In the rush to capture first-mover advantage, many start-ups have offered untenably low prices. Because the Internet, the reasoning goes, is the most transparent and efficient of markets, low prices—for both consumers and businesses—outweigh such factors as product benefits, quality, and service.

Many incumbents, by contrast, have largely neglected on-line pricing and simply transferred their off-line prices to the Internet. They may have done so in the belief that their brand strength inoculates them against the threat posed by their new competitors. More likely, they felt pressure to establish an on-line presence before they had a chance to weigh the complexities of multichannel pricing.

But on-line customers are neither slaves to prices nor clones of traditional shoppers. Instead, they base their buying decisions on a wide range of factors. Far from being a price destroyer, the Internet can bring new detail to pricing strategy, creating enormous value. But companies must act quickly and rethink their on-line policies before habit and customer expectations make change difficult if not disastrous.

The reality of e-pricing

Low-price strategies aren’t without foundation. Indeed, of the various reasons to shop on-line, consumers cite price most frequently.1 But an analysis of consumer click-through behavior reveals that most buyers do very little cross-shopping (Exhibit 1). A separate study of on-line shoppers in North America reveals that only 8 percent of Internet users are aggressive bargain hunters.2 Most of the remainder keep returning to the same sites.

Now, the primary goal of businesses that buy on-line is cutting the total cost of ownership. On its face, this might suggest that they are more likely than retail consumers to shop for the best price. But in on-line business-to-business (B2B) markets too, factors other than price are driving most buyers’ choices.

In a recent McKinsey study, only 30 percent of purchasing managers identified lower prices as the key benefit of buying on-line. B2B purchasing managers said that they expected the primary benefits to be lower transaction and search costs—for example, less time required for paperwork—and automated purchasing information that permits them to track their purchases and to make better purchasing decisions. When asked to identify the source of these cost savings, only 14 percent said that they would come from the suppliers’ lower profit margins, so buyers clearly recognize the benefit, to both themselves and suppliers, of reduced transaction costs.

Business behavior confirms such findings. Half of the companies buying through reverse auctions don’t choose the cheapest supplier.3 Also, 87 percent of the buyers that didn’t choose the cheapest supplier stayed with their current ones, even at a higher price. Overall, only 15 percent of companies that make purchases over the Internet have even tried reverse auctions. Only 3 percent intend to continue using them in 2001.

Three ways to profit from the flexibility of e-pricing

Neither business-to-consumer (B2C) price insensitivity nor B2B purchasing behavior means that on-line suppliers can raise prices indiscriminately. While price may not be the most important factor, it is one of several that consumers weigh before making on-line purchasing decisions. It is critical that prices, both on- and off-line, be competitive so customers can meet strategic volume and profit objectives. Price changes that appear capricious or, worse, deceptive can cause long-term damage to a company’s price proposition.

The Internet gives companies that respect such constraints better information about who their customers are. It also gives these companies the flexibility to set the maximum price customers would be willing to pay and to adjust that price instantly as circumstances change.

1. Precision in price levels and price communication

The location of products within the pricing-indifference band can dramatically affect the profits of the companies that market them

All products have a pricing-indifference band: a range of prices within which price changes have little or no impact on customers’ willingness to make a purchase. Pricing-indifference bands can range from 17 percent for branded consumer health and beauty products to as little as 0.2 percent for some financial products. A product’s location within this band can dramatically affect a company’s profits. For example, a financial-services company moving from the middle to the top of a 0.2 percent indifference band for personal loans would increase the operating margins it earned from those products by 11 percent.

Determining the off-line boundaries of these bands is difficult, expensive, and time-consuming. Traditional price sensitivity research into a given product category can cost up to $300,000 and take from six to ten weeks to complete. No wonder only about a quarter of companies have conducted such research. In addition, only categories, such as airlines and other reservation-based industries, with enough price variability to create a statistically significant demand curve can be subjected to historical regression analysis. Market mechanisms define the extremes of a product’s price range but offer companies little help in determining how much room there is to maneuver within it.

But on the Internet, measurements of consumer tolerance for different price levels are cheap and instantaneous. If, for example, an e-business wants to test the sales impact of a 3 percent price increase, it might quote the higher price to every 50th visitor to its site. Such tests can also be used to predict volume fluctuations that result from price changes falling outside the pricing-indifference band.

The sales impact of labeling a price as a percentage discount or a limited-quantity offer can be tested in much the same way. For example, FairMarket, which sets up auctions and develops automated pricing technology, has found that discount sales move goods more quickly—and at higher prices—than do limited-quantity sales. Such continual testing of Internet pricing approaches is a low-risk way to develop pricing principles that won’t lead companies astray. In a brick-and-mortar store, these tests would be impractical or unaffordable.

2. Time flexibility in responding to market changes

Off-line price changes take time. B2B markets may need several months to a year to communicate changes to distributors, to print and send out new price lists, and to implement systemic changes. B2C prices, such as those printed on concert tickets, are set too far in advance to permit revision. On-line pricing allows companies to make instantaneous adjustments and thus to profit from even small fluctuations in market conditions, such as customer demand and competitors’ behavior.

Products that otherwise generate little demand may actually fare better on the Web because the consumer base is larger there

Contrary to the conventional view, companies can sometimes charge more on the Internet, especially when demand fluctuates sharply (Exhibit 2); Tickets.com has increased revenue for some events by up to 45 percent in this fashion. On-line prices for hot products—from video games to luxury cars to concert tickets—are 17 percent to 45 percent higher than off-line prices because the World Wide Web increases the chances of finding a buyer willing to pay a higher price. And as products near the end of their life cycle, companies can test the consumer’s willingness to continue to pay the established price. Consumer electronics companies that did so achieved a 17 percent increase in profits by delaying price reductions for two weeks. Products for which there is little demand fare better on-line as well because the consumer base is often larger on the Internet. AucNet attracts four to five times as many buyers as do traditional wholesale car auctions, for instance, and FairMarket has very successfully helped electronics and apparel companies dispose of excess inventory and obsolete products quickly and profitably.

In addition, the Internet allows companies to pinpoint their industry’s supply-and-demand situation and to revise their pricing structure accordingly. For example, when capacity utilization is high, order lead times short, or inventory levels low, prices can be raised temporarily. When demand sags, a company might try auctions, lower prices, or targeted short-term promotions. The ability to react quickly and decisively is essential. One electronics supplier realized an estimated $25 million increase in profits by adjusting prices faster than its competitors did after an overseas production shortfall led to temporary shortages of a key component.

3. Segmentation of prices

It is well understood that some consumers will pay more than others for a product because they attach great value to the benefits it offers. But in the off-line world, companies have trouble tailoring prices to customer segments—particularly retail segments—either because those companies cannot identify which customers to target before a purchase or because it is difficult to customize offerings. Usually, visitors entering a store are a statistical mystery. The sales staff has no idea what their buying histories are, what combination of price and benefits would be likely to trigger a purchase, whether they generally buy high-priced or discounted items, and whether some kind of incentive would turn their browsing into sales. The mystery is cleared up on the Internet. On-line companies can quickly segment their customers by drawing upon multiple sources of information, from clickstream data on the current on-line session to customer buying histories tracked in databases or stored in "cookies" on customers’ computers.

Once a retailer can identify an on-line customer’s segment, that retailer can immediately offer a segment-specific price or promotion. Ford, for example, expects that on-line customer information will significantly improve the yield from its nearly $10 billion in annual expenditures on promotional pricing. From time to time over the years, the automaker has offered discount financing and cash-back programs to all customers. But the Internet, by permitting Ford to track an individual customer’s history and behavior, should put an end to such wasteful blanket offers.

The Internet makes it possible to identify those consumers who are willing to pay a price premium

The Internet also makes it possible to identify customers willing to pay a price premium. An on-line electronic-components company, for example, relies on the purchase histories of its customers to determine if they are core customers, who buy a majority of their components from the company, or "fill-in" customers, who buy a majority of their components from its competitors and come to the company only in emergencies. Through segmented on-line pricing, this supplier regularly charges its fill-in customers up to a 20 percent premium on the price its core customers pay. Fill-in customers gladly pay that premium for an assured supply in crises.

Executing strategic on-line pricing

How does a company devise and execute an on-line pricing strategy that fully exploits the opportunities afforded by more precise pricing and segmentation and by greater speed in responding to market shifts?

Identify degrees of freedom consistent with strategy and brand

Given the pricing flexibility the Internet allows, companies must take care that the e-pricing approaches they favor don’t inadvertently conflict with key strategic objectives, core business principles, or brand promises. For instance, a company would not want to lower the price of a new product it intended to position as high benefit and upscale, even if research suggested that it could profitably increase volume in the short term by doing so. Similarly, a retailer that puts consistency and trustworthiness at the core of its brand image might not want to treat different customers in different ways. But a bank may decide it is safe to "price-segment" aggressively on-line because consumers understand that more affluent—and thus more profitable—customers may justifiably receive better interest rates on loans.

Amazon.com’s recent stumble demonstrates the risks of on-line price experiments. The company angered its customers and triggered a wave of bad publicity when, in a pricing test, it offered DVD buyers 30 percent, 35 percent, or 40 percent off the manufacturer’s suggested retail price. When the experiment was revealed, some who were quoted the smaller discounts complained. Companies setting out to undertake on-line price tests must take great care to safeguard customer relations—first by designing the test in the right way (for example, by choosing the right customers, products, frequencies, and price variations) and then by responding sensitively to complaints or inquiries. Above all, companies should remember that these tests aim to gather input for pricing decisions, not to generate revenue.

Build appropriate technological capabilities

The technology for optimizing e-pricing doesn’t necessarily require a huge initial investment. On-line surveys of customers’ reactions to prices, or software that monitors competitors’ prices, are inexpensive and without risk. Such rudimentary tracking and testing initiatives can provide a strong foundation for more sophisticated systems added later on.

Ideally, companies would support their pricing strategies with an array of techniques to monitor the behavior of customers, markets, and competitors. Several such techniques may be appropriate:

1. Conduct on-line tests to explore opportunities along three dimensions—pricing precision, time flexibility, and segmentation. Many companies have failed to move aggressively in these areas because they are used to operating in the off-line world, where mistakes take a long time to correct. The Internet, however, permits modest and relatively cheap tests of alternative prices and pricing structures, as well as tests of the effectiveness of the seller’s message. One kind of test can indicate the level of detail a company requires. A financial-services company with a fairly automated price analysis system, for example, might realize tremendous value by changing interest rates hourly. But an industrial manufacturer that wanted to make price changes only bimonthly would obviously require less sophisticated systems for tracking the peaks and valleys of supply and demand. On the segmentation dimension, an on-line office products supplier observed various customer groups responding quite differently to on-line price tests and used those insights to drive a fresh customer segmentation system and a new, differentiated approach to pricing.
2. Develop early indicators of customer price perceptions. The Internet is unmatched in its ability to reveal both the response of customers to prices and the boundaries of pricing-indifference bands. One consumer electronics retailer used a simple on-line survey to help it decide how to respond to other companies’ offers of the same products that were at or below cost. To the managers’ surprise, only 5 percent of nonbuyers cited lower prices as their primary reason for buying from a competitor. The retailer’s decision not to engage in a price war proved to be the correct one; within months, several pure-play rivals had gone out of business or announced price increases.
3. Use "look-to-book" ratios as another indicator of customer perceptions. Companies can monitor on-line customer behavior all along the purchasing process, comparing how many people visit a site with how many view and configure a product, check its price, or make a purchase. The ratio’s rise or fall outside certain thresholds could be a signal that the time is right for a price increase or, conversely, that the product isn’t worth the price charged.
4. Identify supply-and-demand imbalances. To take full advantage of the Internet’s flexibility, companies need to spot supply-and-demand shifts that justify price changes. While many companies collect this information for operational purposes, it must also be made available to pricing and marketing managers.

Be prepared to act

Armed with the information such techniques can glean, businesses should create an entrepreneurial pricing group. Many businesses selling on-line rely on pricing organizations and processes that fail to exploit e-pricing’s full potential because they have not been configured to do so. This is especially true of incumbents, whose approach to pricing on-line is often firmly grounded in their traditional pricing processes and organizational structures. Pure plays, by contrast, often fail to develop a pricing capability in the first place.

To improve their on-line pricing performance, companies must acquire the authority, the skills, and the tools to act decisively and confidently. Employees will have to be trained to handle the new statistical and testing tools as well as various semi-automated pricing tools.

Moreover, pricing authority should be concentrated in a single organization rather than turned over to multiple stakeholders, who inevitably lengthen the interval between the gathering of market information and the implementation of price changes. Finally, pricing responsibilities must be elevated to a higher strategic level within the marketing organization and the overall corporate structure.

Improved pricing represents a large and as-yet untapped opportunity for pure plays and for traditional off-line companies that have ventured onto the Internet. Getting pricing right has emerged as one of the ultimate keys to the success of e-businesses, but few companies have even begun to explore the opportunities.