
• This is particularly relevant to goods with a
  high fixed cost and low (perhaps close to zero)
  marginal cost such as digital goods like online
  journals.

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Business Economists Guy Judge, September 2004
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Differential Pricing is it always a bad thing
for consumers? Odlyzkos recent example

• Odlyzko has recently published a paper in the
  journal Nature explaining why electronic
  publishing means people will need to pay
  different prices for online journals.
• He provides a simple example to illustrate a
  situation in which a journal publisher might be
  unwilling to publish a journal unless it was able
  to price discriminate among subscribers.

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Business Economists Guy Judge, September 2004
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The details of Odlyzkos example

• Suppose the publisher has two potential libraries
  as subscribers.
• Library A is willing to pay a maximum of 700 per
  year, while library B is willing to pay up to
  1000 annually.
• However, suppose the publisher needs at least
  1500 to cover costs (or even to make a small
  profit and thus persuade him to enter the
  market).
• If the publisher is obliged to charge the same
  price it will not be able to create the journal.
  If the price does not exceed 700 both libraries
  would be willing to subscribe, but at only 1400
  the revenue would be insufficient to persuade the
  publisher to publish.
• If the price exceeds 700 library B would be
  willing to subscribe but library A would not
  the journal wouldnt be published.
• But if the publisher was allowed to charge
  library A 650 and library B 950, both libraries
  would subscribe. Total revenue for the publisher
  would be 1600 enough to make it profitable.
• In this example price discrimination
  (differential pricing) is essential to create new
  economic activity

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Business Economists Guy Judge, September 2004
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Dynamic pricing - a definition

• A dynamic pricing model is defined as the buying
  and selling of goods and services in free markets
  where the prices fluctuate in response to demand
  and supply and changing customer preferences
• Srivastava (2001) - my underlining
• Dynamic pricing takes advantage of real-time
  market and customer information to customise the
  offer. Other related terms revenue or yield
  optimization. An old idea in new clothes.

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Business Economists Guy Judge, September 2004
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Dynamic pricing - an old idea given a new boost

• In traditional markets the high transactions
  costs associated with dynamic pricing mechanisms
  have limited their adoption (except in specific
  circumstances - e.g. shares and commodities)
• But the Internet provides instant and cheap
  communication and information updating
• Hence the development of online auctions and
  other dynamic pricing systems on the web

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Business Economists Guy Judge, September 2004
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Dynamic pricing with intelligent software (1)

• Early efforts were based around Excel
  spreadsheets, dynamically linked to information
  sources, that could be used as a decision support
  tool
• Now intelligent software is available
  commercially that can track market conditions and
  automatically change prices. Examples of
  companies supplying this software are Talus (now
  part of Manugistics), Azerity, Maxager and PROS
  Revenue Management
• Experiments are being conducted with intelligent
  software agents (pricebots) - see Kephart et
  al (2000) on the IBM Information Economics
  project - could move beyond just pricing - humans
  could delegate responsibility to agents who
  negotiate with each other.

The Internet for
Business Economists Guy Judge, September 2004
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Dynamic pricing with intelligent software
(2)problems

• todays dynamic pricing software is only as good
  as the information fed into it - which is not
  always current and even enthusiasts admit that it
  can depend on sales force staff entering the data
  and they ..do a pretty wimpy job, to be honest
  (Fred Jones, whose company MicroTechnologies,
  uses Azeritys ProChannel software agent)
• hence the interest in developing pricebots that
  autonomously collect and update information
• but there are concerns about potential pitfalls -
  their collective behavior may not closely
  resemble that of humans (Kephart et al.)

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Business Economists Guy Judge, September 2004
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Dynamic pricing with intelligent software
(3)simulation experiments

• market simulators can be used to determine the
  best agent strategies for each type of market
  (see Morris 2001 who describes the Learning
  Curve simulator)
• Better than purely theoretical solutions that may
  be difficult to apply - numerical results easier
  to interpret.
• Inputs market scenariobuyer bahaviour seller
  strategies
• Types of seller strategies explored by Learning
  Curve
• Derivative Following
• Myopically Optimal
• Dynamic Programming
• Reinforcement learning

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Business Economists Guy Judge, September 2004
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Dynamic pricing - did Amazon experiment?

• stories circulating on bulletin boards and mail
  lists that Amazon was charging customers
  different prices for the same product, perhaps
  based on customer profiles (frequency of purchase
  on Amazon, date of last purchase etc.)
• ManagingChange.com carried out a survey (July
  2001-June 2003) to test for links between prices
  and these factors - asked for responses on 4
  items (a book, a music CD, a video DVD and a PDA)
• no evidence that price was linked to any of these
  characteristics (or whether customer had browser
  cookie enabled) but there were lots of price
  fluctuations - perhaps sales promotions or
  seasonal effects?
• In any case would this really be dynamic
  pricing or just differential pricing?

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Business Economists Guy Judge, September 2004
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Types of dynamic pricing

• One buyer, one seller
• negotiation/haggling
• One buyer, many sellers
• Reverse auctions (e.g.B2B procurement and
  sourcing)
• One seller, many buyers
• Forward auctions (e.g. C2C via eBay, B2B for
  disposing of old stock)
• Many sellers, many buyers
• Aggregation systems

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Business Economists Guy Judge, September 2004
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Types of auction

• English auction - open cry - bids increase
• Dutch auction - opening price gradually
  discounted
• Vickrey auction - sealed bids - winner offers the
  highest amount but pays 2nd highest amount
• Used in disposing of excess inventories
• Used in valuing unique or rarely traded products
• Revenue Equivalence Theorem
• Reverse auctions for procurement - invitation to
  bid to supply inputs - RFQ (Request For Quote
  sales)
• Online systems for C2C auctions - eBay

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Business Economists Guy Judge, September 2004
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Request for Quote (RFQ) systems

• Buyer posts an RFQ for a product meeting certain
  minimum requirements
• Sellers respond with a single closed bid within
  agreed time period
• possible subsequent renegotiation
• example for B2C is Lycos Merchant Match
  (Request-a-Quote) - they use their
  request-response technology to search for
  offers
• they e-mail quotes to you within 24 hours

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Business Economists Guy Judge, September 2004
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eBay

• C2C auction system
• you place a bid for the item you want (maximum
  amount)
• eBay bids for you up to your limit
• reviews are available to help you rate sellers
• most sellers accept payment by PayPal

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Business Economists Guy Judge, September 2004
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Priceline.com

• Priceline.com is not a shopping service - it is a
  bidding service. (Reverse auction) .Customers
  are asked for their highest bid (maximum WTP) -
  priceline searches for a suitable deal
• airlines use it as an independent clearing house
  to unload cheap last minute deals (they dont
  like to advertise this) - also available are car
  rentals, holidays and hotel rooms
• Founded by the excellently named Jay Walker
• Walker calls it his buyer-driven commerce
  business model
• But customers have to be flexible - may have to
  compromise on product specification

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Business Economists Guy Judge, September 2004
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Dynamic pricing - inhibiting factors

• Moral and ethical issues Customers may perceive
  it to be unfair for firms to charge different
  people different prices (although they have done
  for many years - price discrimination and
  discounting)
• Unacceptable excessive price variations? - too
  much variation in price may be counterproductive
  - customers may not accept it
• May cut across established customer relationships
• Set up costs - there may be a high set up cost in
  terms of purchasing and customising the software
  and integrating it into the business - will it be
  worth it?
• Not always appropriate to product and market -
  for example where distribution cost is high
  relative to other costs

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Business Economists Guy Judge, September 2004
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Key references if you only read one, pick from
this list !

• Bradford et al (2001) Pricing, agents, perceived
  value and the Internet
• Odlyzko (2004) Why electronic publishing means
  people pay different prices
• Srivastava (2001) Dynamic Pricing Models
  Opportunity for Action
• Varian (1997) Versioning Information Goods
• Varian (1996) Differential Pricing and Efficiency

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Business Economists Guy Judge, September 2004
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Thats all folks!

• Any questions?

The Internet for
Business Economists Guy Judge, September 2004