April 8, 2006

1

Teck-Hua Ho

Internet Pricing Models

I. Economic and Behavioral Foundations of Pricing

II. Innovative Pricing Concepts and Tools

III. Internet Pricing Models

April 8, 2006

2

Teck-Hua Ho

OutlineOutline

A taxonomy of Pricing Models

Seller vs buyer posted pricing models

April 8, 2006

3

Teck-Hua Ho

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?

http://www.priceline.com/

April 8, 2006

4

Teck-Hua Ho

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 re-enter 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

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 http://www.priceline.com/

April 8, 2006

5

Teck-Hua Ho

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: YesLoyalty Miles or Points:

Available for some airlines.

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: YesLoyalty Miles or Points:

Available for some airlines.http://www.qixo.com/flight.html

April 8, 2006

6

Teck-Hua Ho

ObservationsObservations

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

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Teck-Hua Ho

A Taxonomy of Pricing ModelsA Taxonomy of Pricing Models

Seller Buyer Seller & Buyer

Price Setting Party

Pri

ce O

ver

Tim

e / P

rice

For

mat

ion

Stat

icD

ynam

ic

www.priceline.com

www.landsend.com www.freemarkets.com

www.ebay.com

www.letsbuyit.com

Financial markets

www.amazon.com

April 8, 2006

8

Teck-Hua Ho

Criteria to Evaluate Pricing Criteria to Evaluate Pricing ModelsModels

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

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Teck-Hua Ho

A Simple MarketA Simple Market

Seller 1 c=0

Seller 2 c=0

Buyer 1 40 Buyer 2 20Buyer 3 15Buyer 4 90Buyer 5 60Buyer 6 50

WTP

April 8, 2006

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Teck-Hua Ho

Maximum Possible Surplus Maximum Possible Surplus (MPS)(MPS)

Seller 1 c=0

Seller 2 c=0

Buyer 1 40 Buyer 2 20Buyer 3 15Buyer 4 90Buyer 5 60Buyer 6 50

WTP

MPS = 40 + 90 + 60 + 50 = 240

April 8, 2006

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Teck-Hua Ho

An Example: Fixed Price An Example: Fixed Price FormatFormat

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

Seller 1 c=0

Seller 2 c=0

Buyer 1 40 Buyer 2 20Buyer 3 15Buyer 4 90Buyer 5 60Buyer 6 50

45

40

40

WTPPrice

April 8, 2006

12

Teck-Hua Ho

Experimental Test-BeddingExperimental 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

13

Teck-Hua Ho

Vernon SmithVernon 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

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Teck-Hua Ho

An ApplicationAn 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

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Teck-Hua Ho

Three Internet Pricing ModelsThree Internet Pricing ModelsSellers 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

16

Teck-Hua Ho

Experimental DesignExperimental DesignNine experimental sessions Eight subjects per session; 2 sellers and 6 buyersStandard experimental economics methodology (i.e.,

induced value, monetary incentives)Seller’s earnings = sum of (price – cost) for each unit

soldBuyer’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

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Teck-Hua Ho

Design of Amazon MarketDesign of Amazon Market

Determine the role of each subjectDetermine each buyer's WTP for the product (1-100) Each seller decides on a priceDetermine each buyer's buying sequenceDetermine 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

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Teck-Hua Ho

Design of Priceline MarketDesign of Priceline MarketDetermine 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

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Teck-Hua Ho

Design of Priceline Market with Design of Priceline Market with MAPMAPDetermine 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 priceDetermine each buyer’s buying sequenceDetermine 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

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Teck-Hua Ho

Results: Social Welfare Results: Social Welfare MetricsMetrics

AmazonAmazon PricelinePriceline Priceline with Priceline with MAPMAP

SellerSeller

SurplusSurplus50.6% 45.1% 45.7%

BuyerBuyer

SurplusSurplus33.2% 42.6% 42.3%

InefficiencyInefficiency 16.2% 12.3% 12.0%

April 8, 2006

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Teck-Hua Ho

Results: Marketing MetricsResults: Marketing Metrics

Amazon Priceline Priceline

with MAP

Price 43.00 28.43 33.00

Sales

Volume

3.00 3.75 3.33

April 8, 2006

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Teck-Hua Ho

Amazon: Price DistributionAmazon: Price Distribution

0.0%5.0%

10.0%15.0%20.0%25.0%30.0%35.0%40.0%45.0%50.0%

Frequency

< 38 38-45 >46

Price Range

Amazon: Price Frequency Plot

April 8, 2006

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Teck-Hua Ho

Average Prices Over TimeAverage Prices Over Time

Prices Over Time

0

10

20

30

40

50

60

1 2 3 4 5 6 7 8 9 10

Time

Pri

ce Amazon

Priceline

April 8, 2006

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Teck-Hua Ho

Seller Posted Price (Amazon) versus Seller Posted Price (Amazon) versus MAP (Priceline with MAP)MAP (Priceline with MAP)

Seller Posted Price versus MAP Over Time

0

10

20

30

40

50

60

70

1 2 3 4 5 6 7 8 9 10

Time

Po

ste

d P

rice

o

r M

AP MAP

Posted Price

April 8, 2006

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Teck-Hua Ho

Priceline: Posted Price versus Priceline: Posted Price versus WTPWTP

Priceline: Buyer Posted Price versus WTP

010203040506070

0 10 20 30 40 50 60 70 80 90 100

WTP

Bu

yer

Po

sted

Pri

ce

Posted Price = 5.62 + 0.41 x WTP (R2=0.73)

April 8, 2006

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Teck-Hua Ho

Priceline with MAP: Priceline with MAP: Posted Price versus WTPPosted Price versus WTP

Posted Price = 4.25 + 0.39 x WTP (R2=0.71)

Priceline with MAP: Buyer Posted Price versus WTP

05

101520253035404550

0 10 20 30 40 50 60 70 80 90 100

WTP

Bu

yer

Po

sted

Pri

ce

April 8, 2006

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Teck-Hua Ho

SummarySummaryDevelop 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

28

Teck-Hua Ho

Punch-linePunch-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