Demand-Based Pricing Methods

Letting Demand Drive Price

Demand-based methods adjust prices based on demand conditions—charging more when demand is high, less when it's low, and varying prices across customers with different willingness to pay. These methods can significantly increase revenue by capturing more of the consumer surplus that would otherwise be left on the table.

Price Discrimination: Capturing Differentiated Value

Price discrimination means charging different prices to different customers for essentially the same product. Economists identify three degrees:

First-Degree (Perfect) Price Discrimination

Charge each customer their maximum willingness to pay. This captures all consumer surplus as producer revenue. It's rarely achievable perfectly but is approximated through individual negotiation, auctions, and personalized pricing based on customer data.

Second-Degree Price Discrimination

Offer different price-quantity packages and let customers self-select based on their preferences. Examples include quantity discounts (buy more, pay less per unit), versioning (good-better-best product tiers), and bundling (packages priced below sum of components).

Third-Degree Price Discrimination

Charge different prices to different customer segments based on observable characteristics. Examples include student and senior discounts, geographic pricing (different prices in different markets), time-based pricing (matinee versus evening movies), and channel-based pricing (online versus retail).

Type

Mechanism

Examples

Key Requirement

First-Degree

Individual pricing

Negotiation, auctions

Know each customer's WTP

Second-Degree

Self-selection menus

Versioning, bundles

Design revealing choices

Third-Degree

Segment-based pricing

Student discounts, geography

Observable segment indicators

Requirements for Effective Price Discrimination

Price discrimination requires market power (ability to set prices, not just take them), customer heterogeneity (different customers have different willingness to pay), segmentation ability (you can identify or sort customers), and limited arbitrage (low-price customers can't resell to high-price customers).

Yield Management

Yield management—also called revenue management—dynamically adjusts prices based on demand, capacity, and time. It originated in airlines and hotels but applies to any product with perishable capacity: seats, rooms, advertising slots, rental cars, even professional services time.

The core principle: maximize revenue from constrained capacity by charging more when demand is high or capacity is scarce, and charging less when demand is low to fill capacity that would otherwise go unsold.

Key Elements of Yield Management

• Demand forecasting: Predict demand patterns by time, segment, and channel
• Capacity allocation: Determine how much capacity to reserve for high-paying versus low-paying segments
• Dynamic pricing: Adjust prices in real-time as conditions change
• Overbooking: Accept more reservations than capacity to account for cancellations and no-shows

Case Study: Yield Management in Action: Airline Pricing Consider a 150-seat flight. Six months out, with low demand: fares start at $199 to build base load and attract price-sensitive leisure travelers. As departure approaches with moderate demand: fares rise to $349-$449, targeting travelers with firmer plans. Two weeks out with strong demand: fares reach $599, capturing business travelers booking late. Final seats for last-minute travelers: $899 or higher. The same seat sells for vastly different prices based on when purchased and demand at that moment. The airline captures consumer surplus from those willing to pay more while still filling seats that would otherwise fly empty. Sophisticated algorithms continuously optimize prices based on booking pace, competitive fares, and historical patterns.

Auction-Based Pricing

Auctions let market demand directly determine price. They're particularly useful when optimal price is uncertain, when buyer valuations vary widely, and when the item is unique or supply is limited.

Common auction types include English auction (ascending price, highest bidder wins—common for art and real estate), Dutch auction (descending price, first to bid wins—used for flowers, some IPOs), sealed-bid auction (simultaneous bids, highest wins—government contracts), and Vickrey auction (sealed-bid, winner pays second-highest price—encourages truthful bidding).

Online platforms have made auctions accessible for many product categories. eBay auctions for consumer goods, Google Ads auctions for advertising placement, and B2B exchanges for industrial commodities all use auction mechanisms to discover market-clearing prices.

Key Takeaways

• Price discrimination charges different customers different prices based on willingness to pay
• Three degrees: individual pricing, self-selection menus, and segment-based pricing
• Yield management dynamically adjusts prices based on demand, capacity, and time
• Auctions discover prices when optimal price is uncertain or buyer valuations vary widely