When Customers Are — and Aren’t — OK with Personalized Prices

May 31, 2018 Justus Haucap

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There’s a lot of buzz around price differentiation these days, especially with the spotlight on AI and big data.  Machine learning makes it much easier to customize the marketing of products and services – and that includes the price.

Let’s be clear: price differentiation is not a new phenomenon. We encounter it regularly and, as consumers, often profit from it. Market-goers can sometimes get bargain prices on fruit and vegetables if they come at the end of the day as the stallholders are packing up.  Frequent customers get discounts through loyalty programs.  And there’s no objection to these kinds of price discrimination.

Despite that, people do have issues with the general idea of price differentiation. We exposed a representative sample of consumers to different types of differentiated pricing in a large-scale experiment and found that they did not like the idea in principle regardless of whether or not they benefited from the initiative.

Why? To begin with consumers feared that differentiated pricing would bring long-term disadvantages. Although they might gain from lower prices at certain times, they felt they might lose out more often.

And even those who accepted that they would benefit more often than not disliked the idea because they were worried that other consumers might get a still better deal.  Envy of others is a big factor in customer dissatisfaction: if I receive a sizeable discount on a pair of sunglasses, I will be unhappy about my bargain if I discover my neighbor bought the same pair for even less. It doesn’t matter that I benefit: if someone else gets a better deal than I do, I resent it. This has the potential to seriously damage my relationship with and attitude towards a company engaging in price differentiation, for all the economic sense it makes for me and everyone else.    What starts as differentiation becomes discrimination.

How can companies prevent this from happening? Our research suggests that respecting the following four rules will help you make sure that your price differentiation is seen as fair (or at least not too unfair):

  • Have a good reason. Differentiated pricing is seen as fair if it has socially desirable effects (for example, senior citizen and student discounts or free entry for children), or if it discourages avoidable waste (lower prices for perishable products right before expiry). If customers suspect that the sole motive behind different prices is company profit, the pricing scheme will be hard to sell.
  • Combine price with product differentiation. The more similar two transactions are, the less acceptable different prices will be. However, companies can use variations in willingness-to-pay to offer different product versions. This is already familiar territory: many companies offer a basic version and a premium version of the same product and customers can self-select in the higher or lower price segment, but do not have the feeling of being ripped off. Product customization can supply the same cover; customers selecting product features expect the price to reflect their choices.
  • Make pricing predictable. Another way of giving customers control over whether to benefit or not from a differentiated price is to make discounts (or premiums) predictable in time. For instance, car owners know that fuel is often cheaper in the early evening of a workday than on a holiday morning. If I do not care to pay a few cents more or need to get gas very urgently, I will be prepared to pay the higher price without blinking an eye. I won’t blame the gas station for the higher price, because I know I could have paid less if I had planned my refueling better.
  • Proceed incrementally. People can accept differentiated pricing.  As noted above, we are already used to it in a number of sectors. In addition to market stands, we see it every day in the airline and hospitality industries. We’re also used to gasoline prices fluctuating during the day. But our research suggests that consumers will be more likely to accept differentiating pricing schemes if they are introduced gradually. We also find that that time-based differentiation is more acceptable the less frequently prices are changed because fluctuating prices put the burden on the consumer to figure out favorable prices.

There is more to successful pricing than hitting individual consumers’ reserve prices and it will be a long time before computers can model your reactions to the prices the Joneses next door are getting. Human beings aren’t likely to ignore the Joneses next door anytime soon, that means that totally personalized pricing is still a long way off.

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