NEW INTERNET PRICING MODELS BRING PAIN, AND FORTUNE, TO RETAILERS
Knowledge@Wharton, February, 2001
On the runaway train that is the Internet, companies soon found
themselves sharing space with an unexpected--and unwanted--passenger. It
was called price transparency, and while it would prove to be bad news for
business, it was great news for consumers.
Price transparency refers to the ability of consumers (at both the
wholesale and retail level), to know what it will cost to buy a given good
or service at a variety of outlets. While prices will vary in any
marketplace because of such factors as distribution network, consumer
preferences and differing rates of sales tax, the transparency to consumers has been historically limited because constraints like distance
and time have hampered their ability to engage in widespread
comparison-shopping.
The Internet changed all that and gave consumers the ability to
price-shop with the click of a mouse. Businesses, in turn, found that
their old, static pricing models were becoming obsolete; they had to
formulate a new way to respond to changes in the digital marketplace.
"There are various pricing models," notes Wharton operations and
information management professor Eric Clemons.
"One is dynamic pricing, a mechanism for matching supply and demand
through the pricing structure. This is the model used by the stock
exchanges and commodities markets."
Think of the way stock prices rise and fall, sometimes in a matter of
seconds. Or consider a lower-tech example, like that of Secaucus,
N.J.-based Syms Corp., which operates a chain of off-price apparel stores
throughout the U.S. "After 10 days on the sales floor, the price of our
women’s daytime dresses (work-casual) decreases," says Douglas C. Meyer,
the company’s vice president of marketing. "After 20 days, the price drops
again."
Clemons points out that another pricing model, variable pricing, is
often used in the consumer segment. "Variable pricing aims to generate
incremental sales and revenues by varying the price of an item," he
explains. "In this model, the customer has already demonstrated that he or
she is not willing to pay the current price for the product, but a
manufacturer is betting that after a trial use (often sparked by a steep
price discount) the customer’s willingness to pay will be altered."
There are several other ways to implement variable pricing based, for
example, on different versions of the same goods or services. Think of
day-old bread or other baked goods. Will a consumer buy a stale item? He
or she might if it’s offered at half the price of a similar, fresh-baked
one.
Properly implemented, variable pricing can result in additional sales
without cannibalizing existing ones. But as at least one big-league
player, Priceline.com, found out, even the skills of the Starship
Enterprise captain aren’t always sufficient to navigate this
pathway to profits.
Priceline gained fame by offering online "name your own price" bidding
for a variety of goods. In fact, it was often hailed as the poster child
of the new economy. But Clemons says the company (which recently lost
Star Trek’s William Shatner as its celebrity spokesman) stumbled
when it tried to expand its variable pricing model from items like airline
tickets to another category, groceries.
He notes that variable pricing will work in some perishables
environments, like the bakery that offers "day old" goods at a discount.
But those items are "damaged" and do not directly compete with the sale of
"premium" (or undamaged) goods. So if someone was going to pass on your
bakery’s bread because it was too expensive, he might buy a less-expensive
day-old loaf.
It’s worth it for the bakery owner to sell the day-old goods at a
discount (perhaps even below the original cost) because otherwise the
goods would just be discarded, contributing no revenue at all.
But how about airline tickets? Short of ripping up the upholstery or
placing tacks on the cushions, how does a class of seats become "damaged
goods" which don’t compete with other seats that could sell at full or
near-full price?
In fact, says Clemons, railroad companies in 19th century
France did something just like that. "First class passengers paid a
premium and were feted with champagne and delicacies," he notes. "Second
class passengers received standard seating."
Attracting additional passengers through further discounts would
undercut the people who paid full second-class fare, says Clemons (Late
last year, Amazon.com got into hot water for doing something
similar—offering the same Digital Versatile Discs, or DVDs, to different
customers at different prices. Although the company denied it was testing
prices based on customer demographics, Amazon ended up refunding 6,896 customers an average of $3 apiece, according to published reports).
In the case of the French railroads, the companies created "damaged
goods" by actually ripping off the roof of a rail car and billing it as
"third class" seating, which was offered at a discount to the second class
price.
Airlines had already addressed some of the seating issues through
dynamic pricing "yield management," which involves reducing prices on
empty seats proportionately as the day, or even the hour, of the flight
draws closer.
But Priceline went a step further by letting consumers name their own
price for a flight (subject, of course to the airline’s acceptance), but
with a catch—the consumer couldn’t name the exact day, time or origination
of the flight. In fact, the passenger might not even get his choice of
airline.
"The beauty of this variable pricing model lay in the fact that it
created ‘damaged goods’ in the form of uncertainty," according to Clemons.
"If you were a student on a tight budget but with time to spare, it might
not bother you to drive two extra hours to a distant airport, leave a day
earlier than planned and fly back a day later, with layovers each way. On
the other hand, a business traveler on a tight schedule would never pass
up a regularly scheduled flight for a Priceline bid. So instead of losing
a full-pay customer to a discount seat, the airlines could fill an
otherwise-empty seat with a passenger who otherwise may not have even
flown."
Priceline had a hit on its hands, and saw its stock price hit a record
$162 per share in April 1999, shortly after its IPO. Then, near the end of
that year, the company decided to tap into a wider consumer market by
launching the Priceline WebHouse Club, a service that let online consumers
name their own price for groceries.
Perhaps the company should have spoken to Clemons or some of his
colleagues before launching the expansion. "Variable pricing doesn’t work
for every situation," he says. "While it may attract incremental grocery
sales in specific situations, this was the wrong application."
One reason is because unlike financial instruments such as commodities
futures, where supply and demand can fluctuate on a second-by-second
basis, consumer demand for goods like groceries tends to be stable,
enabling retail outlets to predict demand with relative accuracy and place
their orders accordingly. So the volume of "damaged goods" like day-old
bread may not be great enough to support variable pricing in the grocery
segment--at least not on a widespread basis. And as Clemons’ marketing
colleagues could have pointed out to Priceline, no consumer packaged goods
manufacturer would want to participate in a system that "damaged" their products, their brands or their brand equity.
Priceline found this out the hard way, and in October 2000 announced
that WebHouse would shut its doors. Priceline’s market value, along with
that of many other Internet-based companies, has since plunged and company
shares traded recently at $2.84.
"Companies should do their research and determine where variable
pricing will work," comments Clemons. "Supermarkets, for instance, can use
their vast database of consumer history to encourage product adoption
through variable pricing by launching selective deep price discounts."
He offers a hypothetical shopper as an example. "If a fellow buys
laundry detergent on a regular basis, he is probably a good candidate for
fabric softener as well," says Clemons. "So as he picks up his purchases
at the cash register, it can generate a discount ticket for a fabric
softener. If it’s inexpensive enough, the consumer may try the product.
Even if the initial sale is a loss leader, the manufacturer wants the non-using customer to try the product."
He adds that this is not news to marketing faculty or to brand
managers; but what is new is the ease with which these consumers
can be identified and courted.
The Internet has brought challenges, as well as opportunities, to
businesses. While it enables a local company to hawk its wares worldwide
at an affordable price, it has also forced firms to ramp up their response
to shifts in consumer demand. But as the example of variable pricing
shows, taking the time to research an approach--instead of jumping the gun to implement it--will
still yield value.
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