Ecommerce is growing and information technology is becoming more robust. As a result, some innovative pricing strategies have come into play.

Dynamic pricing is one that has been applied more broadly across a variety of industries, and its usage is growing among retailers.

Let’s take a closer look at price discrimination and how it has evolved, the legality and ethical implications, and why many companies see it as an effective tactic.

What is price discrimination?

The most basic definition of price discrimination is the act of charging different prices for identical items.

The purpose is to capture consumer surplus (the money left on the table by charging a fixed price when some consumers would be willing to pay more), and maximize the area under the demand curve (i.e. revenue).

There are three degrees of price discrimination:

First degree

This assumes that a seller knows the maximum price that every consumer is willing to pay.

In theory, this allows the seller to maximize profit with no deadweight loss since it creates a perfectly efficient market (in economic terms), although in practice this is difficult to observe.

Second degree

buy in bulkPrice varies depending on the quantity in demand. A common example of this is bulk discounts. Buyers differentiate themselves based on their preferences.

To broaden the definition, it can also apply to quality. For example, first class and economy airline tickets, but the common factor is that the consumers differentiate and group themselves.

Third degree

Involves selling the same product at different prices to buyer segments. This happens when a company cuts the market into segments (segmentation variables) and fixes different prices for each group.

Charging different prices to different customers is legal (save for race-based and other sensitive cases), but if determined to have anticompetitive implications, it can be deemed illegal under the Sherman Antitrust Act and subsequent legislation (such as the Robinson-Patman Act of 1936).

Price is varied between segments – the assumption being that these attributes factor into a customer’s willingness to way. The main segmentation variables are geographic, demographic, psychographic, and behavioral (seniors, students, price per country, etc).

Examples of price discrimination

First degree:

Victoria’s Secret was inadvertently a pioneer in this field, when it tested price discrimination in 1996 through a mail order campaign. It mailed different versions of the same catalog, with different prices offered for the same item to different groups of consumers.

By doing this, it could essentially create a real demand curve and assess the willingness to pay of different customer segments. One consumer was not happy to discover this, and filed a class action lawsuit claiming mail fraud against Victoria’s Secret. She lost.

Retailers can distinguish between customers and price differences (as long as they do not discriminate based on impermissible attributes) and dynamic pricing is perfectly legal.

To further drive the point home, the Judge even issued sanctions on the Plaintiff’s attorney for filing a frivolous lawsuit.

Second degree

  • Men’s Wearhouse is just one example of a retailer that offers deals such as, a suit at $299, but a discount when two are purchased ($500 for 2).
  • Pharmaceutical company GOLDPHARMA uses this approach. For example, tablets were sold at $29.08 for 24 tablets, but only $60.15 for 96 tablets.

Third degree

  • customers can purchase a discount card called ‘GOLD CARD’ which gives a discount for GNC purchases.
  • Office Depot offers a credit card bearing the logo of the store, and in return customers will receive special discounts throughout the year. Another technique that Office Depot uses is to send discount coupons to customers on the mailing list.
  • Pharmaceutical company Fraser utilizes geographic price discrimination indirectly through its sub-suppliers. For example, 10 tablets of Viagra will be $69.95 for Canadian customers, while sites primarily designed for customers in the US sell the product at $103.99.

Is it legal or ethical?

A University of Pennsylvania study (Open to Exploitation: American Shoppers Online and Offline, Joseph Turow, Lauren Feldman, and Kimberly Meltzer) that addressed online price discrimination revealed that the majority of those surveyed believed that price customization was illegal, or strongly believed it ought to be. The truth is, it’s usually legal.

Price discrimination is illegal if it’s done on the basis of race, religion, nationality, or gender, or if it is in violation of antitrust or price-fixing laws. The Robinson-Patman Act targets anticompetitive effects of differential pricing, but the online market is highly competitive and those effects are unlikely to arise.

Companies retain cookies and maintain records for marketing purposes. It may be ethical if the customers allow it. But what about when this data can also be used to adjust the price or if the data is sold?

Companies may include disclosures but how many customers actually read them? With the growth of big data, the ethics of such practices are a growing source of debate.

Who wins here?

Customers want to be treated fairly. But price discrimination occurs offline all the time, whether it be at a car dealership or a flea market.  So why is online price discriminating upsetting? It’s because often, customers don’t know that they are getting different prices. Privacy is another issue.

There’s something a little unsettling about the amount and type of information that can be captured about you online. A recent J.D. Power research study found that over 80% of consumers feel they have lost all control over how their personal information is collected and used by companies.

Consumers already have their doubts and it is essential for retailers to try to maintain trust. Otherwise they may face scrutiny as retailers such as Amazon, Staples and more did after their pricing experiments.

On the flip side, there are tech-savvy consumers out there and it’s quite easy for them to log in from a different IP address. These consumers may be able to take advantage of companies with geographic price differentials. Consumers also constantly utilize data themselves through price checking.

Retailers also need real-time data and analytics to stay ahead of the curve. They are increasingly investing in dynamic pricing technologies that allow them to optimize prices based on changes in the marketplace.

And if part of the strategy is to outprice a competitor? The consumer can win here too. Dynamic pricing can be consumer-friendly in many aspects, and can often result in a win-win situation for retailers and consumers (i.e. lower prices for consumers, higher volume for retailers).

Dynamic pricing isn’t just about using customer data; it’s about market benchmarking such as taking into consideration what competitors are doing, or setting prices according to an optimal margin.

Price adjustments may sometimes mean someone is paying a lower price today than you did last week, but it’s not much different from missing out on a temporary promotion. Fluctuating prices can mean higher prices at times, but it also can mean lower prices at other times. The manifestation is just a bit different now since it’s changed in line with technology.

A fine line for retailers

There’s no denying that data is a powerful tool. The key to implementing a dynamic pricing strategy is having the right data, and utilizing it in a responsible, effective way without alienating customers.

At last year’s Silicon Valley Comes to Oxford event Michael Chui of the McKinsey Global Institute, who has done extensive research on Big Data, concluded that:

The use of data and analytics in general is going to be a basis of competition going forward… Those companies that are able to use data effectively are more likely to win in the marketplace.

Dynamic pricing can be an effective way to optimize sales for retailers, but if it’s not implemented responsibly or if it doesn’t support the overall business strategy, it can carry potential risks just as any pricing strategy can.

Ensure that the data is reliable and accurate. Use the data responsibly and be aware of best practices. Make sure not to lose the trust factor and evaluate the level of transparency you want to maintain regarding your policies.

Fixed pricing isn’t dead, but the market is rapidly changing, and more retailers continue to adopt dynamic pricing. For other retailers, will their pricing strategies get them left behind the competition if they don’t adapt?