1 Teck-Hua Ho April 8, 2006 Internet Pricing Models I. Economic and Behavioral Foundations of Pricing II. Innovative Pricing Concepts and Tools III. Internet Pricing Models

2 Teck-Hua Ho April 8, 2006 Outline  A taxonomy of Pricing Models  Seller vs buyer posted pricing models

3 Teck-Hua Ho April 8, 2006  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?

4 Teck-Hua Ho April 8, 2006  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

5 Teck-Hua Ho April 8, 2006  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.  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.

6 Teck-Hua Ho April 8, 2006 Observations  Emergence and co-existence of new pricing mechanisms (e.g., 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., )  Erosion of “ignorance premium”

7 Teck-Hua Ho April 8, 2006 A Taxonomy of Pricing Models Seller Buyer Seller & Buyer Price Setting Party Price Over Time / Price Formation Static Dynamic Financial markets

8 Teck-Hua Ho April 8, 2006 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

9 Teck-Hua Ho April 8, 2006 A Simple Market Seller 1 c=0 Seller 2 c=0 Buyer 1 40 Buyer 2 20 Buyer 3 15 Buyer 4 90 Buyer 5 60 Buyer 6 50 WTP

10 Teck-Hua Ho April 8, 2006 Maximum Possible Surplus (MPS) Seller 1 c=0 Seller 2 c=0 Buyer 1 40 Buyer 2 20 Buyer 3 15 Buyer 4 90 Buyer 5 60 Buyer 6 50 WTP MPS = = 240

11 Teck-Hua Ho April 8, 2006 An Example: Fixed Price Format Seller surplus= = 125 = 52.08% of MPS Buyer surplus= = 75 = 31.25% of MPS Inefficiency= 40 = 16.67% of MPS Average Price= Sales Volume = 3 Seller 1 c=0 Seller 2 c=0 Buyer 1 40 Buyer 2 20 Buyer 3 15 Buyer 4 90 Buyer 5 60 Buyer WTP Price

12 Teck-Hua Ho April 8, 2006 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

13 Teck-Hua Ho April 8, 2006 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"

14 Teck-Hua Ho April 8, 2006 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)?

15 Teck-Hua Ho April 8, 2006 Three Internet Pricing Models  Sellers posting prices ( e.g., )  Buyers posting prices ( e.g., )  Sellers posting minimum acceptable prices (MAP) and buyers posting prices (a modified version of )

16 Teck-Hua Ho April 8, 2006 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)

17 Teck-Hua Ho April 8, 2006 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

18 Teck-Hua Ho April 8, 2006 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

19 Teck-Hua Ho April 8, 2006 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

20 Teck-Hua Ho April 8, 2006 Results: Social Welfare Metrics AmazonPriceline Priceline with MAP SellerSurplus 50.6%45.1%45.7% BuyerSurplus 33.2%42.6%42.3% Inefficiency16.2%12.3%12.0%

21 Teck-Hua Ho April 8, 2006 Results: Marketing Metrics AmazonPriceline with MAP Price Sales Volume

22 Teck-Hua Ho April 8, 2006 Amazon: Price Distribution

23 Teck-Hua Ho April 8, 2006 Average Prices Over Time

24 Teck-Hua Ho April 8, 2006 Seller Posted Price (Amazon) versus MAP (Priceline with MAP)

25 Teck-Hua Ho April 8, 2006 Priceline: Posted Price versus WTP Posted Price = x WTP (R 2 =0.73)

26 Teck-Hua Ho April 8, 2006 Priceline with MAP: Posted Price versus WTP Posted Price = x WTP (R 2 =0.71)

27 Teck-Hua Ho April 8, 2006 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

28 Teck-Hua Ho April 8, 2006 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