The pricing of services

Abstract

This paper aims to provide a deeper conceptual understanding of demand behavior and the pricing of services. It argues why all services are sold in advance and shows how the specificities of services result in two types of risks faced by buyers that buy in advance, that of unavailability of service and a low valuation of the service at the time of consumption. Furthermore, advanced buyers run the risk of not being able to consume at the time of consumption and this relinquished capacity may be re-sold by service firms. The paper develops a theoretical model that shows that advance prices are always lower than spot prices. Also, providing a refund to advanced buyers may improve revenue. A counter intuitive result demonstrates that the firm's strategy may be pareto optimal in that a guarantee against capacity unavailability as well as a refund guarantee against valuation risk may be offered to advance buyers at a lower advance price than if a refund offer is not provided. Finally, the study also shows that the firm can earn higher revenue when the risks are asymmetric. Profits are higher when the market faces high valuation risks than when the market faces unavailability risk.