Dynamic Pricing: A Strategic Advantage for Electronic Retailers

We develop an analytical framework to investigate the competitive implications of dynamic pricing technologies (DPT), which enable precise inferring of consumers’ valuations for firms’ products and personalized pricing. These technologies enable first-degree price discrimination: firms charge different prices to different consumers, based on their willingness to pay. We first show that, even though the monopolist makes a higher profit with DPT, its optimal quality is the same with or without DPT. Next we show that in a duopoly setting, dynamic pricing adds value only if it is associated with product differentiation. We then consider a model of vertical product differentiation, and show how dynamic pricing on the Internet affects firms’ choices of quality differentiation in a competitive scenario. We find that when the high quality firm adopts DPT both firms raise their quality. Conversely, when the low quality firm adopts DPT, both firms lower their quality. While it is optimal for the firm adopting DPT to increase product differentiation, the non-DPT firm seeks to reduce differentiation by moving closer in the quality space. Our model also points out firms’ optimal pricing strategies with DPT, which may be non-monotonic in consumer valuations. Finally, we show that consumer surplus is highest when both firms adopt DPT. Thus, despite the threat of first-degree price discrimination, dynamic pricing with competing firms can lead to an overall increase in consumer welfare.