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dynamic_pricing_and_revenue_management_converted.pdf
Dynamic Pricing and
Revenue Management
IEOR 4601 Spring 2013
Professor Guillermo Gallego
Class: Monday and Wednesday 11:40-12:55pm
Office Hours: Wednesdays 3:30-4:30pm
Office Location: 820 CEPSR
E-mail: [email protected]
Why Study Dynamic Pricing and Revenue
Management?
¡� Revenue Management had its origins in the
airline industry and is one of the most
successful applications of Operations
Research to decision making
¡� Pricing and capacity allocation decisions
directly impact the bottom line
¡� Pricing transparency and competition make
pricing and capacity allocation decisions
more difficult and more important
Applications of Dynamic Pricing and
Revenue Management
¡� Capacity allocation of limited, perishable,
resources to different fare classes
l� Airlines, hotels, car rentals, cruises, travel packages, tickets for events
¡� Design and pricing of products
l� Fare restrictions and pricing
l� Consumption and fulfillment options
l� Upgrades, downgrades and upsells
¡� Pricing under competition
l� Electronic-commerce
Objectives of this course
¡� Understand the critical tradeoffs and
decisions in Revenue Management
¡� Learn how to
l� Monitor and control product availability for single and multiple resources
l� Overbook limited resources when customers
shows are random
l� Use upgrades, upsells and real options to improve revenues
l� Price under competition
l� Improve on the current practice of Revenue
Management
“Physics should be explained as simply as possible, but no simpler.”
Albert Einstein
Professor Gal ego’s experience and
background on subject
¡� Author of seminal papers on dynamic
pricing and revenue management
¡� Winner of several prices from academia
and industry related to work on Revenue
Management
¡� Consultant for airlines and RM solution
providers
¡� Consultant for other users of Revenue
Management
Readings
¡� Class Notes
l� I will provide with notes of the different topic we cover in class
¡� Textbook
l� R.L. Phillips, Pricing and Revenue
Optimization, Stanford University Press,
2005, ISBN 0-8047-4698-2.
¡� References
l� K.T. Talluri and G.J. Van Ryzin, The Theory and Practice of Revenue Management,
Springer, 2005, ISBN 0-387-24376-3.
l� Assigned papers
Prerequisites and Grading
¡� Prerequisites
l� Probability and Statistics at the level of IEOR
4150
l� Deterministic Models at the level of IEOR 4003
¡� Corequisites: Stochastic Models IEOR 4106
¡� Grading
l� Assignments
20%
l� Midterm
35%
l� Final
45%
Introduction to Revenue Management
¡� Revenue Management refers to the
strategy and tactics used by perishable
capacity providers to allocate capacity to
different fare classes or market segments
to maximize expected revenues. (See
Chapter 6 in Phillips.)
¡� RM is often practice when
l� Sellers have fixed stock of perishable capacity l� Customers book capacity prior to usage
l� Seller offers a sets of fare classes
l� Seller can change the availability of fare
classes
History of Revenue Management
¡� Prior to 1978 the Airline Industry was
heavily regulated
¡� In the early 80’s the industry was
deregulated to encourage new entrants
¡� Low-cost carriers such as People Express
started encroaching into key markets of
large carriers
¡� American Airline dilemma:
l� Match fares and lose money
l� Keep fares and lose customers
AA’s Response to People Express
¡� Ultimate Super Saver Discount Fare
l� Same fare as People Express
l� Passenger must buy at least two weeks
prior to departure
l� Stay at his destination over a Saturday
night
¡� AA restricted the number of
discount seats sold on each flight to
save seats for full-fare passengers
Rational and Impact of Strategy
¡� Product Design
l� Imposing restrictions that appealed to the
leisure segment without cannibalizing the
business segment
¡� Capacity Allocation
l� Carefully control capacity to maximize
revenues
¡� Strategy started in January 85
l� PE was struggling by March
l� PE was at the verge of bankruptcy by August
Post-mortem
¡� People Express was bought by
Texas Air for 10% of the market
value it had enjoyed a year before
¡� “We had great people, tremendous
value, terrific growth. We did a lot
of things right. But we didn’t get
our hands around the yield
management and automation
issues.” Donald Burr CEO of PE
RM: The System Context
¡� AA was based on a computerized
reservation system (CRS) called Sabre
developed in 1963. This system:
l� Replaced index cards to manage reservations
l� Sabre is also a GDS (global distribution
system) that allowed AA to distribute its
products and fares globally
¡� Other GDSs: Amadeus, Galileo, Worldspan.
RM Constraints Imposed by Systems
¡� AA’s used Sabre’s Computerized
Reservation System as the backbone to
Revenue Management
l� The reservation system served as a repository of all the bookings that have been accepted for
future flights
l� The CRS also contains the controls that specify how many bookings from different fare classes
the airline will accept on future flights
¡� Remember: RM systems were developed
in the context of existing CRSs.
Levels of Revenue Management
¡� Strategic:
l� Market segmentation (leisure vs business)
l� Product design (restrictions, fares, options) l� Pricing (Static vs. Dynamic)
¡� Tactical:
l� Calculate and updated booking limits
¡� Booking Control:
l� Determine which booking to accept and which
to reject based on booking limits
Strategic Revenue Management
¡� Design low fares to increase sales without
cannibalizing full fare demand
l� Time of Purchase Restrictions
¡� Advance purchase requirements
l� Traveling Restrictions
¡� Saturday night stays
l� High cancellation and change penalties
¡� Other opportunities
l� Contingent options on capacity
l� Flexible and callable products
Tactical Revenue Management
¡� Resources
l� Units of capacity
¡� Seats on a flight
¡� Hotel capacity for a specific night
¡� Products
l� What consumers seek to purchase
¡� May involve one or more resources
¡� Fares
l� A combination of a price and a set of
restrictions
Tactical Definition of RM
¡� A supplier controls a set of resources with
fixed and perishable capacity, a portfolio
of products consisting of combinations of
one or more of the resources, and a set of
fare classes associated with each of the
products. The tactical revenue
management problem is to chose which
fare classes should be open and which
closed for sale at each moment to
maximize total revenue.
Components of Tactical RM
¡� Capacity Allocation
l� How many customers from different
fare classes should be allowed to book?
¡� Network Management
l� How should bookings be managed
across a network of resources?
¡� Overbooking
l� How many total bookings should be
accepted for a product when there are
cancellations and show uncertainty?
Booking Controls
¡� Limits on bookings for different fare
classes:
l� Example: An airline receives a B-class
request for 3 seats departing in two
weeks. The current B-class booking
limit is two seats. As a result, the
request is rejected
Booking Limits
¡� Nesting Controls:
l� Label the fare classes so that 1 is the highest fare class and n is the lowest fare class. For any i let bi denote the nested booking limit for class i.
b 1 ≥ b 2 ≥�≥ bn
l� Protection Levels:
y
�
i = b − b
, i
i
= ,
1 2, n −1
1
1
+
l� Updates: If x units are sold in a transaction b
�
i ← max( bi − x
),
0
,
i = ,
1 2, n −1
Nested Booking Limits (Example)
Booking Limits
Protection Levels
Requests
1
2
3
4
5
1
2
3
4
5 Seats
Class
Action
1
100
73
12
4
0
27
88
96
100
100
2
5 Reject
2
100
73
12
4
0
27
88
96
100
100
5
2 Accept
3
95
68
7
0
0
27
88
95
95
95
1
2 Accept
4
94
67
6
0
0
27
88
94
94
94
1
4 Reject
5
94
67
6
0
0
27
88
94
94
94
3
3 Accept
6
91
64
3
0
0
27
88
91
91
91
4
3 Reject
7
91
64
3
0
0
27
88
91
91
91
2
3 Accept
8
89
62
1
0
0
27
88
89
89
89
Is RM successful?
¡� By most measures (revenues relative to
resources) it has been a success at most
major airline, hotel, rental car companies.
l� Why have major airlines have been losing
money?
¡� Costs are 25-30% higher per mile, so even though larger carriers bring in about 25% more revenue
per mile the cost disadvantage is overwhelming
l� What can be done?
¡� Cost costs
¡� Improve RM systems
l� Big move from independent to dependent demand models
RM and Price Discrimination
¡� Price discrimination exists when sales of identical goods or services are transacted at different prices from the same provider.
¡� A feature of monopolistic or oligopolistic markets where market power can be exercised.
¡� Requires market segmentation and means to discourage discount customers becoming resellers.
l�
This is achieved by fences to keep segments separate.
¡� Price discrimination is more common in services where resale is not possible.
¡� Price discrimination can also be seen when the requirement of identical goods is relaxed.
l�
Premium products have price differential not explained by production costs.
Taxonomies of Price Discrimination
¡� First degree: requires selling at maximum willingness to pay
¡� Second degree: quantity discounts (sellers not able to differentiate consumer types)
¡� Third degree: Prices vary by attributes (e.g., senior discounts)
¡� Fourth degree: Prices are the same but costs are different (reverse discrimination)
¡� Alternative taxonomy:
l�
Complete discrimination (like first degree)
l�
Direct discrimination: seller conditions price on some attribute (like third degree)
l�
Indirect discrimination: the seller relies on some proxy such as quantity discounts (like second degree)
RM and Price Discrimination
¡� Differentiating by time-of-purchase and imposing traveling restrictions like Saturday night stays is a form of second degree or indirect discrimination.
¡� Selling premium seats is another form of second degree or indirect discrimination.
l� Eg., uncomfortable second class seats on trains to entice wealthier people to purchase first class seats.
l� Advance seat selection, mileage accrual, use of lounge, and priority boarding may be forms of second and/or fourth degree discrimination.
Other Examples of Price Discrimination
¡� Retail price discrimination is in violation of the Robinson-Patman Act (1936)
¡� Coupons
¡� Segmentation by age group and student status
¡� Discounts for members of certain occupations
¡� Employee discounts
¡� Retail incentives (rebates, seasonal discounts, quantity discounts)
¡� Gender based examples
¡� College financial aid
¡� User-controlled price discrimination
¡� See http://en.wikipedia.org/wiki/Price_discrimination Static and Dynamic Pricing
¡� Pricing is studied by people in Economics
and Marketing
¡� Economist look at equilibrium prices
¡� Marketing focuses on demand estimation
¡� We focus on more tactical aspects of
pricing
l� Customer arrival rates
l� Capacity constraints
l� And increasingly on choice models and
competition
Static Pricing
¡� d(p) demand at p
¡� z unit cost or dual of capacity constraint
¡� r(p,z) = (p-z)d(p) profit function
¡� Find p to maximize r(p,z)
¡� Is there a finite maximizer p(z)?
¡� Is p(z) monotone?
¡� Is r(z) = r(p(z),z) monotone? Convex?
¡� Multiple market segments with limited
price menus
Dynamic Pricing
¡� Finite sales horizon
¡� Customers arrive stochastically over time
¡� State (t,x)
l� t time-to-go
l� x remaining inventory
¡� What price p(t,x) should be charged at
state (t,x)?
¡� Are there simple and effective pricing
heuristics?
¡� What about strategic customers?
¡� What about competition?
Topics to be Covered
¡� Single Resource RM
l� Independent Demands
¡� Dynamic Programming, Bounds and Heuristics
l� Dependent Demands based on choice models
¡� Static and Dynamic Pricing
¡� Network RM
l� Independent Demands, Choice Models
¡� Overbooking
¡� Service Engineering
l� Design and pricing of service features
Useful Techniques you wil Learn
¡� Dynamic Programming (DP)
l� Tool for sequential decision making
l� Optimal Control (continuous time DP)
¡� Approximate Dynamic Programming
l� Tool to approximate DPs
¡� Bounds and Heuristics Techniques
¡� Choice Modeling
¡� Game Theory
