Ed McLaughlin and I just finished a very interesting study on consumer reaction to dynamic pricing in the restaurant and grocery industries.
We asked a variety of questions on attitudes toward dynamic pricing, but I want to focus on just a few. Before I get into the findings, let’s quickly talk about reference prices, rate fences and framing.
Before We Get Started
The reference price is how much people think something will cost and consists of things like the last price someone paid, prices seen in advertisements or perhaps on what friends have paid. If the actual price is higher than the reference price, customers may feel that it is unfair. Think about how the airline industry uses the concept of full fares. Hardly anyone pays full fare (maybe 3–4 percent of customers), but the airlines show other fares as discounts off of that full fare.
The possible reasons why people pay different prices are called rate fences. Rate fences take five basic forms: physical, controlled availability, customer characteristics, transaction characteristics, and product line. Regardless of the rate fence used, it must be clear to both customers and employees, must be easy to enforce and must make sense to customers.
This might seem like an academic topic but think about how the restaurant industry already uses rate fences. For example, “Taco Tuesdays” (day of week rate fence), “Happy Hours” (time of day rate fence), Restaurant Week, senior discounts, and coupons. Why am I focusing on rate fences? Well, you need to have reasons for charging different prices and your customers must be okay with them.
And, finally, let’s talk about framing. In one of my previous articles I talked about the benefits of framing prices as a discount. A simple example would be something like “you pay 20 percent less on weekdays” as opposed to "you pay 20 percent more on the weekends.” Even though they’re financially equivalent, research has repeatedly shown that consumers strongly prefer things presented as a discount. Keep that in mind as you read the rest of this article.
What Happens Without Rate Fences?
First of all, research has shown that customers hate prices bouncing all over the place without an associated rate fence. We decided to test this out in our study. We presented respondents with the following scenario “Imagine that you buy a certain pizza from the same restaurant every Friday night. You notice that sometimes the pizza costs $20, sometimes it costs $24 and sometimes it costs $16.” We then asked them to evaluate its acceptability on a 1–5 scale (1 being very unacceptable and 5 being very acceptable. The average rating was 2.54—as in they thought it was quite unacceptable. This result did not vary by gender, age or whether the respondent had children at home, but it did vary by frequency of ordering. Customers who ordered pizza more frequently were more likely to view varying prices as acceptable (2.96/5) than infrequent customers (2.11).
Testing Out Some Rate Fences
So what could be done to make dynamic pricing more palatable to customers. Time-of-day pricing and day-of-week pricing work well, but are there other approaches? We decided to test three other rate fences: loyalty membership, restaurant busyness and pre-orders. We framed the scenarios as either a premium (i.e. if you’re not a member of the loyalty program you pay more) or a discount (‘if you are a member, you pay less). Respondents were randomly assigned to three different scenarios. We then asked them to evaluate the acceptability of the scenario on a 1 (very unacceptable) to 5 (very acceptable) scale.
Loyalty programs provide value to the restaurant by not only helping them build a regular base of customers, but also providing them with customer data that can be used to better target marketing campaigns. Offering a discount to loyalty members can enhance the attractiveness of the program and help increase membership.
We presented respondents with either a discount (“if you’re a member of the loyalty program, you pay 10 percent less”) or premium scenario (“if you’re not a member of the loyalty program, you pay 10 percent more”). They viewed the discount scenario as significantly more acceptable (4) than the premium scenario (2.77). This is interesting, but what can you do with this result? Leverage your loyalty program.
Using Price to Spread Demand
During busy periods, operators often have challenges with fulfilling orders. The labor shortage has made this even harder. Some operators actually turn off online and delivery orders during busy periods because they don’t have the capability to fulfill them in a timely fashion. As a result, they forgo revenue and profit opportunity. All restaurants have peaks and valleys in their demand. If they can even their demand out, they can generate additional profit.
Can you use pricing to help spread out demand? Restaurants have used things like happy hour and early bird specials for years, but are there other things that can be done with pricing? We decided to test two different approaches out: having customers order during less busy periods and having customers order ahead.
Let’s start off with busyness. We again framed the questions as either a premium (i.e. if you order during a busy period, you pay 10 percent more) or a discount (i.e. if you order the during a slow period, you pay 10 percent less). Respondents were randomly assigned to one of the framing conditions for busyness. Respondents viewed paying less during a slow period as being significantly more acceptable (4.02 out of 5) than having to pay more during a busy period (2.77 out of 5).
In a similar vein, we looked at how customers viewed different prices for ordering the day before or ordering the same day. If customers order early, it gives the restaurant more control over when to prepare the order and helps them better manage their demand. Spreading out the load on the kitchen will allow them to be able to produce more and as a result, help the restaurant generate more profit. Again, we used framing. Half of the respondents were shown a discount scenario (“if you order the day before, you pay 10 percent less”) while the other half saw a premium one (“if you order the same day, you pay 10 percent more”). Bet you can guess the result. Discount framing was rated as significantly more acceptable (3.77/5) than the premium scenario (2.83/5).
The takeaway from this is to consider offering discounts during your slower periods. Use the prices during your busy periods as your “reference price.” This is similar to what hotels do with their rack rates and airlines do with full fares. This helps you avoid saying that you’re increasing your menu prices, but gives you the opportunity to generate additional revenue during your slower periods.
Back again to what should you do? Don’t be afraid to experiment with prices that vary by demand or loyalty status. But, when you do, be sure to frame the “regular” prices as a discount. And again, keep an open mind toward dynamic pricing. It holds great potential for the restaurant industry. I’d love to hear some examples of what you’ve tried.
Sherri Kimes is an Emeritus Professor at Hotel School at Cornell and specializes in pricing and revenue management. She is passionate about helping restaurants increase profitability. She can be reached at firstname.lastname@example.org.