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Applications of flexible pricing in business-to-business electronic commerce

IBM Systems Journal, July, 2002 by M. Bichler, J. Kalagnanam, K. Katircioglu, A.J. King, R.D. Lawrence, H.S. Lee, G.Y. Lin, Y. Lu

For centuries, businesses used negotiations and bartering as a matter of routine. The industrial age saw the emergence of mass production and extended distribution chains, which made face-to-face negotiations with each customer impractical. Fixed prices became necessary to manage the enormous growth in both the volume and the variety of products, distributed over larger geographic regions. (1) The advent of the Internet and electronic commerce has greatly impacted the way businesses price their goods and services, and has allowed for more flexible pricing based on customer characteristics or dynamically determined based on supply and demand.

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Two trends in electronic commerce are causing this shift from fixed to dynamic pricing. First, the Internet has reduced the transaction costs associated with dynamic pricing by eliminating the need for people to be physically present in time and space to participate in a market. The menu costs are also considerably reduced. Whereas in the physical world changing a price incurs huge costs, the same task in electronic commerce is reduced to a database update. Second, price uncertainty and demand volatility have risen and the Internet has increased the number of customers, competitors, and the amount and timeliness of information. In addition, the increased use of flexible pricing itself leads to increased price uncertainty. Businesses are finding that using a single fixed price in these volatile Internet markets is often ineffective and inefficient.

Differential pricing. Electronic markets can reduce customers' costs for obtaining information about prices and product offerings from alternative suppliers. They can also reduce these suppliers' costs for communicating information about prices and product characteristics to customers. This has implications for the efficiency of an economy in terms of the search costs experienced by buyers and their ability to locate appropriate sellers. (2) Electronic catalogs were the first step in this direction. Over the past few years, companies have put their product catalogs on the Web, in order to make them widely available. Most electronic catalogs are comprised of fixed offers in the form of fixed list prices. Search engines and shopping bots (robots) make it easy for customers to compare these offers. In particular, standardized goods are subject to price wars and strong brands often become commoditized. Researchers in agent-based computational economics have analyzed these developments using computer simulations. (3) MySimon (http://www.mysimon.com) or DealTime (http://www.dealtime.com) provide real-world examples for this new kind of competition.

Many economists see product and price differentiation as a solution to this "over-commoditization." Product differentiation can be accomplished by adding additional attributes (e.g., service agreements) or by generalizing existing attributes (e.g., flexibility in terms and conditions). By differentiating products, suppliers can decrease the substitutability of their products and services and customize offers to the requirements of specific consumers or market segments. The more successful a company is at differentiating its products from those of others, the more monopoly power it has--that is, the less elastic the demand curve for the product is. In such markets (often referred to as monopolistic competition), it is possible for providers to extract consumer surplus even from consumers who have perfect price information. Often, suppliers use mechanisms such as personalization, targeted promotions, and loyalty programs in order to distinguish their products from those of their competitors and establish customer relationships.

Impeding price comparison basically means reintroducing search costs. (4,5) This can also be achieved by charging different prices to different consumers for the same product. Price differentiation (6) is achieved by exploiting differences in consumer valuations, such as volume discounts and group pricing (e.g., senior citizen discounts). This discrimination strategy requires detailed consumer information and independent billing and is also described as third-degree price differentiation. Second-degree price differentiation (or "nonlinear pricing") means that the producer sells different units of output for different prices, but every individual who buys the same amount of the product pays the same price (i.e., quantity discounts and premiums). Finally, first-degree or "perfect" price differentiation means a producer sells different units of output for different prices and the prices may differ from person to person.

Airlines are often cited as pioneers in differential pricing. Airline pricing can actually be seen as an example of both price discrimination (e.g., frequent fliers) and product differentiation (e.g., refund policies, weekend stays, etc.). Currently, it is easy to search for convenient flights, but finding the least expensive rate is cumbersome, because the number of different tariffs is huge. Complicated pricing schemes for airline tickets defy comparison shopping. Airlines introduced this discriminated price structure (frequent flyer programs, early reservation discounts, weekend tariffs, etc.) to deliberately reduce market transparency after a phase of open price competition. (7) This field has matured, and by the mid-1970s most airlines had already deployed sophisticated revenue (or "yield") management systems, which use optimization and forecasting techniques to calculate the prices that are to be offered to customers now in order to maximize overall profitability. (8)

Technology Industry

Applications of flexible pricing in business-to-business electronic commerce

IBM Systems Journal, July, 2002 by M. Bichler, J. Kalagnanam, K. Katircioglu, A.J. King, R.D. Lawrence, H.S. Lee, G.Y. Lin, Y. Lu

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