Revenue Management &

Dynamic Pricing
Krishna Mohan T V
Assistant Professor
Operations, Supply Chain Management & Quantitative Techniques
✉ [email protected]
 Scope of RM
• Goal: to provide the right price
• for every product Customer type
• to every customer segment

Product
• through every channel
• Customer commitments PRO Cube

• A seller agrees to provide a product or service now or future at a price

• List price, coupons, contracts, reserve price, pocket price
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 RM & Strategic pricing
• Strategic pricing
• more long term
• Goal: establish a position in the marketplace
• Revenue Management
• More tactical and operational
• Recognizes the need to change prices rapidly based on market conditions
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 RM Decisions

Structural Price Quantity

selling format (posted How to set posted price,

price/negotiations/auctio individual offer price, Accept or reject offers
ns)? reserve price? Allocating capacity to
segmentation/ How to price across different segments/
differentiation product categories? channels
mechanisms ? When to withhold a
How to price over time?
terms of trade (volume product form market and
discounts, cancellation or How to offer discount? sale at later points
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refund options?
 RM: Methods
• Capacity Management
• Balances risks of overbooking against potential loss of revenue from reservation cancellations
and no-shows
• Discount allocation
• Restricts time period and product mix available at reduced or discounted rates
• Differential Pricing
• Charge different customers different prices according to their price sensitivity
• Dynamic Pricing
• Charge a different price based on the point of time of sale
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 Differential Pricing Strategies
• Also termed as Price Discrimination
• Group Pricing
• Discounts to specific groups of customers
• Senior citizen discounts at diners, software discounts to universities
• Works only when there is a correlation between group members and price sensitivity
• Channel Pricing
• Charging different prices for the same product sold through different channels
• Works only if customers who use different channels have different price sensitivities
• Product Versioning
• Offer slightly different products in order to differentiate price sensitivities
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 Segment RM Process:
market
General framework
Supporting RM Activities Determine
(Strategic) market
response

Operational RM Activities
Set goals Update Choose the
Analyze Execute The
and market best
alternatives pricing market
constraints response alternative

Monitor and
evaluate
performance
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 Benefits of RM
• Improved pricing and inventory decisions
• Identification of new market segments
• Determination of discounting activity
• Improved development of short-term and long-term business plans
• Establishment of a value-based rate structure
• Increased profits

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 RM: Financial Impact
• Fastest and most cost-effective way to make profits
Average impact on a 1% improvement of variables on operating profit
McKinsey (1992) A. T. Kearney (2000)
Price management 11.1% 8.2%
Variable cost 7.8% 5.1%
Sales volume 3.3% 3.0%
Fixed cost 2.3% 2.0%

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 Tools to aid in Pricing:
Price Waterfall (McKinsey and Company)

Price
Waterfall:
for a
consumer
packaged
good

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Tools to aid in Pricing: Pocket-price distribution

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 Tools to aid in Pricing:
Correlation of discount with customer size

A: Management expectation
B: Actual distribution

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 Challenges of Pricing
• Complex set of decisions involved.
• Huge variability between list and pocket prices.
• Need for speed decisions
• Ethical issues

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 Core Concepts

Basic PO Customized Capacity

Pricing Allocation

Intro. to Pricing with RM, Legal & Ethical

constrained strategies, Network
RM Aspects in
Supply effectiveness Management
Pricing

Price Markdown
Differentiati mgmt. & Overbooking
on DP
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 Ethical Issues
Customer Acceptance

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Ethical Issues…(contd.)

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 Project: Sample Topics
• Industry Slowdown COVID-19: Pricing Tactics - used, possibilities, failures
• Pricing and rationing of COVID-19 vaccine: ethical, legal aspects
• Machine Learning and Artificial Intelligence: Scope in RMDP
• Public Transportation: Effective use and Social cost of RMDP
• How Airlines reinvented their pricing strategies during COVID-19?
• Bundling in Services
• Aspects of RM in Sharing economy (Network effects?)
• RM techniques: possibilities in Indian Agriculture 17
Basic Price Optimization

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 Basic Price Optimization
• Objective:
Max. Contribution (total revenue - total incremental cost from sales)
• Constraints: No supply constraints
• Assumptions: single seller, single product
• Key elements
• Price-Response Function
• Incremental cost of sales
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 Price-Response Function
• Price-Response Function or Price-Response Curve d(p): how demand of a
product varies as a function of price p
• One Price-Response Function associated with each element in a PRO cube
• Different from the market demand curve
• Price-Response Function: Demand for the product of a single seller as a function of
the seller
• Why different functions for different sellers?
• Factors: effectiveness of marketing campaigns, perceived quality, product differences
location, etc.
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 Price Response Function (contd.)

D D = d(0)

d(p)
Demand

d(p)

0 Price P 0 P
Price

Price-Response Curve for a perfectly competitive market Typical Price-Response Curve

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 Price-Response Function: Properties
• Is dynamic
• Non–negative
• Continuous
• Differentiable
• Downward sloping
• Exceptions: Giffen goods; when price is an indicator of quality; conspicuous
consumption
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 Measures of Price Sensitivity: Slope
• Slope measures how demand changes in response to price change
• δ(p2, p1) = [ d(p2) - d(p1) ]/(p2 - p1) …(1)
• Slope at a single price:
• δ( p1) = 𝒍𝒊𝒎[ d(p1 +h) - d(p1) ]/h = d’(p1)
𝒉→𝟎
• Slope as a local estimator. For small changes in price:
• d(p2) - d(p1) ≈ δ( p1) (p2 – p1) …(2)
• Large slope (highly negative) demand is more responsive to price and vice-versa
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 Exercise 2
• The slope of the price-response function facing an IC manufacturer at the
current price of $0.13 per IC is -1000 ICs /week per cent.
a) What is the reduction in demand from a 2 cent increase in price?
b) What is the increase in demand from a 3 cent reduction in price?
c) Ans: a) 2000 ICs per week b) 3000 ICs per week
• Is slope a good measure of price response?

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 Exercise 3
• A price of bulk chemical can be quoted either in cents per pound or dollars
per ton. Assume that the demand for the chemical is 50,000 pounds at 10
cents per pound but drops to 40,000 pounds at 11 cents per pound.
• Slope δ(10,11) = (50,000 -40,000)/(10-11) = -10,000 pounds per cent
• Slope in tons per dollar?
• (25-20)/(0.1-0.11) = -500 tons/dollar
• Slope depends on the unit
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 Measures of Price Sensitivity: Price Elasticity
• Price elasticity is the ratio of percentage change in demand to percentage change in price
100{[d(p2) − d(p1) ]/ d(p1)}
• ε(p1 , p2) = − 𝟏𝟎𝟎{(p2 − p1)/ p1}
…(3)
• Reducing (3) gives
[d(p2) − d(p1) ]/ p1
• ε(p1 , p2) = − [p2 − p1] d(p1)
…(4)
• The above equation gives Arc elasticity
• Point elasticity (local estimate)
• ε(p1) = - [d’ ( p1) p1 ] /d(p1) …(5)
• Calculate arc and point elasticity for Exercise 3
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 Exercise 4
• An IC manufacturer is selling 10,000 ICs per month at $0.13 per IC. He
believes that the price elasticity for his ICs is 1.5. Thus, what would be the
new demand for a 15% increase in price from $0.13 to $0.15
• % decrease in demand = 15% × 1.5 = 22.5%
• New demand = 10,000 (1-.225) = 7,750.

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Measures of Price Sensitivity: Price Elasticity

Elasticity depends
Price Elasticity ≈ Price Elasticity >1,
on time frame :
Price Sensitivity elastic; <1 , inelastic
short-run or long-run

Market elasticity <

Nature of product:
Individual
Substitution effects
suppliers’ elasticity

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 Exercise 5
Estimated price elasticities for various goods and services
Good/Service Short-run elasticity Long-run elasticity
Salt 0.1 -
Airline travel 0.1 2.4
Tires 0.9 1.2
Restaurant meals 2.3 -
Automobile 1.2 0.2
Chevrolets 4.0

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 Price Response and Willingness to Pay
• Price-Response function is based on assumption about Customer Behavior
• Model of Customer Behavior :
Willingness to Pay (WTP)
• WTP approach assumes that each potential customer has a maximum
willingness to pay (sometimes called a reservation price) for a product or
service. A customer will purchase if and only if the price is less than the
maximum willingness to pay.

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 WTP function
• Let a function w(x) be the WTP distribution across the population, then for
any values 0 ≤ p1 < p2:
𝒑𝟐
• ‫𝒘 𝒑׬‬ 𝒙 𝒅𝒙 = fraction of the population that has WTP between p1 and p2
𝟏

• Let D = d(0) be the max. demand achievable, then

∞
d(p) = D ‫𝒘 𝒑׬‬ 𝒙 𝒅𝒙 …(6)
d’(p) = - D w(p)
w(x) = - d’(x)/ d(0)
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 Exercise 6
• The total potential market for an executive notebook is D = 20,000, and
WTP~U( $0,$10)
1. Draw the WTP distribution
2. Represent WTP mathematically
3. Compute the price response function and
4. Comment on the nature of price-response curve

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 WTP : Characteristics
• A uniform WTP distribution corresponds to a linear Price-Response
function
• The different total demand component and WTP components is convenient
to model, e.g. For a seasonally varying demand given a forecast of total
demand D(t),
𝑷
d(p(t)) = D (t) ‫𝒙𝒅 𝒙 𝒘 𝒑׬‬ …(7)
• Changing circumstances changes customers’ WTP, but WTP distribution may
remain unchanged due to aggregation effects
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Exercise 6: Answers
1. As shown in figure
2. w(x) =
1
𝑤 𝑥 = , if 0 ≤ 𝑥 ≤ 10,
10
𝑤 𝑥 = 0, otherwise
10 1
3. ⅆ 𝑝 = ‫ 𝑝׬‬10 𝑑𝑥 = 20000(1-p/10) = 20000-
2000p
4. The price-response curve will be linear in nature
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 WTP : Characteristics
• Systematic changes across a population changes WTP
• Disadvantage: Assumes customers are considering only a single purchase
• Applicable: Expensive goods, durable goods, industrial goods, etc.

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 Case 1: Harrah’s Entertainment Inc.
• The case discusses about the effective use of Data Base Marketing (DBM)
and Customer Relationship Marketing in RM.
• Comment on the objectives and effectiveness of various Data Based marketing
programmes incorporated by Harrah’s
• Identify and comment on the metric developed in the process and how it is better than
the earlier one
• How does Harrah’s integrate the various elements of its marketing strategy to deliver
more than the results of DBM?
• What is Sustainability of Harrah’ Strategy? Can it withstand competition?
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