Whether in your business or personal life, you’ve probably had to work with someone incapable of accomplishing a task without being given detailed instructions every step of the way. That’s a bit like most modern computers. They’re tremendously capable if the problem they’re solving is well-defined.
Machine learning is like working with someone who only needs to know the goal and can determine how to get to it on their own. Imagine taking a company full of people who need instructions for everything and replacing them with real problem solvers. This is only part of the potential of machine learning.
Machine learning flourishes in areas where humans can’t; places where our biases hold us back. No wonder it’s perfect for pricing optimization. As odd as it sounds, we humans are pretty bad at determining how much something should cost. This costs businesses big, and most don’t even know how much they’re losing.
What Is Price Optimization?
Price optimization is a method to determine the best price or set of prices for your business offering. Talking about the “best price” is easy, but price optimization is about trade-offs. Ask yourself what matters most to your company: customer lifetime value, customer loyalty, quantity of product sold, average price per product sold, or even which products to make cheaper so others can be more expensive (AKA the grocery store model).
To understand price optimization, you need to understand the factors that go into it from the customer side.
How Do Customers React to Different Pricing?
Consider history and context. Pricing is just numbers, but the way customers react to it is deeply human and therefore quite complex. Let’s break down some of the elements at play:
Obviously, if a product was previously $10 and is now $7, that $7 price will not be perceived the same by humans compared to a product that was formerly $5. This pricing history is as important a factor for machine learning as for humans addressing price optimization.
Your company’s reputation may come into play. Are you known for competitive prices? Much like the previous example, this can account for customer reactions that wouldn’t otherwise make sense.
If your competitors adjust their prices, customer perception of your prices will be affected.
Is it more important for your firm to beat the price of said competitor? For example, do you need to make sure your prices are always equal or lower than Amazon’s?
Look at the time that Walmart faced customer backlash by offering different prices for items online and in stores. The context in which someone sees a price matters, primarily when it comes to online vs brick and mortar stores. The ease with which products and services can be price-compared online means customers have different expectations and reactions to pricing.
As seasons change, so do humans and their buying patterns. Price optimization needs to take seasons into account as well (or even hour-to-hour weather data).
Price optimization has to take input costs into account if it’s going to optimize a final sale price, so using operating costs is essential.
There’s hardly a more central concept to price than demand, so this must be built into the core of any price optimization strategy.
As mentioned above, your particular KPIs you have are crucial in determining your optimal price.
The Four Key Prices in Pricing Optimization
Price optimization strategies can also work to individually determine:
Above, we mentioned how the initial price can affect how customers perceive a later price. Price optimization strategies can actually determine optimal initial prices which can be based on the season, time of day, or other factors.
This is the general price which best meets your unique KPIs.
This answers the question: If you’re starting with an initial price, what is the ideal discount price based on that starting point?
Taking human psychology into account, what price is optimal in the context of a one-time promotion? How does that change based on the promotion (e.g. How Black Friday expectations compare to Christmas expectations)?
How Machine Learning Helps Price Optimization
We’ve established the complexity of price optimization, but how do the unique capabilities of machine learning help? How can a model successfully take all of these factors into account when determining optimal prices?
A machine learning model is only as good as the data its fed. The process begins with data scientists carefully evaluating your data sources, then ensuring that they’re accurate and fed into the model correctly. With quality data, these models determine whole price distributions (say, comparing money earned upfront to customer lifetime value) along with numerous variables which can help you determine the best price for your goals.
Machine learning can also predict how customers will respond to prices they haven’t yet encountered. By plotting responses and predicting patterns, you can evaluate pricing strategies at a basic level without necessarily having to execute each one. These techniques can even be applied on the level of individual customers, determining the optimal price for a specific person based on what your company knows about them.
Here’s a breakdown of just how machine learning algorithms achieve these goals:
- Gather Data: Machine learning models can either work entirely off of a historical data set, live data, or – as is most often the case – a combination of the two. In any case, the model must first be trained using an initial data set before it can begin price optimization.
- Define Goals and Limits: Here, you input the parameters to shape the model. More specifically, these parameters will tell the model which KPIs are most important to you.
- Choose an Algorithm: While machine learning is a catch-all term, there are many variations. Such algorithms can be supervised or unsupervised, explainable or unexplainable, generative or discriminative, etc. You’ll need to work with a data scientist to determine the optimal algorithm for your needs.
- Modeling and Training: The individual model is then built and prepped with the training data. At this point, you can begin to determine whether you’ve made the right choices in steps 1-3.
- Tweak the Prediction Mechanism: At this stage, the model goes through thousands of iterations, testing assumptions, and adjustments of its prediction mechanism. This is, essentially, the machine learning model “learning”.
- Execute and Adjust Prices: Once you have a price, it’s time to test it, gather data, and repeat the process, if necessary.
Advantages of Machine Learning in Price Optimization
Not Thinking Like a Human
As briefly noted above, humans are plagued by biases and tend to think in relatively similar ways when approaching problems. Machine learning models, by contrast, are left to approach problems in ways a human may have never considered.
Number and Nature of Parameters (Large Amount of Products)
There are only so many things the human mind can consider at once. With each additional variable potentially affecting all the others, the complexity of these pricing models increases exponentially. That makes them ideal for machine learning.
Multiple Sources and Channels (Optimizing Prices Globally)
As the number of data sources increases, so does the difficulty for humans to take them all into consideration.
High Level of Accuracy
It’s not simply that machine learning models are highly accurate, but that you can determine the level of accuracy that’s appropriate for your needs. Do you need to be 99% certain of a conclusion or just 90%? Adjustable confidence gives you more options.
Anticipating Trends at Earlier Stages
With enough data, machine learning models can spot and anticipate trends that a human may never have noticed.
The Ability to Crawl the Web and Social Media to Gather Valuable Information:
- Prices of competitors
- What customers say about products and competitors
- Top deals
- Price history
Companies Already Using ML in Their Pricing Models
Brands from fast fashion Zara to higher-end Michael Kors don’t just use machine learning for pricing: They rely on it. Everything from deciding when to stock products to how much those products should sell for, AI touches nearly every stage of their products and is viewed as an essential tool in this highly-competitive space.
You’ve likely heard that your location, previous buying habits, and number of website visits can all impact airfare prices. Airlines have been on the cutting edge of price optimization the 1970s, but today, that extends far beyond simple tickets. Airlines need to consider how options like baggage policies, loyalty programs, aircraft type, and departure times impact the prices customers are willing to pay. For those needs, machine learning is the only option.
2004 was a big year for major hotel chains like Hilton and Intercontinental, when they ended fixed pricing and introduced their first variable pricing model. Today, variable pricing is an industry standard, allowing hotels to factor in innumerable variables to calculate the optimal price for each individual customer. These techniques have been so successful for hotels that major chains have increased the adoption rates of dynamic pricing.
It’s no wonder that companies across numerous industries are building their price optimization with machine learning. What do you need in place before using this technology to address your own business needs?
Prerequisites for Price Optimization with Machine Learning
As much as we’d like to imagine that machine learning algorithms will solve our pricing problems on their own, success wholly depends on cooperation with data scientists and business professionals. For this (and other big data analytics solutions) to work, there are certain requirements:
Be Open to Using External Sources of Data
This may include information from your competitors, stock market, and even the National Weather Service. What matters is the complexity of customer psychology, meaning that it’s nearly impossible to conduct reliable price optimization without some external data sources for context.
Access to All Kinds of Internal Data
Larger organizations often face the challenge of various departments siloing themselves off and not sharing data or learnings. This poses enormous business challenges, but for machine learning, it can be disastrous. As mentioned above, a model is only as good as the data you give it, so having free access to quality data from all parts of an organization is paramount.
Quality Professionals on Both Sides
While you obviously need quality data analytics professionals with experience in using machine learning for price optimization, you also need business professionals ready to work with them. These data professionals will need help translating business KPIs into algorithm parameter, and the business professionals will need help analyzing the data which comes out. It’s a symbiotic relationship which is just as important as the quality of the technology you’re using.
RapidMiner for Price Optimization
Are you ready to take on machine learning and start impacting your business? Data science platforms like RapidMiner can help jumpstart your project. Built for analytics teams, RapidMiner unifies the entire data science lifecycle from data prep to machine learning to predictive model deployment. 400,000 analytics professionals use RapidMiner products to drive revenue, reduce costs, and avoid risks. Contact us about your project or get started with our 30-day free trial of RapidMiner Studio Large.
What You Should Learn Next
Now that you’re familiar with the fundamentals of machine learning for price optimization, you should learn about prescriptive pricing. This is a slightly more complex way of applying machine learning to complex decision making like price optimization. Used well, it has tremendous benefits on top of the basic capabilities of machine learning outlined here.