2 13.1 IntroductionImplicit assumption so far has been that demand cannot be influencedIn reality, this is not trueDemand level changes can be made through:Advertising, displays, and promotional toolsPricing
3 Dell’s Pricing Strategy Product price different based on type of customerProduct price varies over timePrices of options offered also vary over time
4 Other ExamplesIBM is investigating software that will allow it to adjust prices according to demandNikon Coolpix Digital Camera sold for about $600.Manufacturer provides a rebate of $100 independently of where the camera is purchasedBoise Cascade Office Products sells many products on-linePrices for the 12,000 items ordered most frequently on-line might change as often as daily
5 Questions Related to Pricing What are these companies doing?Why does Dell charge a different price for different consumers? At different times?If Dell can do it, can it work for other companies?What is the impact of the mail-in rebate?Shouldn’t Nikon and Sharp just reduce the wholesale price paid by the retailers instead of asking the consumer to mail in the coupon?What is wrong with a traditional fixed-price policy?
6 Revenue Management Principles All companies trying to boost profit by using what are know as smart pricing or revenue management techniquesTechniques first pioneered by the airline, hotel, and rental car industries.Airline industryRevenue management has increased revenue significantlyAmerican Airlines’ estimates of annual incremental revenue of $1 billion through revenue management
7 13.2 Price and Demand All things being equal Demand for a product will typically go up as the product’s price goes downCertain products more or less sensitive to price changesIn general the property holdsDownward-sloping demand curve
8 Manager’s IssueWhat is the optimal price at which revenue is maximized?Need to characterize the relationship between pricing and demand for each productUtilize this characterization to determine the optimal price for each productMay involve many complexitiesVast quantities of data may need to be analyzedCompetitors’ behavior may need to be capturedMany firms do manage to at least approximate this relationship.
9 Example – Single Product Management estimates the relationship between demand, D, and price, pD = 1, pWhen the p=$1,600, D=200When the p=$1,200, D=400
10 Price vs Revenue Table Maximum Revenue = $500,000 when price = $1,000 DemandRevenue$250875$218,750$500750$375,000$750625$468,750$1,000500$500,000$1,250375$1,500250Maximum Revenue = $500,000 when price = $1,000
11 Demand-Price CurveFIGURE 13-1: Price/Demand curve for Example 13-1
12 13.3 MarkdownsAssumption in example: demand is deterministic based on priceRealistic pictureDemand is randomAt the end of a selling season, there may be remaining inventoryFirms frequently employ a markdown or sale to dispose excess inventoryThink about demand from the customer’s perspective:Each customer has a maximum price that he or she is willing to pay for the productReservation price
13 Markdown Concept When the p=$1,200, D=400 400 customers have a reservation price at or above $1200When the price is below their reservation price, they will buyThe lower the price, the more customers with a reservation price at or above that priceSell product to customers whose reservation prices were below the original price, but above the sale price.Traditionally, retailers have tried to avoid markdownsEvidence of mistakes in purchasing, pricing, or marketingLow reservation price customers seen as:less desirable or profitable,useful to get rid of the excess inventory
14 13.4 Price Differentiation Customers who are willing to buy at sales price were different than the customers who were willing to buy at original priceIn fashion, some customers are very fashion consciousEager to buy at the start of the selling seasonWilling to pay more to have fashionable items firstOther customers are value-consciousWilling to wait until the end of the sales seasonUnwilling to pay the same high prices as the fashionable customersDifferent customers charged different prices can result in higher revenue
15 Price Differentiation Example According to the demand–price curve, the retailer charges many customers who are willing to pay a higher price only $1000About 200 customers willing to pay $1,600About 100 willing to pay $1,800By charging a single price, management is leaving a large amount of money on the table
16 Multi-tiered Pricing Strategy Money left on the table = (2, ,000) • 500/2 = 250,000Consider a differential or customized pricing strategyTailors pricing to different market segmentsConsider a two-price strategy in which the firm introduces two prices, $1,600 and $1,000.At a p=$1,600, there is demand for 200 itemsAt a p= $1,000, there is demand for 500 itemsTotal revenue in this case is 1,600 • ,000 • ( ) = 620,000$120,000 more than in the single-tier strategyA three-tier pricing strategy can do even betterAt p=$1,800, D=100; p=$1,600, D=200; p=$1,000, D=500Total revenue equals1,800 • ,600 • ( ) + 1,000 • ( ) = 640,000$20,000 more than in two-tier strategy
18 13.5 Revenue ManagementSelling the right inventory unit to the right type of customer, at the right time, and for the right priceIntegrates pricing and inventory strategies to influence market demand,Provides controls for companies to improve the bottom lineRevenue management techniques have been traditionally applied in the airline, hotel, and rental car industriesCommon characteristics of such industries:existence of perishable productsfluctuating demandfixed capacity of the systemsegmentation of the market based on sensitivity to price or service timeproducts sold in advance
19 History of Revenue Management Pioneered by American Airlines in the 1980sAs a counter to new airlines like PeopleExpressTechniques employed differentiated pricingWidely successfulPeopleExpress went out of businessOther airlines started adoptingHotels and rental companies adopted later
20 Customer Segments in Airline Industry Leisure travelersHighly sensitive to priceNot generally sensitive to the duration of the tripWilling to book non-refundable tickets far ahead of timeBusiness travelersNot particularly price-sensitiveHighly sensitive to trip durationNeed high flexibility to adjust their travel plans as needed
21 Customer Differentiation in the Airline Industry FIGURE 13-4: Customer differentiation in the airline industry
22 Differential Pricing“Build fences” to prevent business travelers from moving from the top-left box to the bottom-right boxRequire weekend stays and early bookingThe more fare classes, the more fences requiredOther factors:How many of each type of ticket to offer?How much to price for each ticket
23 Revenue Management Systems Market SegmentationFor a specific time and flight (origin to destination),Different products designed and priced to target different market segmentsProducts feature different restrictionsNon-refundableAvailable up to 21 days before the flight.Booking ControlAllocates available seats to fare classesSetting limits on the number of seats that can be allocated to lower fare classesRequires:Sophisticated algorithmsBasic criterion: Equal marginal revenues in each class
24 Optimal Allocation of Flights Leisure fare is $100 per ticketBusiness fare is $250 per ticket80 seats on the planeCompany can sell as many seats as they make available at the leisure fareBusiness fare is random
25 Demand Distribution for Business Fares FIGURE 13-5: Demand distribution for Example 13-4
26 Marginal Revenues of the Two Classes FIGURE 13-6: Marginal revenue of leisure and business class for Example 13-4
27 Marginal RevenuesDetermine expected revenue for each number of allocated seatsDetermine expected marginal revenue of business classrevenue associated with allocating one additional seat can also be calculatedthis decreases as the number of allocated seats increasesMarginal revenue associated with leisure class seatsunlimited demand for seats implies marginal revenue is constantMarginal revenue of the two is equal at 18 seats18 seats should be allocated to business class
28 Complexities of the Real Systems Variety of flight classesDifferent hierarchies of classesMore complex demand informationNetwork managementA flight can be part of many ultimate origin-destination pairsSystem needs to account for this by allocating seats to particular flightsPrices change over timeFlight may be expensive on some days and timesIf a plane is not filling up, the airline might increase the allocation of lower price fares to that flight over time
29 13.6 Smart PricingAmerican Airlines’ success prompted other industries to adopt similar practices regarding pricingSpecific techniques and tools of airline revenue management don’t necessarily apply to very different industriesMany of the underlying principles and concepts of revenue management do
30 Fundamental Approaches to Smart Pricing Differential PricingCharging different prices to different customersDynamic pricingCharging different prices over time
31 Differential PricingCharge different customers different prices according to their price sensitivityDell does this by distinguishing between private consumers, small or large businesses, government agencies, and health care providersDifficult to do in many cases
32 Differential Pricing Strategies Group PricingDiscounts to specific groups of customers very common in many industriesSenior citizen discounts at diners, software discounts to universities, student discounts at movie theaters, “ladies night” at barsWorks only when there is a correlation between group members and price sensitivityChannel PricingCharging different prices for the same product sold through different channelsDifferent prices on web sites vs. retail storesWorks only if customers who use different channels have different price sensitivitiesRegional PricingExploiting different price sensitivities at different locationsBeer is much more expensive in a typical stadium than in a bar
33 Differential Pricing Strategies Time-based DifferentiationSimilar products differentiated based on timeAmazon.com charges different rates for different delivery timesA technique for segmenting price sensitive customers and customers who are more delivery time sensitive.Dell charges different prices for repair contracts that complete repairs in different amounts of time (overnight vs. within a week)Product VersioningOffer slightly different products in order to differentiate price sensitivitiesMay take the form of branding.Store brand vs Generic brandAdditional features added to products at the higher end of the lineHigh end buyers are inclined to buy the higher end products in the linePay significantly more than the lower end productsCost very little more to manufacture.
34 Differential Pricing Strategies Coupons and Rebates Distinguish between customers that place a high value on time or flexibilityThose who are willing to spend the time to get a lower price by using a coupon or submitting a rebate formMail-in rebates at the point of saleAdds a significant hurdle to the buying processCustomers willing to pay the higher price will not necessarily send the couponDo not incorporate fencesRequire a more detailed analysis.
35 Rebates No rebate Mail-in-rebates Each retailer decides on the price and the amount to order from the manufacturer to maximize its profit.Retailer needs to find a price and an order quantity so as to maximize its expected profitManufacturer would like the retailer to order as much as the wholesale priceMail-in-rebatesmanufacturer influences customer demandprovides an upside incentive to the retailer to increase its order quantityRetailer’s profit increasesIncrease in demand forces the retailer to order more from the manufacturer.Optimal order quantity:Compensates for the rebate/ Implies an increase in the manufacturer’s expected profit.
36 Why Not Discount the Wholesale Price? Rebate strategy implies not every consumer will mail the coupon to the manufacturer.If the manufacturer merely reduces the wholesale price, the retailer may keep the discount and not transfer it to the customers.Even if the retailer uses the discounted wholesale price to optimize its pricing and ordering decisions, and even if every consumer mails back the rebate, the mail-in rebate strategy is a better strategy for the manufacturer – WHY?
37 Mail-in Rebate Strategy Better Assume retailer orders the same amount in both strategiesOrder quantity < realized demandthe two strategies provide the manufacturer with exactly the same profitOrder quantity > realized demandManufacturer’s profit with rebate is larger than its profit under discounted wholesale price
38 Dynamic PricingRetailers change price at the end of the season to get rid of excess inventoryManufacturers change price during the season to distinguish between low and high reservation price customersUse pricing to affect demand
39 Dynamic Pricing Better than Fixed-Price Strategy Dynamic Pricing may increase profit by 2-6%Significant in industries with low marginsRetail industryComputers industry
40 Conditions under which Dynamic Pricing Is Superior Available capacitySmaller the production capacity relative to average demand, the larger the benefit from dynamic pricingDemand variabilityBenefit of dynamic pricing increases as the degree of demand uncertainty increasesSeasonality in demand patternBenefit of dynamic pricing increases as the level of demand seasonality increasesLength of the planning horizonLonger the planning horizon, the smaller the benefit from dynamic pricing
41 13.7 Impact of the InternetMany approaches of smart pricing made more practical by internet and e-commerceMenu costcost that retailers incur when changing the posted priceMuch lower on the Internet than in the off-line worldUpdating of prices possible on a daily basisLower buyer search pricecost that buyers incur when looking for a productforces competition between sellersleads to a focus on smart pricing strategies
42 Impact of the Internet Visibility Customer segmentation to the back-end of the supply chainmakes it possible to coordinate pricing, inventory, and productioninformation has facilitated growth of smart pricingCustomer segmentationusing buyers’ historical data is possible on the Internetvery difficult in conventional storesTesting capabilityInternet can be used to test pricing strategies in real timeOn-line seller may test a higher price on a small group of the site visitorsUse those data to determine a pricing strategy
43 13.8 CaveatsMust avoid the appearance of unfair treatment of customersAmazon.com’s failed experimented with a pricing strategy in which customers were paying different amounts for the same DVD based on demographics or the browser usedCoke’s development of a soda machine that would measure the outside temperature, and increase prices as the temperature increasedOn-line sites Priceline and Hotwire.com provide:an outlet for last-minute, unsold seats and hotel roomsopaque fares“Protects” the published fares promoted by the airlines and hotels themselvesWhen many published fares are about as good as the opaque fares, it is harder to attract customers to the Priceline and Hotwire sites
44 SUMMARYPricing and promotion can be used to influence the level of demand.Traditionally, fashion retailers have used price markdowns to sell off excess inventory at the end of the season.Mid-1980’s: airline executives began to use a set of more sophisticated approaches to manipulating demand.Revenue management has two goalsDifferentiate demandUse pricing to adjust aggregate demandVariety of techniquesDifferential pricingDynamic pricingMade more effective by the Internet and e-businessCaveat that customer should not be unfairly treated