Fixed vs. Variable Pricing
One of the first decisions that a company must make in its pricing strategy is whether to offer different prices to different customers. Doing so is called variable pricing.
The alternative is fixed pricing. Fixed pricing entails every customer in every situation receiving the same price for the same product or service. One price.
Fixed pricing is simple, but economically inefficient. Potential customers have a wide range of willingness to pay, and so long as that willingness is higher than the marginal cost of providing the good, accepting the deal will leave your company better off, i.e., with more revenue and higher profitability. Grouping and charging customers by willingness to pay is called price segmentation.
If such segmentation is defensible so that the right customers get the right price, tailoring price to customers’ willingness to pay will enable your company to serve more customers and earn more money.
It is important that such segmentation be fair, however, if you want your customers to accept variable pricing. Your pricing strategy should help with your customer relationship. The last thing you want to do is alienate potential customers through unfair price discrimination.
It is fair to charge a customer a higher price if that customer is more costly to serve, or to offer a discount to a customer who is less costly to serve. It is not fair (or legal) to give a customer a favorable or less favorable price because of their race or religion.
Price segmentation by willingness to pay is especially common in B2B markets. Let’s say your company in the life sciences industry has developed an innovative new method of testing the medical efficacy of various compounds.
Both universities and pharmaceutical companies will be potential customers. The university will be able to conduct better research and publish more papers. The pharmaceutical company, through better research, may be able to deliver a billion-dollar product to the market faster than before.
While the university may gain prestige, the pharmaceutical company may gain enormous profits. The value to the company, expressed in dollars, is much higher than the value to the university. From a value-based perspective, it makes complete sense to segment customers according to the different value that they receive from a product or service.
Grouping customers by common characteristics is a good step in variable pricing, but inevitably ignores significant or subtle differences between customers within the same group. Wouldn’t it be better to have ever smaller, more targeted segments? Even down to a segment of one?
The goal in individualized pricing is to flatten out that sawtooth edge in the graph of many prices so that every customer receives its own individual price:
At this point, theoretically the company is optimizing its revenue and profit potential by serving every customer who is willing to pay at a profitable price, at exactly their willingness to pay.
The idea that every customer may receive his or her own price is gaining in popularity as information technology makes it both easier to present any number of prices and know enough about a customer’s willingness to pay to present the correct price to that customer.
Promise and Peril
This can be incredibly profitable to companies, as illustrated in the growth in size of the green area in each graph above. Studies on web companies suggest that they could see double-digit profit gains from enacting even relatively basic price segmentation, let alone individualized pricing.
So, what’s the downside? Well, it turns out customers don’t particularly like feeling taken advantage of, and receiving a different price for the same product often feels that way.
You may have sat next to a friend and searched online for the exact same flight, only to discover that you don’t see the same price. Whoever received the higher price probably wasn’t elated to know that the other was getting a better deal.
In an infamous example from 2012, it was found that Staples and other companies varied online prices based on zip code. Customers felt tricked.
Especially if you are in a customer intimacy-heavy company, you risk alienating your customers by offering different prices in ways that feel unfair. Some companies, therefore, decide to forgo the potential increased revenue and profits from segmentation or individualization in order to have a better customer relationship.
Groupon is one company that has decided to have fixed pricing, perhaps surprisingly given its complete e-commerce focus and wealth of pricing data. It certainly has the ability to segment and individualize like Amazon, but determined that doing so was against its larger strategy and priorities.
I spoke with a leading data scientist at Groupon for my upcoming book, The New Invisible Hand, about just this. Here’s a sneak peak of what I learned.
“You can charge different consumers different prices,” he told me. “But the route we’ve gone is we think that results in a poor consumer experience. I don’t want to charge you one price and charge someone else a random price just based on different browser histories.”
For Groupon, the customer experience is critical to its strategy. It doesn’t want to engender any feelings of exploitation, whether or not those feelings are justified by theory.
He continued: “We’re going to focus on targeting what the right price is, rather than experimenting on individual users. We want to figure out which deals are overpriced and adjust them downward, and figure out which are underpriced and adjust them upward.” In sum? “Taking a data-driven approach to the prices we offer every day.”
Tailoring price according to willingness to pay is theoretically sound but culturally still questionable. It’s important to determine how your customers will react to such variable pricing when deciding whether to have price variance and by what characteristics.
Segmentation according to value and cost-to-serve is more likely to be seen as fair and acceptable, but there is no hard and fast rule. More so, culture around pricing is constantly in flux. The promise of better earnings and more customers is high, but so is the peril of customer alienation and backlash.