11/10/2015

Dynamic Pricing
Manish Gangwar
Indian School of Business

Price Promotions or Discounts

Changing prices over time (i.e., on sale, not on sale)

Random Discounting


Periodic Discounting


Does not follow a regular pattern over time

Follows a regular temporal pattern

Weekend sales

Seasonal Sales

markdown and yield management

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Yield Management?
Techniques to allocate limited resources (airplane seats or hotel rooms) to
customer types (business or leisure traveler) to maximize profitability
Demand uncertainty
Capacity Constraint ( Wasted opportunity )
Perishable ( Loss if not sold )
Perfect segmentation pricing is not possible still relationship between
consumer price sensitivity and customer arrival time is necessary.
Same service to all customer segments
Source: Netessine, Serguei and Shumsky, Robert, Introduction to the Theory and practice of Yield Management, INFORMS
Transactions on Education, 3:1, p. 34-44.

Lets do a simple hotel example




Hotel with 210 rooms (all the same)

Two types of customers
Leisure (more price sensitive, flexible, purchase in advance)
Urgent / Last Minute (less price sensitive)

Marginal cost of service is zero

WTP

Its Feb, and the hotel is taking reservations for the night of march 1

Leisure: $105 (Discounted Price)

Urgent: $159 (Full Price)

(30 day prior)

Leisure customer wants a room for march 1

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All rooms are categorized as protected

or available to be sold at a discount


Graphically, the room allocation looks as follows:

Max available: 210 rooms

$159

Rooms protected

protection level
$105

Rooms sold at a discount (booking limit: 210 protection level)

Opportunity Cost: Should the hotel continue to sell at the lower price or hold the room for a
high paying customer who may or may not come in future?

Should the hotel sell a protected

room to a low value customer?



Lets say the current protection level is Q+1

Should the hotel adjust the protection level down to Q?

This is the same question as in the headline

210 rooms

$159

Q+1 rooms protected (protection level)

Low value customer wants this first protected room at a discount

$105

210-Q-1 rooms sold at a discount (booking limit)

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The answer depends on 2 factors

The relative sizes of the full and discount prices
The anticipated demand for a full price room

1.
2.

These factors are evident in a decision tree:

Yes : sell (Q+1)th room now at a discount

Decision:
Lower protection level
from Q+1 to Q

Sold at full price later

Revenue
Discount price
($105)

Relative size
of discounts
$54

Full price
($159)

No : protect room Q+1

Anticipated demand for

full price room

Not sold by Mar 1

$0

Demand Uncertainty
Expected Marginal Cost = Expected Marginal Benefit


If we protect a room at the higher price (Cost)

If we do not protect a room forgone profit (Benefit)

The critical ratio is:

Lost sales= lost revenue from low priced room (pL)

Extra margins = revenue from high priced room minus revenue from low priced room (pH - pL)

Critical ratio =


Benefit
pH pL
159 105
=
=
= 0.34
Benefit + Cost ( pH pL ) + pL
159

Optimal Protection level is:

probability of realizing a demand up to protected level = critical ratio

The optimal protection level is the smallest Q such that the probability (demand for full price
room <= Q) is greater than or equal to the critical ratio.
In other words at any point of time Pr(D <= Q) should be greater than 0.34
similar to newsvendor problem

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To find the probability of selling the room at full price

in next X (say 30) days, we can look at historical data
Demand for rooms at
full price (Q)

# of times
(frequency)

0-70

12

Cumulative probability
= Prob(Demand<=Q)
0.098

71

0.122

72

0.146

73

0.163

74

0.163

75

0.195

76

0.228

77

0.268

78

0.285

79

0.341

80

0.374

81

10

0.455

82

13

0.561

83

12

0.659

84

0.691

85

0.764

86

10

0.846

Above 86

19

1.000

Total

123

1.000

Historical data or guesstimate of all

bookings that happened in last X
(say 30) days before an event.

Cumulative Probability is the

fraction of days with demand for
rooms at full price is at or below
the number of rooms in the first
column (Q)

*Historical data (123 occasions) could be for only specific days of the week, holiday weekends, or any other data
set that makes most sense for the period in question

We can use historical data

to find the appropriate Q
Demand for rooms at
full price (Q)

# of days with
demand

0-70

12

Cumulative probability
= Prob(Demand<=Q)
0.098

71

0.122

72

0.146

73

0.163

74

0.163

75

0.195

76

0.228

77

0.268

78

0.285

79

0.341

80

0.374

81

10

0.455

82

13

0.561

83

12

0.659

84

0.691

85

0.764

86

10

0.846

Above 86

19

1.000

Total

123

1.000

Look down the probability column until

you find the smallest Q with a
cumulative probability that is greater
than or equal to 0.34

At Q=79, probability (demand for full

price is <= Q)=0.341

The optimal protection level for the

hotel (Q*) = 79 rooms

Thus, our booking limit should be 21079 or 131 rooms

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Advance Example : Yield Management



Suppose we can identify three categories of customers that differ in

their willingness to pay: business travelers, high-demand leisure
travelers, and low-demand leisure travelers (who will only book a
flight if they can get a rock-bottom price).

Fortunately for the airline, these groups can be sorted based on their
ability to book in advance: business travelers are least able to book
in advance, high-demand leisure travelers are somewhat willing to
do so, and low-demand leisure travelers are very willing if they can
get a low fare in return.

Advance Example : Yield Management

The airline will therefore create three fare categories, which are sometimes
referred to as fare buckets. Now the airline has to decide what prices to set for
each of the three fare categories, and how many seats to allocate to each category.
Furthermore, the airline will want to modify these prices and seat allocations as
the departure date gets closer, as it updates its demand estimates for this
particular flight based on how many tickets in each category have been sold.

Time varying demand functions

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Added Versioning and Segmentation



You can fill the event up to the booking limit by advertising low price
and switch to high price once protection level is reached

Furthermore segmentation and versioning is also practiced by the

airline and hotel industry. In the airline/hotel industry, this is
typically done with a required Saturday night stay for leisure
travelers, offering lower price if Saturday and Sunday is included in
the request.

Leisure travelers typically travel for weekends

Business travelers typically want to get home for weekends

Fairness concerns need to be managed

Competition: Game Theory



Your Objective and Information

Before you start some work, always ask

yourself three questions - Why am I doing it,
What the results might be and Will I be
successful. Only when you think deeply and
find satisfactory answers to these questions,
go ahead. Professor Chanakya

The optimal choice depends on your best

guess of others actions

350 BC, Kautilya

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Competitive Pricing
Coke Lovers, Loyal Consumers = 30 % of the market
Pepsi Lovers, Loyal Consumers = 30 %
Rest are Switchers = 40 %
Consumer Maximum Willingness to Pay = 10
Marginal Cost = 0

  
 
One should not reveal what is been planned in mind.
Because if others know about your plan they may mess it up.
Niti-Sastra by Kautilya, chapter 7, 300BC

Optimal Promotions Under

Competition




Suppose there are only three price points possible 5, 4 and 3

Proportion of loyals for each firm is 30% and rest 40% are switchers
What should be the optimal price(s)
5.0

4.0

3.0

2.5

5.0

250,250

150,180

150,210

150,175

4.0

280,150

200,200

120,210

120,175

3.0

210,150

210,120

150,150

90,175

2.5

175,150

175,120

175,90

125,125

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Price Promotion
Rationale for Hi-Lo Pricing


Competitive Explanation: Hi-Lo pricing as a means to mitigate the

intensity of price competition

Two competing brands with some brand-loyal consumers e.g. Maggie

and Top Ramen

A significant segment of switchers or price-shoppers who care only

about price

In order to get the switcher segment, each firm has incentive to undercut
the competitor

No pure strategy equilibrium in retail prices

Promotional pricing as mixed pricing strategy

=> Weaker brand gains due to price competition over brand switchers
=> Weaker brand will promote more frequently

Strategic Pricing Pyramid?

Price
Level
Price setting

Capture
Value

Pricing
Policy

Customer

Negotiation Tactics &

Criteria for Discounting

Cost
Competition
Context

Price/Value Communication

Communicate
Value

Communication, Value Selling Tools

Price Structure
Metrics, Fences, Controls

Calibrate
Value

Collaborators
Value Creation
Economic Value, Offering Design, Segmentation

Create
Value

Price setting is just the tip of the iceberg of a profitable pricing strategy.

11/10/2015

Key Takeaways
1.

How to think about changing prices?

2.

How to predict industry level price outcomes?

3.

What are the relevant cost for pricing?

4.

What is value based pricing?

5.

How to understand value?

6.

How to align communication with value?

7.

How to estimate willingness to Pay?

8.

How is conjoint useful (market simulation) for better pricing decision?

9.

How to estimate elasticity? How to price based on elasticity?

10.

How to price product line with complements and substitutes?

Key Takeaways Contd..

1.

How and when segmenting the market improves profits?

2.

How to create and price, versions of your products and services?

3.

Why network effects lead do firms offering freemium?

4.

Why firms are moving from products to services?

5.

How and when to offer per-unit price vs. subscription based pricing?

6.

What is 2PT or 3PT, how to design two Part tariff?

7.

Why and when bundling is profitable?

8.

How does yield management works?

9.

Why do firms offer promotions and not advertise them?

10.

How to design promotions in competitive markets?

10