Internet Pricing Models
I. Economic and Behavioral
Foundations of Pricing
II. Innovative Pricing
Concepts and Tools
III. Internet Pricing
Models
April 8, 2006
Teck-Hua Ho
1
Outline
 A taxonomy of Pricing Models
 Seller vs buyer posted pricing models
April 8, 2006
Teck-Hua Ho
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http://www.priceline.com/
Product categories: Airline tickets, hotels, car rentals, vacation
packages, and cruises.
Perishable inventories (e.g., yield management)
Price fairness is less of an issue
Marginal costs are close to zero
Will grocery products work?
April 8, 2006
Teck-Hua Ho
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 Rules: Customer bids, waits up to 1
hour. If bid is accepted, ticket must
be purchased. If not accepted,
customer must wait 7 days to reenter bid.
 Restrictions: Cannot specify time of
flight, connection city or airline.
 Refund Policy: No
Refunds/Exchanges.
 Hotels, Rental Cars: Yes
 Loyalty Miles or Points: No
http://www.priceline.com/
April 8, 2006
 Rules: Customer can see fare and
has 30 minutes to accept offer.
Customers will be locked out for 72
hours if they reject offer.
 Restrictions: Cannot specify time of
flight, connection city or airline.
 Refund Policy: No
Refunds/Exchanges.
 Hotels, Rental Cars: Yes
 Loyalty Miles or Points: No
http://www.hotwire.com/index.jsp
Teck-Hua Ho
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Rules: Customer gets fares,
number of tickets available
and how long offer is valid.
Customer can purchase ticket
then or be notified if price falls
to desired rate.
Restrictions: Can’t specify
airline.
Refund Policy: No
Refunds/Exchanges
Hotels, Rental Cars: Yes
Loyalty Miles or Points:
Available for some airlines.
April 8, 2006
Rules: Will search fares
globally. Customers will be
able to purchase tickets at
Qixo for 1% on top of price
found at searched site.
Restrictions: None.
Refund/Policy: Depends on
site policy.
Hotels, Rental Cars: Yes
Loyalty Miles or Points:
Available for some airlines.
http://www.qixo.com/flight.html
Teck-Hua Ho
5
Observations
 Emergence and co-existence of new pricing mechanisms (e.g.,
www.priceline.com, www.ebay.com, www.landsend.com and etc.)
 Unsubstantiated claims made by new pricing mechanism designers
(e.g., “auction is the selling format of the future”, “priceline gives
power back to the buyers”)
 Shift in balance of power  Buyer plays a bigger role in price
setting process
 Menu costs are very low so dynamic price customization is now
practical (with customer information) (e.g., www.techdata.com )
 Erosion of “ignorance premium”
April 8, 2006
Teck-Hua Ho
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A Taxonomy of Pricing
Models
Price Setting Party
April 8, 2006
Static
Dynamic
Price Over Time / Price Formation
Seller
www.amazon.com
www.landsend.com
www.freemarkets.com
Buyer
Seller & Buyer
www.priceline.com
www.letsbuyit.com
www.ebay.com
Financial markets
Teck-Hua Ho
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Criteria to Evaluate Pricing
Models
 Social Welfare Metrics
 Seller surplus
 Buyer surplus
 Inefficiency
 Marketing Metrics
 Average price
 Sales volume
 Price Posting Behavior
 Seller posted price
 Buyer posted price as a function of WTP
April 8, 2006
Teck-Hua Ho
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A Simple Market
WTP
Seller 1
c=0
Seller 2
c=0
April 8, 2006
Buyer 1
Buyer 2
Buyer 3
Buyer 4
Buyer 5
Buyer 6
40
20
15
90
60
50
Teck-Hua Ho
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Maximum Possible Surplus
(MPS)
WTP
Seller 1
c=0
Seller 2
c=0
Buyer 1
Buyer 2
Buyer 3
Buyer 4
Buyer 5
Buyer 6
40
20
15
90
60
50
MPS = 40 + 90 + 60 + 50 = 240
April 8, 2006
Teck-Hua Ho
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An Example: Fixed Price
Format
WTP
Price
Seller 1
c=0
45
40
40
Seller 2
c=0
Buyer 1
Buyer 2
Buyer 3
Buyer 4
Buyer 5
Buyer 6
40
20
15
90
60
50
Seller surplus
= 45 + 40 + 40 = 125 = 52.08% of MPS
Buyer surplus
= 45 + 20 + 10 = 75 = 31.25% of MPS
Inefficiency
= 40 = 16.67% of MPS
Average Price
= 41.67
Sales Volume
=3
April 8, 2006
Teck-Hua Ho
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Experimental Test-Bedding
 Develop a new price setting mechanism
 Organize experimental/field markets with buyers and sellers
using the new price mechanism and a benchmarked price
mechanism
 Provide sufficient monetary incentives to motivate buyers
and sellers
 Evaluate the price mechanisms based on performance
criteria
 Continue to fine-tune features of the new price setting
mechanism to maximize a particular performance criterion
April 8, 2006
Teck-Hua Ho
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Vernon Smith
Vernon Smith
2002 Nobel Laureate in Economics
"for having established laboratory experiments as a tool in
empirical economic analysis, especially in the study of alternative
market mechanisms"
http://xlab.berkeley.edu/
April 8, 2006
Teck-Hua Ho
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An Application
Is priceline’s mechanism superior to the traditional
retail price setting mechanism?
Does the party who sets the price gains a greater
portion of the surplus?
How would the priceline’s mechanism’s perform if the
seller is allowed to set a minimum acceptable price
(MAP)?
April 8, 2006
Teck-Hua Ho
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Three Internet Pricing
Models
Sellers posting prices (e.g., www.amazon.com)
Buyers posting prices (e.g., www.priceline.com)
Sellers posting minimum acceptable prices (MAP) and
buyers posting prices (a modified version of
www.priceline.com)
April 8, 2006
Teck-Hua Ho
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Experimental Design
 Nine experimental sessions
 Eight subjects per session; 2 sellers and 6 buyers
 Standard experimental economics methodology (i.e.,
induced value, monetary incentives)
 Seller’s earnings = sum of (price – cost) for each unit
sold
 Buyer’s earnings = WTP - price
 Subjects made $20 on average, the actual payoffs
ranged from $8 to $39 (the experiment lasted for 75
minutes)
April 8, 2006
Teck-Hua Ho
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Design of Amazon Market
 Determine the role of each subject
 Determine each buyer's WTP for the product (1-100)
 Each seller decides on a price
 Determine each buyer's buying sequence
 Determine whether there is a trade between each buyer
and seller
 According to the buying sequence, each buyer is
sequentially asked to indicate whether she would buy
from each of the sellers
 Determine the earnings for everyone
April 8, 2006
Teck-Hua Ho
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Design of Priceline Market
Determine the role of each subject
Determine each buyer's WTP for the product (1-100)
Each buyer decides on a price
Determine each buyer's buying sequence
Determine whether there is a trade between each
buyer and seller
According to the buying sequence, sellers are
asked whether they would sell a unit to each buyer
Determine the earnings for everyone
April 8, 2006
Teck-Hua Ho
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Design of Priceline Market
with MAP
 Determine the role of each subject
 Determine each buyer's WTP for the product (1-100)
 Each seller decides on a minimal acceptable price (MAP)
 Each buyer decides on a price
 Determine each buyer’s buying sequence
 Determine whether there is a trade between each buyer
and seller
 Buyer prices that are below all MAPs are rejected
 According to the buying sequence, sellers are asked whether they
would sell a unit to each buyer whose price is above their MAPs
 Determine the earnings for everyone
April 8, 2006
Teck-Hua Ho
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Results: Social Welfare
Metrics
Seller
Surplus
Buyer
Surplus
Inefficiency
April 8, 2006
Amazon
Priceline
Priceline with
MAP
50.6%
45.1%
45.7%
33.2%
42.6%
42.3%
16.2%
12.3%
12.0%
Teck-Hua Ho
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Results: Marketing Metrics
Amazon
Priceline
Priceline
with MAP
Price
43.00
28.43
33.00
Sales
3.00
3.75
3.33
Volume
April 8, 2006
Teck-Hua Ho
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Amazon: Price Distribution
Amazon: Price Frequency Plot
50.0%
45.0%
40.0%
35.0%
30.0%
Frequency 25.0%
20.0%
15.0%
10.0%
5.0%
0.0%
< 38
38-45
>46
Price Range
April 8, 2006
Teck-Hua Ho
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Average Prices Over Time
Prices Over Time
60
50
Price
40
Amazon
30
Priceline
20
10
0
1
2
3
4
5
6
7
8
9
10
Time
April 8, 2006
Teck-Hua Ho
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Seller Posted Price (Amazon)
versus MAP (Priceline with MAP)
Seller Posted Price versus MAP Over Time
70
60
Posted Price
or MAP
50
40
MAP
Posted Price
30
20
10
0
1
2
3
4
5
6
7
8
9
10
Time
April 8, 2006
Teck-Hua Ho
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Priceline: Posted Price
versus WTP
Buyer Posted Price
Priceline: Buyer Posted Price versus
WTP
70
60
50
40
30
20
10
0
0
10
20
30
40
50
60
70
80
90 100
WTP
Posted Price = 5.62 + 0.41 x WTP (R2=0.73)
April 8, 2006
Teck-Hua Ho
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Priceline with MAP:
Posted Price versus WTP
Buyer Posted Price
Priceline with MAP: Buyer Posted
Price versus WTP
50
45
40
35
30
25
20
15
10
5
0
0
10 20 30 40 50 60 70 80 90 10
0
WTP
Posted Price = 4.25 + 0.39 x WTP (R2=0.71)
April 8, 2006
Teck-Hua Ho
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Summary
 Develop a new price setting mechanism
 Organize experimental/field markets with buyers and
sellers using the new price mechanism and a
benchmarked price mechanism
 Provide sufficient monetary incentives to motivate
buyers and sellers
 Evaluate the price mechanisms based on performance
criteria
 Continue to fine-tune features of the new price setting
mechanism to maximize a particular performance
criterion
April 8, 2006
Teck-Hua Ho
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Punch-line
The power to set a static price (i.e., make a
take-it-or-leave-it offer) allows a party to gain a
higher surplus
In analyzing a price model:
Determine the criteria of performance
Engage in experimental test-bedding
April 8, 2006
Teck-Hua Ho
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