Dynamic pricing, also known as time-based pricing or third-degree price discrimination, occurs when customers are divided into two or more groups with separate demand curves, and different prices are charged to each group. When done successfully, price discrimination practices like this can increase the profit of a firm by enabling the firm to capture more consumer surplus. However, ethical issues exist with some price discrimination policies, especially thanks to the advent of technology, which gives firms the possibility of charging prices based on consumer history and profiling.
Price Discrimination & Consumer Surplus
Dynamic pricing is one method of price discrimination, which is the practice of charging different prices to different consumers for similar goods. This is part of the producer's intent to capture what economists call "consumer surplus"--the difference between what a consumer is willing to pay for a good and the amount they actually have to pay. Economists refer to the price that a consumer is willing to pay as the "reservation price", and if producers could find out a way to calculate what a specific consumer's reservation price was for a good, they could charge the exact highest amount that the consumer would pay for the good before walking away, capturing all of the consumer surplus. However, as it is highly difficult for firms to judge individual consumers' reservation prices, price discrimination is more about separating consumers into groups than aiming at individual consumers.
Price Discrimination Examples
There are several types of price discrimination. First-degree price discrimination refers to charging each consumer that consumer's reservation price, but is highly impractical, if not impossible. Second-degree price discrimination occurs when consumers are charged different prices per unit for different quantities of the same good or service. (An example might be breakfast cereal: a large package will have a lower price per ounce than a small package, typically.) Third-degree price discrimination is the practice of charging consumers different amounts based on their characteristics as consumers. For example, airlines typically charge more on flights that are going to be populated mostly by business travelers (whose demand is relatively inelastic, and therefore more tolerant of high prices), and charge less for flights populated mostly by family travelers.
Time based pricing is popular in the electricity industry, and is an example of dynamic pricing. This could mean 'real-time pricing', meaning electricity prices change as often as hourly and occasionally even more often; or time-of-use pricing, where electricity prices are set for a time period in advance. These methods may be supplanted by critical peak pricing, where on certain days of the year, prices may reflect generating costs at the wholesale level. This is a sort of dynamic pricing, but not the most controversial
Dynamic pricing can and does take on increasingly complex meanings, thanks to the technological and Internet revolutions, but not without controversy. In 2000, when Amazon was found to be analyzing customers based on past purchase history and on other information and then pricing goods like DVDs to match customer's ability to pay, Amazon.com received bad press. In response to customer's complaints, Amazon was forced to use cost-cutting promotions to retain clientele.
Dynamic Pricing & the Future
Today, firms (especially Internet firms) have the ability to gather large amounts of consumer information through click loggers, ad sites, and statistic engines operating in many common web functions. Almost all web servers have integrated statistics processors, which log users based on requested content. With this information available to corporations, consumers must be wary against unfair price discrimination, even though price discrimination generally isn't bad for the economy.
Collin Fitzsimmons has been writing professionally since 2007, specializing in finance and the stock market. He serves as a financial analyst at AMF Bowling Centers, Inc. Fitzsimmons earned a bachelor's degree in economics from the University of Virginia.