Price Optimisation using Dynamic Pricing and Machine Learning
The article provides a comprehensive explanation of Dynamic Pricing and the role of machine learning in optimizing revenue. Additionally, it presents case studies of Uber and Airbnb to illustrate how these companies are leveraging Dynamic Pricing and machine learning in their business strategies.
In today's world, personalization has become a ubiquitous feature. The advancements in data science have enabled the creation of tailor-suited products that cater to the unique preferences of each individual. The initial phase of personalization was introduced through recommender systems, which predict a user's preference and suggest products to increase profitability. For instance, Amazon, Netflix, and Spotify utilize recommender systems to recommend products, movies, and playlists, respectively.
One of the critical decisions a company makes about a product is its price. Nowadays, merchants require sophisticated pricing strategies to succeed in a highly competitive marketplace and satisfy all consumers’ needs. Businesses face two key challenges: optimizing prices and managing income in a constantly changing environment. So, companies use a strategy called dynamic pricing to solve them simultaneously.
The method’s efficiency can be noticeably increased with artificial intelligence (AI) and machine learning (ML) capabilities. AI and ML technologies open up opportunities to find new revenue sources, flexibly adapt to market requirements, and strengthen customer focus.
What is Dynamic pricing?
Dynamic pricing is a flexible strategy in which the product or service price is determined by the current (and continually changing) market conditions. For instance, the merchant can increase rates when it knows that the competitor’s stocks are running low or demand is getting higher.
Dynamic pricing uses big data to understand and act upon changing terms. Following this strategy, companies set the optimal product prices, considering their costs, sales volumes, competitors’ rates, market trends, etc. Dynamic pricing calculations are based on different approaches:
Prices are dynamically adjusted following business expenses to maintain the desired return on investment (ROI);
Pricing is based on competitors’ decisions; or
Prices rise with increasing demand or decreasing supply (and vice versa).
Analyzing a massive amount of information in real time allows businesses to instantly adjust prices, adapt to consumer activity, and thus extract the maximum benefit. Dynamic pricing is commonly used in e-commerce, entertainment, travel and hospitality, transport, energy, and other sectors. This approach works great for ground and air transport rates, the cost of vouchers and hotel rooms, and tickets to the zoo, the cinema, or concerts.
How Machine learning is helping Dynamic pricing?
While dynamic pricing has been used in various industries for decades, the advent of machine learning has significantly enhanced the effectiveness of this strategy.
Machine learning is a subset of artificial intelligence that enables computers to learn from data and improve their performance without being explicitly programmed. Machine learning algorithms can analyze large amounts of data on customer behavior, market trends, and other relevant factors to identify patterns and predict future demand. This capability is particularly valuable for implementing dynamic pricing strategies, as it allows businesses to quickly respond to changes in market conditions and optimize pricing for maximum profitability.
There are several ways that machine learning can be applied to dynamic pricing. First, machine learning algorithms can process real-time data on market demand, competitor pricing, and other factors to adjust prices on-the-fly. For example, an e-commerce company could use machine learning to adjust prices for a product based on factors such as customer demand, competitor pricing, and availability. This could help the company capture more revenue and stay competitive by quickly responding to changes in market conditions.
Second, machine learning algorithms can help businesses create personalized pricing strategies based on customer data. By analyzing customer data such as purchase history, demographics, and online behavior, businesses can create targeted discounts and promotions for specific customer segments. This can improve customer loyalty and increase sales by offering pricing that is tailored to individual customer needs.
Third, machine learning can help businesses optimize their pricing strategies by testing different pricing models, analyzing the results, and identifying the most effective pricing strategies. For example, an energy company could use machine learning to test different pricing models for electricity usage and identify the pricing strategies that are most effective at encouraging customers to shift their usage to off-peak hours.
Finally, machine learning can help businesses predict customer behavior and optimize pricing strategies based on these predictions. By analyzing data on customer behavior and market trends, businesses can identify patterns and predict future demand for products and services. This can help businesses determine the optimal price for a product or service at any given time and adjust pricing strategies accordingly.
Overall, machine learning is a powerful tool for implementing dynamic pricing strategies. By using data and analytics to optimize pricing strategies, businesses can improve profitability, increase customer loyalty, and stay ahead of competitors. As machine learning continues to evolve and become more accessible, we can expect to see even more sophisticated and effective dynamic pricing strategies implemented across a wide range of industries.
When creating a dynamic pricing model, a typical approach involves three steps.
First, you need to decide on the level of granularity you want to achieve. Do you want to model individual users, specific groups of users, or the entire user base?
Next, you need to develop a predictive model that can estimate the likelihood of purchase (or the total number of purchases) based on various parameters.
Finally, you can use an optimization algorithm to determine the ideal price and product features that will increase the probability of a purchase. This technique can also be employed to generate product bundles and discounts.
What are the models of dynamic pricing algorithms?
Depending on the mathematical model, businesses can create numerous algorithms that fit their dynamic pricing strategy. Here are a few approaches compiled from research articles:
1. Bayesian model
In a Bayesian model, the user picks a prior value indicating the initial belief about the possible price. Then, whenever a new data point is entered into the algorithm, the initial belief shifts either higher or lower. This type of dynamic pricing model uses historical pricing data as the most important feature to decide on the final price, like a typical pricing algorithm.
2. Reinforcement learning model
Reinforcement learning (RL) is a goal-directed dynamic pricing model which aims to achieve the highest rewards by learning from environmental data. An RL dynamic pricing model analyzes data regarding customers’ demand, taking into account seasonality, competitor prices, and the uncertainty of the market, to achieve a revenue-optimal price.
3. Decision tree model
Decision trees are classification machine learning models that output a tree-like model of decisions and their possible consequences, including the possibility of a certain outcome, resource costs, and utility. Decision tree dynamic pricing algorithms help businesses understand which parameters have the most effect on the prices and which of these price ranges predicts the highest revenues, and using this information, the algorithm predicts the best price range for each product.
Use cases where machine learning can be applied to dynamic pricing strategies
Here are a few examples:
1. E-commerce: E-commerce companies can use machine learning algorithms to analyze data on customer behavior, purchasing history, and market trends to optimize pricing strategies. For example, a retailer could use machine learning to identify which products are in high demand at certain times of the year and adjust pricing accordingly.
2. Transportation: Transportation companies, such as airlines and ride-hailing services, can use machine learning to adjust prices based on real-time demand and other external factors. For example, an airline might use machine learning algorithms to predict how many seats will be sold on a particular flight, and adjust prices accordingly to maximize revenue.
3. Hospitality: Hotels and other hospitality companies can use machine learning to personalize pricing for individual guests based on their preferences and past behavior. For example, a hotel might use machine learning to offer a discounted rate to a guest who frequently books rooms on weekends.
4. Energy: Energy companies can use machine learning algorithms to optimize pricing based on real-time demand and supply. For example, a utility company could use machine learning to predict energy demand for the day and adjust prices accordingly to encourage customers to shift their energy usage to off-peak hours.
5. Entertainment: Entertainment companies can use machine learning to adjust ticket prices based on real-time demand and other factors, such as weather or the popularity of a particular artist. For example, a concert promoter could use machine learning to adjust ticket prices for a popular artist based on the demand for tickets in different cities.
Overall, machine learning can be applied to a wide range of industries and use cases to help businesses implement more effective dynamic pricing strategies. By using data and analytics to optimize pricing strategies, businesses can improve profitability, increase customer loyalty, and stay ahead of competitors.
How Uber is Using Dynamic Pricing Strategy for revenue maximization
Uber, the ride-sharing company, uses dynamic pricing as a key strategy for revenue maximization. The company's pricing model is based on supply and demand, where prices increase during peak times when there are more ride requests than available drivers.
Uber's dynamic pricing model is powered by machine learning algorithms that analyze real-time data on user demand and driver availability. During peak times, the algorithms predict the level of demand and increase prices accordingly to incentivize more drivers to go online and provide rides.
One of the key benefits of Uber's dynamic pricing model is that it ensures that ride requests are always met, even during peak times when demand is high. By increasing prices, Uber encourages more drivers to come online and provide rides, thereby reducing wait times for customers and increasing overall customer satisfaction.
In addition to increasing prices during peak times, Uber also uses dynamic pricing to adjust prices based on other factors such as weather conditions, events, and traffic congestion. For example, during heavy rain or snow, Uber might increase prices to encourage more drivers to come online and provide rides in difficult driving conditions.
Uber's dynamic pricing model is designed to balance supply and demand, ensuring that ride requests are always met while also maximizing revenue for the company. By using real-time data and machine learning algorithms, Uber can adjust prices in real-time to respond to changes in market conditions and customer demand. This has enabled the company to become one of the most successful ride-sharing services in the world, with billions of dollars in annual revenue.
This graphic shows predicted and actually completed trips over a 200-day period in one city:
One of the holidays predicting demand for which was the most difficult is Christmas Day Credits
Being able to evaluate a multitude of variables that influence demand, Uber defines a price that corresponds to the market state at a particular time to optimize its operations.
How Airbnb is Using Dynamic Pricing Strategy for revenue maximization
Airbnb uses dynamic pricing to help hosts optimize their prices and attract more bookings. Airbnb's dynamic pricing algorithm is called Smart Pricing, and it adjusts the nightly rates of listings based on market demand, seasonality, local events, and other variables.
To help hosts maximize their revenues, Airbnb offers “Price Tips” and “Smart Pricing” tools. Price Tips presents a calendar view showing the predicted likelihood of bookings on a day-by-day basis, given the current pricing as set by the host. When clicking on a given day, more detail and an Airbnb-suggested price are shown.
With Smart Pricing hosts can set a min and max price and then any new price suggestions generated by Airbnb that fall within these ranges will be automatically adopted for all available nights.
In the ideal world, we’d estimate a demand curve F(P) giving an estimate of demand at a given price P, and then choose P so as to maximize P*F(P). We’ve already seen some reasons why things aren’t quite so straightforward in the Airbnb case (we at least need to factor in the listing itself, and the time, giving ). Moreover, since Airbnb doesn’t directly control pricing but can only suggest —with partial adoption of their suggestions by hosts— it is not so easy to directly experiment and explore different pricing strategies to observe market responses.
The pricing system that Airbnb ultimately settled on has three components:
First, a booking probability binary classification model makes predictions of the likelihood a listing will be booked on each night.
These predictions are then fed into a pricing strategy model which suggests prices for the available nights
Additional personalization logic is applied to the output of the price by the strategy model to incorporate hosting goals, special events, etc..
Here's how Airbnb uses dynamic pricing in some other ways too:
1. Market demand: Airbnb's algorithm analyzes booking trends and adjusts prices based on supply and demand. If demand for a particular listing is high, Airbnb may increase the price, and if demand is low, Airbnb may decrease the price to attract more bookings.
2. Seasonality: Airbnb adjusts prices based on seasonal trends. During peak travel season, Airbnb may increase the prices of listings in popular destinations, while during low season, Airbnb may lower prices to attract more bookings.
3. Local events: Airbnb adjusts prices based on local events such as festivals, conferences, or sporting events. If there is a high demand for accommodations during a particular event, Airbnb may increase the prices of listings in the area to capitalize on the increased demand.
4. Competitor pricing: Airbnb adjusts prices based on the prices of competing listings in the same area. If a host's listing is priced significantly higher than similar listings in the area, Airbnb may lower the price to remain competitive.
Airbnb also offers hosts the option to set custom seasonal pricing, which allows them to adjust prices for specific times of the year when demand is higher or lower.
Overall, Airbnb's dynamic pricing system helps hosts optimize their prices and attract more bookings, while also ensuring that guests are getting a fair price for their stay. By using data-driven pricing strategies, hosts can maximize their revenue and guests can find affordable accommodations that meet their needs.
An effective pricing strategy is crucial for any business, particularly for those operating in the online space where customers can easily compare prices and make informed purchasing decisions. With advancements in computing speed, data storage, and accessibility to data, entrepreneurs can leverage technology to respond to changing market conditions with reasonable prices.
Dynamic pricing, which involves adjusting prices based on supply and demand, can be employed for both revenue management and pricing optimization. Machine learning techniques enable businesses to implement dynamic pricing on a large scale, taking into account numerous pricing factors such as price elasticity, and displaying specific prices to customer segments based on their willingness to pay. This allows businesses to optimize their pricing strategy and maximize profits while remaining competitive in a rapidly changing market.