Dynamic Pricing
Overview
Dynamic pricing adjusts prices in real-time based on demand signals, time, inventory, and competitive conditions. Common in airlines, hotels, ride-sharing, and e-commerce. Objective: maximize revenue (or profit) subject to capacity/inventory constraints.
When to Use
Trigger conditions:
- Pricing perishable inventory (hotel rooms, airline seats, event tickets)
- Implementing demand-responsive pricing for e-commerce
- Building surge pricing or time-based pricing systems
When NOT to use:
- For one-time pricing decisions (use Van Westendorp or conjoint)
- When price changes are impractical (regulated markets, long-term contracts)
Algorithm
IRON LAW: Dynamic Pricing Requires REAL-TIME Data
Stale data produces prices optimal for PAST conditions, not current ones.
Three data streams must be current:
1. Demand signal (bookings, searches, cart additions)
2. Inventory/capacity status
3. Competitive prices (where applicable)
Update frequency: minutes for ride-sharing, hours for hotels, daily for retail.Phase 1: Input Validation
Collect: current demand indicators, remaining inventory/capacity, time until expiration/event, competitor prices, price floor/ceiling constraints. Gate: Real-time data feeds connected, business rules defined.
Phase 2: Core Algorithm
Rule-based: If demand > threshold, increase price by X%. Tiered rules by inventory level.
Demand-curve based: 1. Estimate demand curve at current conditions. 2. Find price that maximizes revenue = P × Q(P). 3. Apply inventory constraint: if capacity is scarce, price up; if excess, price down.
ML-based: Train model to predict demand at each price point given context features. Optimize over predicted demand curve.
Phase 3: Verification
Monitor: revenue per unit, booking pace, customer complaints, competitive position. A/B test new pricing rules. Gate: Revenue improved without significant volume loss or customer backlash.
Phase 4: Output
Return recommended price with reasoning and expected impact.
Output Format
{
"recommended_price": 1200,
"current_price": 999,
"reasoning": {"demand_signal": "high", "inventory_remaining_pct": 15, "competitor_avg": 1100},
"expected_impact": {"revenue_change_pct": 18, "volume_change_pct": -5},
"metadata": {"strategy": "demand-curve", "update_frequency": "hourly"}
}Examples
Sample I/O
Input: Hotel room, 3 days until date, 85% occupancy, average competitor price $150 Expected: Price above competitor ($160-170) due to high occupancy, short time horizon.
Edge Cases
| Input | Expected | Why |
|---|---|---|
| Zero demand | Drop to floor price | Stimulate demand, recover some revenue |
| Last unit available | Price near ceiling | Scarcity maximizes willingness to pay |
| Competitor flash sale | Don't auto-match if unnecessary | Avoid price war; assess if your product differentiates |
Gotchas
- Customer fairness perception: Visible price discrimination (same product, different prices for different users) generates backlash. Segment by time, channel, or bundle — not by individual.
- Price war spiraling: Automated competitive pricing can create a race to the bottom. Set absolute floors and rate-of-change limits.
- Demand cannibalization: If customers learn prices drop later, they wait. This is the "strategic customer" problem — don't train customers to delay.
- Regulatory risk: Dynamic pricing may violate anti-gouging laws during emergencies. Build in legal constraint rules.
- A/B testing bias: Testing different prices creates revenue measurement challenges. The control group at the "wrong" price loses money by design.
References
- For revenue management models (airline/hotel), see
references/revenue-management.md - For fairness constraints in dynamic pricing, see
references/fairness-constraints.md