Personalized pricing, where merchants adjust prices according to data about a consumer's willingness to pay, has been criticized for its potential to unfairly drive up prices for certain customers.
But new research from the University of Toronto's Rotman School of Management shows that the practice can also hurt sellers' profits - particularly in cases where the value of a product or service is directly linked to the number of consumers using it.
The study, published in the Journal of Economic Theory , also outlines measures that companies can take to pursue profits without resorting to simply increasing prices.
Consumers commonly experience personalized pricing through digital coupons or discount offers they receive either as potential customers or after making a purchase. Other recent examples include the practice of "Buy Now, Pay Later" plans that bundle the sale of a product with a subsidized loan - which can offer different prices to different customers based on their willingness to pay - and airlines using artificial intelligence to customize prices for individual airfares.
Companies can tweak their prices according to data about a customer's digital footprint, including their buying preferences, location, lifestyle and even what kind of digital device and operating system they use - all in pursuit of squeezing maximum profit out of the buyer.
The downside of the practice is that it typically obscures the price information available to other consumers, which is an important factor in their decision to buy, says the study's co-author Liyan Yang, professor of finance and Peter L. Mitchelson/SIT Investment Associates Foundation Chair in Investment Strategy at Rotman.
When prices are transparent to everyone and they're low, "you know that on average, more people will be buying," says Yang.
If part of the product's value depends on how many people are using it - think a social media network or e-commerce platform - not being able to see what others are being charged means consumers are fuzzier about how many other people are likely to buy in and join the network.
The upshot? "Consumers are going to spend less," says Yang.
To test the idea, Yang and former Rotman PhD student Yan Xiong - now an associate professor at the University of Hong Kong Business School - used mathematics and game theory to model what happens when consumers can't see what other people are being charged for a network-based product.
Their models revealed that a company ultimately charged more when prices were concealed compared to when they were transparent, resulting in lower profits - in other words, higher prices weren't enough to make up for the drop in sales.
Luckily for companies, there are workarounds. Using similar modelling, the researchers found that the profit pitfall could be avoided through some kind of corporate commitment or backstop related to keeping prices low even as a company also pursued profits.
That could be done by the company committing to keep prices within a certain range or at least to lowering prices through a corporate social responsibility program; by developing a good reputation among consumers; by initially offering low prices that are transparent to attract consumers with a lower price threshold; or through the use of price caps either mandated by government or voluntarily adopted by the company.
Another option is for a government to require companies to charge the same price to all customers, a strategy promoted in China, the European Union and the United States, where personalized pricing practices have raised concerns
While companies typically dislike regulation, Yang points out that, theoretically at least, some form of price restriction may lead to better corporate profits in the end.
"There are trade-offs," he says, adding that regulators would have to "gauge precisely" where the limits should be to hit the pricing sweet spot that optimizes profits to the company.
