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Revenue Management

Session 1:
Introduction to Pricing
Optimization

John Birge
University of Chicago Booth School
of Business
© JRBirge 40108 RM, Winter 2019 1
Goals for Today
• Understand the objectives of the class
• Provide overview of revenue
management and pricing optimization
• Review principles of price theory
• Define objectives for and review Solver
in Excel

© JRBirge 40108 RM, Winter 2019 2


Basics
• Introductions
• Syllabus and materials
• Class format
• Groups
• Case summaries/concept checks

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General Information
• Instructor: John Birge, john.birge@chicagobooth.edu
• TA: Kevin Chen, hongfan.chen@chicagobooth.edu
• Lecture notes: Will be updated each week by Wednesday –
print out before class (no handouts in class)
• Assignments (20%): every week except midterm
- Submit on Canvas for group (4 or 5)
- Mix of case and concept checks (data-driven computation)
- Discuss grading with TA first
• Reviews: tba
• Participation/peers (10%) ; Midterm (25% droppable)
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More Info
• Optional text: Phillips, Pricing and Revenue
Optimization
• Other background: Reviews and McAfee
pricing notes (on Canvas)
• Groups: Form for Week 2 assignments
• Canvas: source of latest information

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Objectives of Pricing and Revenue
Management
• Improve your ability to maximize net
contributions to an organization by knowing:
– How to recognize opportunities
– How to differentiate opportunities
– How to segment markets
– How to incorporate capacity, time, uncertainty
– How to solve basic models
– How to define implementation requirements

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Background on Revenue
Management
• Tactical versus strategic pricing
• Drivers:
– Differentiated products and services
– Identifiable variability in consumer preferences
– Costly capacity
– Available information
– Price communication capability

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Themes
• Available capacity for products and services is
limited especially in the near term
• With limited capacity, the profit maximizing
price may increase
• Segmenting time- and quality-sensitive
customers can lead to additional gains from
fixed capacity
• Commitment decisions may vary with the form
of uncertainties (but basic principles apply)
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Identities
• Names for pricing with limited capacity and
variable demand
– Revenue management
– Yield management
– Dynamic pricing
– Demand management
– Pricing optimization
• Common theme
– Set prices to best use available resources
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Major Industry Users
• Airlines (rail, etc.)
• Hotels (cruise lines, travel and hospitality)
• Entertainment (e.g., Sports:
http://online.wsj.com/article/SB10001424052748704065404574636622642639610.html )
• Rental agencies
• Media (advertising)
• Energy and petro-chemicals
• Telecom and utilities
• Retail
• Real estate
• Freight
• Services (consulting, healthcare, professional)
• Manufacturing and distribution
• Consumer goods
• …

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Why the focus on revenue?
Airline costs (http://www.airlines.org/economics/finance/Cost+Index.htm)

Cents per Share of


Cost Share ASM OpExp

FUEL 10,222 28.7% 4.04 29.4%


LABOR 7,448 20.9% 2.94 21.4%
AIRCRAFT RENTS & OWNERSHIP 2,204 6.2% 0.87 6.3%
NON-AIRCRAFT RENTS & OWNERSHIP 1,530
2,73 4.3% 0.60 4.4%
PROFESSIONAL SERVICES 6 7.7% 1.08 7.9%
FOOD & BEVERAGE 468 6 1.3% 0.18 1.3%
LANDING FEES 15 1.7% 0.24 1.8%
MAINTENANCE MATERIAL 587 1.6% 0.23 1.7%
TRANSPORT-RELATED EXPENSES 4,985 14.0% 1.97 14.3%
OTHER OP. EXPENSES 2,651 7.5% 1.05 7.6%

Suppose United has $20B rev., $18B expenses,


Net=$2B
Note: 10% " revenue  100% "net income

Biggest expense: Fuel (~30%) : 10% +  ~25% "net


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Models
Goal: Use data and tools to determine prices
and controls to maximize contributions:
1. Subject to capacity constraints
2. Segmenting based on value to consumer
3. Marking down limited supply Key:
Uncertainty
4. In auctions with customized bids
5. Controlling a single-resource over time
6. Allocating multiple resources over time
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RM Operations
• Capacity: position for different markets
• Pricing: separate for fare size/length of rent
(fare class)
responding to competition and customer
willingness to pay within segments
• Tactical controls:
Length of rent/fare class booking limits; upgrade
planning; overbooking
• Exercise: Use for a restaurant?
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Traditional Pricing Approaches
• Cost-plus: Take the cost of each unit of product and add on a
markup (e.g., 25%).
• Market-based: Price the product according to the
competition’s price.
• Value-based: Set a price based on the value of the product to
the customer
Example: Open a new coffee shop on 57th Street:
- Marginal cost of medium cappuccino=$1
- Price at Z/M (competitors)=$3.50
Prices? (Markup=150%, Value basis?)
Cost+=$2.50; Market=$3.50; Value=Depends on differentiation
+/- of each approach? 14
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Value-Based Price: Consumer Choice Model
How does a customer decide on what to buy?
Maximize Value minus Cost
• Customers Consider Net Value
• Our Product
– Our Benefits - Our Price = VUs - pUs
• Competitor’s Product
– Their Benefits - Their Price = VThem - pThem ∆V –
Differentiation
• Consumer Choice value
• Select our product if:
[VUs-pUs] ≥ [VThem-pThem]
R -Reference
(VUs-VThem) + pThem ≥ pUs value
∆V + R ≥ pUs
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Economic Value to Customer
Reference
Value
Economic Value
to the Customer
Differentiation
Value

• Reference Value: Price of what customer views as best


substitute
• Differentiation Value: Value of differentiating attributes
• Example: Suppose customers value Z/M’s coffee with
$0.50 premium/cup – what is Economic Value to
Customer?
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Measuring Willingness-to-Pay
• Price elasticity: (-) % change in demand for 1%
change in price (=-(ΔD/D)/(ΔP/P))
Suppose: 200 seats at $150; 150 seats at $200
Demand is linear: D(P)=Dmax-mP
Exercise:
Find D(P) and elasticity at P=$150 and at
P=$200?
How does elasticity change as price increases?
(More or less elastic?)
Elasticity at $150=-(ΔD/D)/(ΔP/P)=-(-50/200)/(50/150)=3/4
Elasticity at $200=-(ΔD/D)/(ΔP/P)=-(50/150)/(-50/200)=4/3 17
© JRBirge 40108 RM, Winter 2019
Common Price-Response Functions
• Linear: D=Dmax- m P
• Constant elasticity: D=C p-ε
• Logit: D=Ce-(a+bP)/(1+e-(a+bP))
– assumes consumer demand with logistic distribution
– multinomial extensions for choice among several
alternatives
• Look at graphs and elasticity
Note: role of competitor here (passive)

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Constant Elasticity
Which of these has elasticity= 0.5, 1, and 2?
1 1 1

0.9 0.9 0.9

0.8 0.8
0.8

0.7 0.7
0.7

0.6 0.6
0.6

0.5
0.5
0.5

0.4
0.4
0.4
0.3
0.3
0.3
0.2
0.2
0.2
0.1
0.1
0.1
0
0 0 10 20 30 40 50 60 70 80 90 100
0 0 10 20 30 40 50 60 70 80 90 100
0 10 20 30 40 50 60 70 80 90 100

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Logit Demand
• Which has highest/lowest b?
( D=Ce-(a+bP)/(1+e-(a+bP))=C/(e(a+bP) +1) )
(a=-modalWTP*b=-(most-likely willingness-to-pay)/b)
4 4
x 10 x 10 4
2 2 x 10
2

1.8 1.8
1.8

1.6 1.6
1.6

1.4 1.4
1.4

1.2 1.2
1.2

1 1 1

0.8 0.8 0.8

0.6 0.6 0.6

0.4 0.4 0.4

0.2 0.2 0.2

0 0 0
0 0.5 1 1.5 2 2.5 0 0.5 1 1.5 2 2.5 0 0.5 1 1.5 2 2.5
4 4 4
x 10 x 10 x 10

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Costs: Incremental vs. Fixed
• Firm’s total costs = variable costs + fixed
costs
• Definition of fixed costs: must be paid
regardless of quantity sold/produced
• Does this distinction matter for pricing?
• Example: what are fixed and variable costs
for our coffee shop?

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Incremental vs. Fixed Costs
• Not always obvious which costs are fixed—
depends on choice frame
– Time horizon matters a lot
• Month-to-month, many costs are fixed
• Year-to-year, inputs can be more flexibly adjusted to
demand conditions
– Key question: how long price must apply
• In long-term contracts where price is pre-set, even
“overhead” can be variable

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Caribbean Sailing Cruise
Adventure

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On Board

Video

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Caribbean Cruise Info
• Departure: any day in June
• Length of cruise: 5 nights
• Ship: 50’/3 cabins/2 crew
(capt./chef)/No AC
• Location: St. Thomas/US/British VI’s
• Price for two people includes all meals
• Airfare: not included

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Game Stages
1. Individual maximum valuations
2. Static pricing (2 rounds)
3. Dynamic pricing
4. Segmented customers and limited capacity

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What price Vertigo?
1. Pricing levels? Market segments? Other
segmentation strategies? Threats?
2. U2.com discounts
– Single price?
– Discount?
– Limit difference to €30?
3. Seated (poor view) option
• Pricing?
• Note differences in Marginal Revenue/Marg.
Space
• Who gains from separate prices?

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What price Vertigo?
1.Segmentation strategies
2.Demand model
3.Optimize prices (one vs. many)

1. Segment 2. Design 5. Manage


3. Forecast 4. Manage Price
the market product line Inventory/
demand Decisions
Availability

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4D Segmentation
Product

Channel Time

Customer
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Vertigo demand curves
50000

45000

40000

35000

30000
Demand

Mem bers
25000 General public
Total
20000

15000

10000

5000

0
0 20 40 60 80 100 120 140 160 180 200
Price

Members Dm(p) = 10,000 – 125 p = 10,000 (1 – p/80)


General public Dg(p) = 40,000 – 200 p = 40,000 (1 – p/200)
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Which segment is more price sensitive?
 Pm 
= Dm 10000 1 − 
• U2 member demand :
 80 

Number of Probability any one


consumers in the consumer decides to
segment purchase

 Pg 
• =
General public demand: Dg 40000 1 − 
 200 
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Which segment is more price sensitive?
1

0.9

Members
0.8
General public

0.7
Purchase probability

0.6

0.5

0.4

0.3

0.2

0.1

0
0 20 40 60 80 100 120 140 160 180 200
Price

For any given price, a U2.com member is less likely to buy than a general public person.
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Vertigo: No Segmentation
If U2 were to charge a single price for GA tickets,
what would it be?
Revenue
2500000

€100 maximizes the revenue 2000000

for 20,000 capacity 1500000

(see chart) 1000000

500000

0
0 50 100 150 200 250

Series2

Which customer segment would benefit from differential pricing?

The members benefit since they receive no utility with a single price.
(Think of airline pricing: who benefits from differential pricing?)

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Revenue
Price = 40 maximizes revenue
curves
from U2.com members 2250000

• Price = 100 maximizes revenue 2000000 Members


General public
from the general public Total
1750000

1500000
• Price = 100 maximizes total
1250000

Revenue
revenue
1000000

• If only one price is feasible, 750000


then the optimal price excludes
500000
the U2.com members
250000

0
0 20 40 60 80 100 120 140 160 180 200

Vertigo: which 2 prices?


Price

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Pricing Optimization
• Goal: Find the price to maximize the net contribution:
Max (P-C)*D(P) over P
where P=price, C=constant incremental cost, D(P)=demand
• Alternatives: 1) Use Solver in Excel.
• 2) If no other constraints, use Marginal Revenue=Marginal Cost:
D(P)+PD’(P)=CD’(P)
where D’(P) is the derivative of demand with respect to price
For linear demand, D(P)=a-bP, D’(P)=-b (slope of demand curve)
Exercise: Suppose demand D(P)=40,000-200*P, cost C=100
What is the contribution-maximizing price with no constraint?
P*(Cost=100)= €150
What if C=0? P*(Cost=0)= €100
What if the capacity is 16,000? If C=100=> D(P*(C=100))=10,000<16,000;
so no change in price; C=0 => D(100)=20,000 so now Pconstrained increases to the
Sell-out price where D(Psell-out)=16,000 or Psell-out=120.
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Pricing with Capacity
• If demand exceeds the capacity at the profit
maximizing price, then the capacitated
profit maximizing price is the sell-out price
where Demand=Capacity.
• Here, D(puncon)=20,000
• Set pcon=16,000 so that D(pcon)=16,000
So, 40,000 – 200 pcon=16,000 => pcon=120

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Pricing Optimization with the
Solver
• Objective: Maximize the total contribution
(Here: prices times quantities or
(prices-costs)*quantities)
• Subject to not exceeding capacity:
• Sum of the capacity used by each product
<= Total capacity
(often: prices and quantities >=0)
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Building an optimization model
• Objective:
(set target cell)

• Decision variables:
(by changing cells)

• Constraints:

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© I.Popescu 2011 DPRM 2


Building an optimization model
• Objective: maximize revenue
(set target cell) max Pm * Dm + Pg *Dg
• Decision variables: prices for members and
general public
(by changing cells) Pm =? Pg =?
• Constraints: total sales ≤ capacity
Dm + Dg ≤ C

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© I.Popescu 2011 DPRM 2


Building an optimization model
• Objective: maximize revenue
(set target cell) max Pm * Dm + Pg *Dg
• Decision variables: prices for members and
general public
(by changing cells) Pm =? Pg =?
• Constraints: total sales ≤ capacity
Dm + Dg ≤ C
no short-selling: Pm ≥ 0 Pg ≥ 0
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DPRM 2
Vertigo optimization model
max Pm * D m + Pg * D g
Pm , Pg
D m + D g ≤ 20000

Dm= 10,000 – 125* Pm


Dg = 40,000 – 200* Pg

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© I.Popescu 2011 DPRM 2


Vertigo optimization model
max Pm * D m + Pg * D g
Pm , Pg
D m + D g ≤ 20000

D m = max( 10,000 – 125* Pm , 0)


D g = max( 40,000 – 200* Pg , 0)

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• Data
Building an Optimization Model
• Objective:
(one cell)
• Variables:
(one cell per decision)
• Constraints:

You calculate > Solver optimizes by (smartly) varying the values of the variables
• Build a spreadsheet to calculate the objective for any input value of the variables
• Initialize the decision variable cells to some values (cannot leave blank)
• Run solver
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Check Solver Options
• Objective:

• Variables:

• Constraints:

Objective & constraints linear in the variables?


Can variables be negative?

Hint: if in doubt, uncheck everything


(check if solution makes sense)

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© I.Popescu 2011 DPRM 2


Building an optimization model
• Objective: maximize revenue
(set target cell) max Pm * Dm + Pg *Dg
• Decision variables: prices for members and
general public
(by changing cells) Pm =? Pg =?
• Constraints: total sales ≤ capacity
Dm + Dg ≤ C
no short-selling: Pm ≥ 0 Pg ≥ 0
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Pricing with a capacity constraint
• Optimal two prices are Pm =55 and Pg = 115
– Use solver in Excel:
Segment Price Quantity Revenue

Members 55 3077 170414


General public 115 16923 1952663

Total 20000 2123077


decisions constraint objective
• Constraints complicate the analysis of optimal prices:

–With no constraint we can optimize the price of each


segment separately.
–With a constraint the optimal price to one segment
depends on the price for the other segment (opportunity
cost)
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Marginal Revenue=Marginal Cost
with Capacity
• Raising price p leads to:
1) Marginal revenue (in price):
Decreased demand effect: pd’(p)=-200p
Increased price effect: d(p)=4000-200p
2) Marginal cost:
Direct cost effect: cd’(p)=0
Marginal cost effect: λd’(p)=0 where
λ is the shadow price or Lagrange multiplier.
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How to Find Lagrange Multiplier
(Shadow Price) in Solver
• Solve the
model:

• Run
Sensitivity
report:

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Finding Lagrange multiplier:
Sensitivity Report
Lagrange multiplier in the Sensitivity Report
(nonlinear model):

Note: shadow price in linear model sensitivity report.


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Checking with MR=MC
1) Marginal revenue: pd’(p)=-200p
+d(p)=40,000-200p
pd’(p)+d(p)=40,000-400p
2) Marginal cost: λd’(p )=-200 λ
MR=MC?
MR=40,000-400 p = 40,000-400*115.3846
= -6153.85
=
MC= -200 λ=-200*30.7693=-6153.85
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© JRBirge
Lessons from Solver
• Finds multiple values simultaneously to
maximize or minimize an objective where
resources are limited
• The solver also finds the marginal value of
additional resources in Lagrange multiplier
(or shadow price)
• Result still reflects marginal revenue equal
marginal cost with opportunity cost for
resources
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Value of Sitting?
• Suppose only the GA and they can add seats
where 2 seats occupy 3 standing places
What is the optimization model?
max Ps * D s + Pn * D n
Ps , Pn
1.5 D s + D n ≤ 20000
D s = 22,000 – 100* Ps
D n = 20,000 – 100* Pn
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Vertigo: State & criticize assumptions?
• Demand for one type of ticket is assumed
independent of the price of the other ticket

• Surely demand for seats depends on the price


of seats relative to the price of regular tickets.

• Here we have two substitutable products, so


a more complex demand model is needed.
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Today to Take-away
• Revenue management focuses on planning
pricing together with capacity, customer
segmentation, and controls within and across
segments
• By modeling carefully, significant revenue gains
and multiples in net contribution
• To apply RM correctly requires understanding
of customer willingness-to-pay and marginal
costs (including lost opportunities)
• Can use optimization solvers to maximize value
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For Next Time
• Miscellaneous articles on segmentation
• Problems for practice/discussion
• Concept Check 1 with data from game
• CSC to hand in (Try logically without Solver)
Goals: practice using Solver for simple problems;
understand tradeoffs with fixed capacity;
consider segmentation possibilities
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