Advanced Topics, Supply Chain

PRO -Price and revenue optimization is how companies set and adjust the right prices for all their products to all their customers through all their channels at all the time

Supply and demand

Assumptions: Infinitely many small players, Transparent information, Free to enter/exit, Identical product

Find good deal:

Consumer strategies to get a cheaper price
Not only do prices vary between sellers, a single seller often sells the same product to different customers at different prices!
Day-to-day pricing decisions are drawn from statistics and operations research
Trend 1 Revenue Management: PRO can deliver strategic benefits, e-Commerce enables PRO
Effective segmentation is critical

Trend 2 Wealth of information, PRO system requires timely information about product cost, availability, and transaction result, IT, especially ERP+CRM
Caesars’ Entertainment, 50+ casino/hotels, 7 golf courses, $8.9 Billion revenue (2010)
Links CRM + Reservation + Revenue Management systems, Categorizes customers into 64 segments
Trend 3 Rise of e commerce, Internet increases the velocity of pricing decision
500,000/day for airlines, Amazon responds in 1 minutes, Immediate wealth of information about customer, Laboratory for experimenting pricing alternatives , $300,000 + 10 weeks vs. real time testing/result, Customers have deeper knowledge about costs and prices
Trend 4 Success of SCM, SCM proved that quantitative method can generate real improvement
Reduced return from cost-deduction initiatives

Trends + challenges (complexity, speed, error tolerance, competitiveness)
 Pricing will increasingly become a tactical and operational function
Price waterfall 

List price, invoice price, and pocket price
Pocket price distribution:

Executives concentrate on invoice price and list price, Customers accept a wide range of prices
Pocket-price distribution should be planned, Value based approach: based on customer, ignores cost,competition, Personalized, customized, or one-to-one pricing, Focus group survey & analysis (in the past), Implementation issues of value-based pricing, Customer’s willingness to pay is not obvious, Arbitrage, cannibalization and regulation concern
Competition
Different from demand curve

Specifies demand for the product of a single company as a function of the price.
Competing companies in the same market have different price-response functions
Even within a single company, different PRO Cube dimensions (channels, customer segments, time) have different price response functions
Price elasticity

−(∆𝑑(𝑝_1 )/(𝑑(𝑝_1) ))/((∆𝑝_1)/𝑝_1 )

Regular goods have lower short-run elasticity, Durable goods have lower long-run
Market elasticity is lower than price-response elasticity
Price response function

d(p) = D – mp

Elasticity[pic 1]

Elasticity is not constant it increases with price. Elasticity is not reasonable but we can livewith it

Optimality condition

𝐷−𝑚∙𝑝=(𝑝−𝑐)∙𝑚
Example:The unit production cost for a can of cat food is $5.00. The price response function is d(p)=10000 – 800p. What is the optimal price

10000 – 800 p*= (p* – $5.00) 800,   Therefore, p*=$8.75 the corresponding demand is

10000 – 800*8.75 = 3000    What if there is a capacity limit of 2000 units

The highest price you can charge to sell out all the capacity is the solution to:
10000 – 800p=2000   Therefore, p=$10     This is called the “run out price”
Alternative model

Unconstrained single optimal price follows inverse price elasticity rule for any price-response function (not restricted to linear

𝜀(𝑝^∗ )=𝑝^∗/(𝑝^∗−𝑐)
Example: The elasticity of TV is 2.5, the cost (whole sale price) is $180, what is the optimal retail price?   2.5=p*/(p* – 180)         p* = 300
Perfect price diff

Area A: profit under one price
Area B: money on the table
Area C: potential profitable customers not served under one price scheme

A= Big square, B= triangle in front, C = triangle on top
Price diff and welfare

Perfect price differentiation provides no consumer surplus
Price differentiation may increase or decrease consumer surplus
If a price differentiation scheme increases profit for a seller but does not result in additional output, it MUST reduce total consumer surplus
Example: if a theater has sold out its tickets under a single price scheme,  going to a two-price scheme can increase its revenue, but doing so makes customers, on the average, worse off.
The rule is most relevant when capacity is constrained
Improving capacity utilization IS the reason many industries do revenue management, which helps firms as well as consumers
Implement challenges: Imperfect segmentation, How to detect customer’s willingness-to-pay
How to create effective market segments such that the average willingness-to-pay is different
Cannibalization and arbitrage, In the cat food example, if 10% of high willingness to pay customers manage to get the low price, the benefit of price differentiation is totally eliminated.
How to prevent a third party from buying low and selling high
Price tactics

Group pricing: senior discount, student discount, contractor pack - Successful group pricing requires: Clear indicator of group membership, Segments strongly correlate with price – sensitivity, Product or service should not be easily traded
Culturally and legally accepted, Pure group pricing is more common in service and business-to-business sales
Channel pricing 

Different channels, different costs
- A $325 flight tickets, $43 for travel agent, $18 for online
Different channels have different price-sensitivities
Regional pricing  NYC-Tokyo ticket in Japan costs more than in the U.S.
Price sensitivity difference in addition to cost differences
Couponing and self selection    Users of coupons are more price elastic
Pure group pricing is difficult and “unpopular”
Seller allows customers to self select depending on their value of time or flexibility
Product versioning