Testing the Attractiveness of Dynamic Pricing as an Entrepreneur

by Will Clayton

Dynamic pricing, in which different groups of customers are charged different prices for the same service based on their varying willingness-to-pay, is very attractive to businesses due to its potential to increase profitability. However, there are situations when adopting dynamic pricing can push potential customers away or damage relationships with your existing customers. So, how can an entrepreneur determine the right course for his or her new product?

First, it is worth differentiating between dynamic pricing driven by real-time variations in supply and demand, such the spike in demand that caused Uber’s rates to fluctuate radically during New Years Eve, and dynamic pricing based on customer profiling, such as an approach in women and men could be charged different prices for the same dress on some online site.

While demand-driven pricing fluctuations might inspire short-term customer frustrations, as Uber experienced, ultimately Brenden Mulligan is likely correct in suggesting that customer unhappiness was driven by a perceived lack of clarity about how much an Uber ride on New Year’s Eve would cost – not that prices were fluctuating based on demand in general. Put another way, the consumer uproar was driven more by (perceived) information asymmetry than by a disagreement about the reasonableness of charging differential prices based on demand fluctuations over time. Most people would abstractly understand that Uber has a limited supply of cars and could be reasonably expected to charge top dollar for its prices.

The second form of dynamic pricing, in which a company determines that certain customer groups can be charged different prices for the same good at the same time, is more likely to generate customer dissatisfaction over the long term. Because this “profile-driven pricing” involves profiting from an information asymmetry, it is likely to cause customers to feel they were taken advantage of – as likely happened to many drunken Uber customers when they saw their bill. Profile-driven pricing is likely to provoke a backlash particularly when customers have a high likelihood of uncovering such practices, a customer’s consequences for paying a higher price are substantive, or there is a high level of communication within your customer base. Consequences are likely to be particularly high if someone paying a higher price is accountable to someone else, a boss for example, who might become aware of their missteps during pricing discussions and penalize them on the basis of that poor performance. High interconnectivity within your customer base makes it more likely that customers will unintentionally discover differential pricing due to frequent interaction across your segmented profile groups. Furthermore, high levels of communication make it more likely that any backlash will grow rapidly beyond a small fraction of your customers who observe the policy first-hand.

When entrepreneurs consider whether dynamic pricing would be appropriate to their product or service, they would do well to conduct some hypothesis testing with potential customers to understand how such a pricing strategy would be perceived. To asses the viability of time-based pricing, one could survey target customers and ask them if they would prefer higher prices that were stable at, for example, $10 or prefer prices that would vary between $5-$15 based on demand. Changing the suggested variable range might provide some clues about potential customers’ tolerance for different ranges. It may even be possible to pose a series of head-to-head choices, e.g. $5-$20 vs. $9 – $18, to receive clearer customer preferences for a variety of different pricing permutations. It would also be important to understand whether the potential customers perceive the logical link between demand and supply – something that would probably be more convincing with a car service than with a web-based software application. In a situation where the product is already available, then the purchasing process could include a prompt for each purchaser to chose between a fixed price and a demand-driven variable price within a given range and assess the breakdown in preferences expressed through customer decisions compared to the initial survey results.

Assessing customer tolerance for profile-driven pricing could be assessed using an A-B smoke test in which potential customers were asked to fill out a short survey on relevant profiling parameters prior to receiving a price. The page displaying the pricing information would state either A) “Based on the information you provided, the price will be X. Please provide your e-mail address to be notified when we launch” or B) “Thank you for helping us understand our potential customer based. Our product will be Y when it is available. Please provide your e-mail address to be notified when we launch”. Comparing the sign-up yield rates for each path would provide some indication of what, if any, negative reaction customers might have to profile-driven pricing. This initial survey may also offer an opportunity to probe how interconnected different profile groups are and thus the probability of your variable pricing being uncovered after launch.

Ultimately, customer tolerance for dynamic pricing seems to be driven by perceptions of information transparency with customers revolting against situations where they perceive pricing to be “unfair”. While the economic benefits of dynamic pricing could be substantial, entrepreneurs would do well to assess customer comfort levels with dynamic pricing prior to launching it and also be cautious with its surrounding messaging to ensure that a firestorm on Twitter doesn’t damage a nascent product or brand. While dynamic pricing could potentially be used effectively in secret, entrepreneurs would be well advised to understand the social networks and communication flows within their customer base to determine how likely it would be that pricing differences might be exposed. In highly networked customer bases, nothing is likely to stay secret forever and the risk of a public backlash should not be ignored. Taking careful steps to understand your customers’ perceptions and values before instituting dynamic pricing can mean the difference between success and failure in your venture.