Revenue Management and Pricing

1. Revenue Management and Pricing Chapter 1

2. Revenue Management and Pricing • Pricing and revenue optimization is a tactical function. It recognizes that prices need tochange rapidly and often and provides guidance on how they should change. • Strategic Pricing: the goal is usually to establish a general position within a marketplace. • While strategic pricing worries about how a product should in general bepriced relative to the market, pricing and revenue optimization is concerned with determiningthe prices that will be in place tomorrow and next week.

3. Revenue Management and Pricing • One of the first applicationsof revenue management systems was by the passengerairlines in the 1980s. • Since then, the rapid development of e-commerce and the availabilityof customer data through customer relationship management (CRM) systems hasled to the adoption of similar techniques in many other industries, including automotive,retail, telecommunications, financial services, and manufacturing. • A number of software vendors provide “price optimization” or “demand management” or “revenue management” solutions focused on one or more industries. • Pricing and revenue optimizationis increasingly becoming a core competency within many different companies.

4. Historical Background • For most of history, philosophers took it for granted that goods had an intrinsic value inthe same sense that they had an intrinsic color or weight. A fair price reflected that intrinsicvalue. • Charging a price too much in excess of the intrinsic value was condemned as a signof “avarice” and often prohibited by law. • Prices were set by custom, by law, or by imperialfiat. • The problem of pricing did not really exist until modern marketeconomies began to emerge in the West in the 17th and 18th centuries.

5. Historical Background • With the emergenceof modern market economies, prices were allowed to move more freely—untied to the traditionalconcept of value. • Speculative bubbles such as “tulipomania” in the Dutch republic in the1630s—in which the price of some varieties of tulips rose more than a hundredfold in18 months before collapsing in 1637—and the “South Sea bubble” in England in 1720—in which the prices of shares in the South Sea Company soared before the company collapsedamid general scandal—fed a sense of anxiety and the belief that prices could somehowlose touch with reality.

6. Historical Background • Furthermore, for the first time, large numbers of people couldamass fortunes—and lose them—by buying and selling goods on the market. • The questions naturally arose: • What were prices, exactly? • Where did they come from? • What determinedthe right price? • When was a price fair? • When should the government intervene in pricing? • The modern field of economics arose, at least in part, in response to these questions.

7. Historical Background • Possibly the greatest insight of classical economics was that the price of a good at any timein an ideal capitalist economy is not based on any intrinsic “value” but rather on the interplayof supply and demand. • In essence,the price of a good or service was determined by the interaction of people willing tosell the good with the willingness of others to buy the good. • That’s all there is to it—neitherintrinsic “value” nor cost nor labor content enters directly into the equation.

8. Historical Background • Of course,these and other factors enter indirectly into pricing—sellers would not last long sellinggoods below cost, and the prices buyers accept are based on the “value” they placed on theitem—but these were not primary. • There are many reasons why sellers sell below cost whenthey are in possession of a cartload of vegetables that are on the verge of going rotten—theclassic “sell it or smell it” situation—or to attract a desirable new customer.

9. Historical Background • According to modern economics there is no normative “right price”for a good or service against which the price can be compared—rather, there are only theactual prices out in the marketplace, floating freely without an anchor, based only on thewillingness of sellers to sell and buyers to buy. • If prices were not tied to fundamental values—if they hadno anchor—why did they show any stability at all? Under normal circumstances, prices formost goods are pretty stable most of the time.

10. Historical Background • If prices are based only on the whims of buyersand sellers, why is the price of bread not subject to wild swings like the Dutch tulip marketin 1689? • Whydoesn’t milk cost five times asmuchin Chicago as it does inNewYork? • Howcan manufacturers and merchants plan at all and make reasonable profits in order to stay inbusiness? • How can an economy based on free-floating prices work at all? • And, assuming thatsuch an economy could work, how could it possibly work better than a centralized economywhere planners carefully sought to allocate resources across the entire economy?

11. Historical Background • One of the great achievements of 20th century economics was to show mathematicallyhow a largely unregulated economy could work: • that an economy consisting of individualswho supply their labor in return for wages and use their earnings to buy goods to maximizetheir “utility” combined with firms who seek to maximize profitability can be remarkablystable and efficient. • Under certain assumptions, this type of capitalist economy can beshown to be at least as efficient as any centrally planned economy. • Furthermore, prices insuch an economy would generally be stable and reasonably predictable.

12. Historical Background • The price for aproduct would equal the long-run marginal production cost of that product plus the returnon invested capital necessary to produce the product. • If someone were selling the productfor less, he or she would go out of business because his or her costs would not be covered. • If someone tried selling for more, other sellers would undercut his price, consumers wouldflee to the lower-priced sellers, and the high-price seller would be forced to lower his priceor go bankrupt for lack of business. • As this happens simultaneously, economy-wide, pricesequilibrate and change only due to exogenous shocks, changes in resource availability, taxationor monetary policy, or changes in consumer tastes.

13. Historical Background • This view of the world is based primarily on the assumption that most markets are perfectlycompetitive, where the idea of perfect competition can be summarized as follows: • A market structure is perfectly competitive if the following conditions hold: • There aremany firms, each with an insubstantial share of the market. • These firms produce a homogenousproduct using identical production processes and possess perfect information. • There is free entry to the industry; that is, new firms can and will enter theindustry if they observe that greater-than-normal profits are being earned. • Since each firm produces a homogenous product, it cannotraise its price without losing all of its market to its competitors • Thus firms are pricetakers and can sell as much as they are capable of producing at the prevailing market price.

14. Historical Background • There are no pricing decisions in perfectly competitive markets—prices are determined bythe iron law of the market. • If one merchant were offering a good for a lower price thananother, neoclassical economics assumes that either customers would entirely abandon thehigher-price merchant and swamp the lower-price merchant or an arbitrageur would arisewho would buy all the goods from the lower-price merchant and sell them at the higher price. In either case, a single market price would prevail. • Furthermore, if prices were so highthat merchants enjoyed higher profits than the rest of the economy, more sellers would enter,lowering the average price until the return on capital dropped to the market level.

15. Historical Background • Inthis situation, there are no pricing decisions at all: Prices are set “by the market”—as stockprices are set by the New York Stock Exchange, NASDAQ or IMKB. The price of Microsoft stock isnot set by any “pricer” but by the interplay of supply and demand for the stock. • Many financialinstruments, such as stocks and bonds, satisfy the economic definition of a commodity. • Certain other highly fungible goods—grain, crude oil, and some bulk chemicals—alsocome very close to being commodities. In these markets, there is simply no need for pricingand revenue optimization—the market truly sets the price.

16. Historical Background • Muchof the real world is messier—prices vary all over theplace, sometimes in ways that seem irrational. • Buyers often behave erratically, sellers do notalways seek to maximize short-run profit, neither buyers nor sellers are possessed of perfectinformation, and opportunities for arbitrage are not immediately seized.

17. Historical Background • Prices range from a low of $1.39 to ahigh of $2.00—a variation of $0.61, or 44%. • Furthermore, the price varied by more than$0.40 even for two stores on the same block. How could this be? Why would anybody buymilk at a high price when they could walk a block and save 40 cents? • Why don’t arbitrageursbuy all the milk at the lower price and sell it at the higher?

18. Historical Background • Suppliers of thesame (or similar) products will often charge different prices. • Furthermore, there are otherways to pay a lower price for exactly the same product: Wait until it goes on sale, travel to aretail outlet, clip a coupon, buy in bulk, buy it online, try to negotiate a lower price. • In fact,it is hardly a secret not only that prices vary between sellers but that a single seller will oftensell the same product to different customers for different prices!

19. Historical Background • Marketing science, which deals with thequantitative analysis of marketing initiatives, including pricing, is usually considered partof the broader field of operations research and management science. • Application of thesetechniques to problems of marketing began to emerge in a significant fashion in the 1960s. • Since then, marketing scientists have developed, applied, validated, and refined importantmathematical models to a broad range of issues, such as forecasting sales, product planning,predicting market response, product positioning, pricing, promotions, sales force compensation,and marketing strategy.

20. Historical Background • Despite these achievements, there remains a gap between marketing science models andtheir use in practice. • The reasons for this gap are numerous. • Many marketing models havebeen built on unrealistically stylized views of consumer behavior. • Other models have beenbuilt to “determine if what we see in practice can happen in theory.” • Other models seemlimited by unrealistically simplistic assumptions.

21. Historical Background • One of the possible reasons for the gap between marketing science theory and its applicationto real pricing decisions is that pricing decisions are becoming increasingly tactical andoperational in nature. • Companies increasingly need to make pricing decisions more andmore rapidly in order to respond to competitive actions, market changes, or their own inventorysituation. • They no longer have the luxury to perform market analyses or extendedspreadsheet studies every time a pricing change needs to be considered. The premium is onspeed.

22. Historical Background • This acceleration—and thecorresponding interest in developing tools to enable better pricing and revenue optimization(PRO) decisions—has been driven by four trends. • The success of revenue management in the airline industry provided an example ofhow pricing and revenue optimization could increase profitability in a real-time pricing environment. • The widespread adoption of enterprise resource planning (ERP) and customerrelationship management (CRM) software systems provided a new wealth of corporateinformation that can be utilized to improve pricing and revenue optimization decisions. • The rise of e-commerce necessitated the ability to manage and update prices in afast-moving, highly transparent, online environment for many companies thathad not previously faced such a challenge. • The success of supply chain management proved that analytic software systemscould drive real business improvements.

23. Success of Revenue Management • In 1985, American Airlines was threatened on its core routes by the low-fare carrierPeopleExpress. • In response, American developed a revenue management program based ondifferentiating prices between leisure and business travelers. • A key element of this programwas a “yield management” system that used optimization algorithms to determine the rightnumber of seats to protect for later-booking full-fare passengers on each flight while stillaccepting early-booking low-fare passengers. • This approach was a resounding success forAmerican, resulting ultimately in the demise of PeopleExpress.

24. Success of Revenue Management • American Airlines featured its revenue management capabilities in its annual report. The team that developed the systemwon the 1991 Edelman Prize for best application of management science. AmericanAirlines’ revenue management has been widely touted as an important strategic applicationof management science and the tale of Americanusing its superior capabilities to defeat PeopleExpress was the centerpiece of a popular business book (Cross 1997). • Not surprisingly this publicity resulted in widespread interest. • Companies began to investigatethe prospects of improving the profitability of their pricing decisions.

25. Success of Revenue Management • Ford MotorCompany was inspired by the success of revenue management at the airlines to institute itsown very successful program (Leibs 2000). • Vendors arose selling revenue management softwaresystems, and consultants appeared offering to help companies set up their own programs. • Revenue management spread well beyond the passenger airlines.

26. Success of Revenue Management • Under its strictest definition, revenue management has a fairly narrow field of application.In particular, the techniques of revenue management are applicable when the following conditions are met. • Capacity is limited and immediately perishable. Most obviously, an empty seaton a departing aircraft or an empty hotel room cannot be stored to satisfy future demand. • Customers book capacity ahead of time. Advance bookings are common in industrieswith constrained and perishable capacity, since customers need a way to ensureahead of time that capacity will be available when they need to consume it. Thisgives airlines the opportunity to track demand for future flights and adjust pricesaccordingly to balance supply and demand. • Prices are changed by opening and closing predefined booking classes. These systems allow airlines to establisha set of prices (fare classes) for each flight and then open or close those fare classesas they wish. This is somewhat different from the pricing issue in most industries,which is not “What fares should we open and close?” but “What prices should we beoffering now for each of our products to each market segment through each channel?”The difference is subtle, but it leads to major differences in system design and implementation.

27. Success of Revenue Management • Many companies are understandably wary about adopting “revenue management” programs,protesting that “we are not an airline.” • In general, this is the right view—the algorithmsbehind airline revenue management do not transfer directly to most other industries. • However, the experience of the airlines contains several important lessons. • Pricing and revenue optimization can deliver more than short-term profitabilitybenefits. Revenue management enabled American Airlines to meet the challengeposed by PeopleExpress.

28. Success of Revenue Management • It also meant the difference between survival and bankruptcyfor National Rent-a-Car. In 1992, National was losing $1 million per monthand was on the verge of being liquidated by its then-owner, General Motors. • Atthis point, National had been through two rounds of downsizing, and corporatemanagement felt there were no more significant savings that could be achieved onthe cost side. As a last-ditch effort, National decided to work on the revenue side. • They worked with the revenue management company Aeronomics to develop asystem that forecast supply and demand for each car type/rental length at all 170corporate locations and adjusted fares to balance supply and demand.The results were immediate.

29. Success of Revenue Management • E-commerce both necessitates and enables pricing and revenue optimization. • Theairlines pioneered electronic distribution—their computerized distribution systems,SABRE and Galileo, were the “Internet before the Internet.” These systemsallowed immediate receipt and processing of customer booking requests. • Theyalso enabled airlines to change prices and availability and have the updated informationinstantaneously transmitted worldwide. In effect, the airlines were wrestlingwith the complexities of e-commerce well before the arrival of the Internet. • Thenecessity to continually monitor demand and update prices accordingly will befelt by more and more industries as electronic distribution channels such as the Internet become more pervasive.

30. Success of Revenue Management • Effective segmentation is critical. The key to the success of revenue management inthe airline industry was the ability of the airlines to segment customers between earlybookingleisure passengers and late-booking business passengers. • Note that thissegmentation was achieved not by direct discrimination—that is, trying to chargea different fare based on demographics, age, or other customer characteristics—but via product differentiation, creating different products that appealed to differentsegments. • Segmenting customers based on their willingness to pay and findingways to charge different prices to different segments is a critical piece of pricing and revenue optimization

31. Success of Revenue Management • Airline yield management systems are highly sophisticated opportunity cost calculators. • They forecast the future opportunities to sell a seat and seek to ensure that the seatis not sold for less than the expected value of those future opportunities. • Most industries donot face capacity constraints as stark as those faced by the airlines. Manufacturers typicallyhave the opportunity to adjust production levels or store either finished or partially finishedgoods. Retailers can adjust their stocks in response to changes in demand. • However, thisdoes not mean that calculating opportunity cost is not relevant to these industries. On thecontrary, in many industries facing inventory or capacity constraints, opportunity cost canbe the critical link between supply chain management and pricing and revenue optimization.

32. New Wealth of Information • By automating and standardizing data consolidationand reconciliation, ERP systems enable much more rapid implementation of pricing and revenue optimization. • Another source of improved data storage and availability came from the increasing adoptionof customer relationship management (CRM) systems. These involve gathering and storingcustomer and transaction information and using the results to improve marketing, sales,and customer service. • Pricing and revenue optimization systems are a natural extension of CRM. In essence,CRM systems provide the rich customer and transaction history that pricing and revenueoptimization systems need to evaluate customer response and update pricing recommendations.

33. New Wealth of Information • Harrah’s Entertainment, which operates 24 casinos and 16 hotels under the Harrah’s,Harvey’s, Rio, and Showboat brands, provides an example of the successful use of aCRM system with pricing optimization. • Harrah’s has linked a homegrown CRM systemwith its reservation and revenue management systems. Based on historical informationabout customer behavior and preferences, customers are classified into 64 segments basednot only on their current value but on their expected lifetime value to Harrah’s. • The revenuemanagement system forecasts daily hotel room demand for each of these segments and calculatesthe minimum room price necessary to optimize the room inventory. • When customerscall for reservations, call-center representatives can see on their screens the customersegment and the approved pricing offers.

34. New Wealth of Information • The Harrah’s system provides an excellent example of aCRMsystem closely linked with aprice optimization system. • The CRM system tracks customer behavior and demographicsinformation, such as zip codes, which enables segmentation of customers into such groupingsas “avid experienced player”andthe calculation of expected profitabilityandgamingrevenuefrom each segment. • The revenue management system balances the need to ensure thatrooms will be available for high-revenue customers while not holding back so many roomsthat occupancy suffers. • The information needed to manage customers at this level of detailsimply would not have been available before the advent of customer relationship managementtechnology. • Harrah’s is an excellent example of how the new wealth of customer informationavailable throughCRMsystems can enable pricing and revenue optimization.

35. Rise of E-commerce • A number of analysts predicted that Internet commerce would inevitably drive prices downto the lowest common denominator. • Many analysts argued, in effect, that the Internetwould bring about the world of perfect competition, in which sellers would lose control ofprices. • This was part of the vision behind Bill Gates’ concept of the “frictionless economy.” • However, the reality has been quite different. Studies consistently show that most onlinebuyers actually do little shopping—for example, a McKinsey study showed that 89% of onlinebook purchasers buy from the first site they visit, as do 81% of music buyers. • As a result,online prices often vary considerably, even for identical items.

36. Rise of E-commerce • Note that thedelivered price varies by more than $8.00 across the vendors, with none of the 10 vendorsoffering the book at the same price. • Note also that the two most successful online booksellers—Amazon and Barnes and Noble—have neither the highest nor the lowest price,and their prices differ substantially from each other. • At least in this case, the Internet seemsto support rather than eliminate price variability!

37. Rise of E-commerce • For any seller offering a large catalog of products (such as an online bookseller), the price ofeach item needs to be set intelligently based on cost, inventory, current competitive prices,and other information. • The pricing problems facing an online bookseller are similar tothose facing retailers: Could I increase my profitability by raising my price? by loweringmy price? How should my price be updated as inventory changes—as competitive priceschange? as demand changes? What is the right relationship between my base price and thetotal delivered price? • Multiply these questions by a catalog of hundreds of thousands ofitems and a need to update daily, and the full magnitude of the pricing problem faced by online merchants becomes clear.

38. Rise of E-commerce • According to a school of thought, e-commerce would become a “market-of-one” environment, in which priceswould be calculated on the fly to maximize the profitability of each transaction. • A customerentering aWeb site would immediately be identified, and, based on his past buying patterns,a pricing engine would calculate personalized prices reflecting his willingness to pay.

39. Rise of E-commerce • Needlessto say, the one-to-one e-commerce pricingworld has not yet arrived. And there are powerfulreasons to believe it will never fully arrive. For one thing, there is strong buyer resistanceto attempts at pricing discrimination that are perceived as unfair or arbitrary. People are nomore inclined to accept online price discrimination than theywould be willing to accept variablepricing at the time of checkout based on the clerk’s estimate of their “willingness to pay.” • In addition, the transparency of the Internet means that whatever online pricing system acompany adopts, the details will be widelyknownacross the buying community within a veryshort period of time. As a result, price differentiation on the Internet will occur, but it willrequire careful analysis and execution to be successful.

40. Rise of E-commerce • Four specific characteristics of Internet commerce increasethe urgency of pricing and revenue optimization. • The Internet increases the velocity of pricing decisions. Many companies thatchanged list prices once a quarter or less now find they face the daily challenge ofdetermining what prices to display on their Web site or to transmit to e-commerceintermediaries. Many companies are beginning to struggle with this increased pricevelocity now. As a possible harbinger of things tocome, a typical major domestic airline needs to evaluate more than 500,000 pricechanges a week.

41. Rise of E-commerce 2. The Internet makes available an immediate wealth of information about customerbehavior that was formerly unavailable or only available after a considerable timelag. This includes not just information on who bought what, but also who clickedon what, and who looked at what and for how long. This information is being increasinglycaptured and analyzed by companies both to support cross-selling andup-selling and also to understand customer behavior and segmentation. 3. The Internet provides a unique laboratory for experimenting with pricing alternativesand alternative pricing models. eBay and Priceline are two Internet successstories, each with a business model based on variations of auction pricing. On the Internet, prices can be testedcontinually in real time, and customers’ responses can be instantly received. 4. Even in cases where a customer does not buy online, the Internet may providedeeper information about costs and competitive prices. This has been particularlytrue in “big ticket” consumer purchases, such as home mortgages and automobiles. In a study made in 2001, 62% of new-car buyers consultedthe Internet to find information on invoice prices, sticker prices, and trade-in values.

42. Success of Supply Chain Management Systems • The success of supply chain management systems proved that sophisticated quantitativeanalysis applied to complex corporate problems could lead to real improvements. • Pricingand revenue optimization is based on the same basic idea of using analytical techniques toimprove corporate decision making—in this case on the marketing and sales side of theorganization. • The successes of SCM has given corporate management greater confidencethat sophisticated analytical software can lead to real improvements in profitability, therebypaving the way for PRO. • Supply chain management has opened the door for pricing and revenue optimization inanother way. Most of the major corporate initiatives of the 1990s were focused on improvingefficiency and reducing cost. While the opportunities to improveefficiency and reduce costs have hardly disappeared, it is fair to say that most companies arebeginning to see reduced marginal returns from cost-focused initiatives. This means that themajor area remaining for corporate profitability improvement will be on the marketing andsales side. And, among opportunities for improvement in marketing and sales, PRO usuallyhas the most immediate impact and the highest return.

43. Success of Supply Chain Management Systems • Supply chain management has a natural synergy with pricing and revenue optimization. • Supply chain management systems have generally assumed that demand, whileuncertain, was exogenous. The job of the supply chain management system was to find away to fill current and anticipated orders at lowest cost while meeting customer service constraints. • Pricing and revenue optimization assumes that variable costs and capacity availabilitiesare fixed, and it looks to find the set of prices and customer allocations that maximizesprofitability, subject to these constraints. • While individually critical, each of thesecapabilities is looking at only a limited subset of the decisions faced by the overall organization. • A company that has achieved both supply chain management excellence and pricingand revenue optimization excellence may still have the opportunity to increase profitabilityfurther by explicitly linking the operations and the customer-facing sides of the company.

44. Success of Supply Chain Management Systems • All four of these factors—revenue management, the rise of the Internet, the new wealthof information, the success of supply chain management—point in the same direction, towarda future in which pricing will increasingly become a tactical and operational function,supported by a wealth of customer and supply information and requiring quantitative decisionsupport technology. • Timeconsuming“offline” analyses will become increasingly irrelevant—their results will be obsoletebefore they can be completed because theworld moves too quickly.Automated pricingand revenue optimization systems will be required to respond rapidly and effectively in thenew world. • However, automated systems are only part of the answer—effective pricing willalso require the right supporting business processes, metrics, and supporting organization.

45. Financial Impact of Pricing and Revenue Optimization • For most companies, better managementof pricing is the fastest and most cost-effective way to increase profits • Some retailers are achieving “gains in gross margins in the range of 5 –15%” from the use of optimizationbasedassortment and pricing optimization systems. Early adopters include J. C. Penney andGymboree (Friend and Walker 2001). • ShopKo Stores has seen a 24% increase in gross marginfrom the pilot use of a markdown management system (Levison 2002). • Ford MotorCompany has used a promotions management system to significantly improve the use of its$9 billion annual North American promotions budget (Leibs 2000) and expects to realizean additional $5 billion in profits over 5 years from effective market segmentation.

46. Outline of Next Lectures • Lecture 2: Discuss pricing and revenue optimization as a corporate process and contrastit with other approaches to pricing. It stresses that PRO is a highly dynamic process,dependent on continual feedback to ensure that pricing decisions are kept in line withchanging market realities. We will also discuss the concept that the core of pricing and revenueoptimization lies in the formulation of pricing and availability decisions as constrained optimization problems. • Lecture 3: Review the basic economics behind price optimization. We will introduce the ideaof a price-response curve and present several common forms of price-response curve. We will show how the price-response curve can incorporate competitive pricing. We will argue thatincremental cost is also a critical input to pricing a customer commitment. Finally we will showseveral ways that prices can be optimized in the simplest case of a supplier selling a singleproduct with a known price-response curve. • Lecture 4: Discuss how markets can be divided into different market segments such that a different pricecan be charged to each segment. Tactics for price differentiation include virtual products,product lines, group pricing, channel pricing, and regional pricing. The idea of multipricingis the source of both the benefits of PRO and the challenges involved in managing a largeportfolio of prices. We will discuss how to optimize differentiated prices in the face of potential cannibalization.

47. Outline of Next Lectures • Lecture 5:Introduce another major theme in pricing and revenue optimization—pricingwhen supply (or inventory) is constrained. Supply constraints are ubiquitous. They mayarise from the intrinsically constrained capacity of a service provider, such as a hotel, restaurant,barbershop, or trucking company; they may be due to limited inventory on hand;or they may be due to “bottlenecks” in a supply chain that restrict the rate at which a goodcan be produced or transported. In any case, constrained supply significantly complicatesoptimal pricing. We will also introduce the key concept of an opportunity cost—theincremental contribution lost due to a supply constraint. • Lecture 6: While revenue management has its origin in theairline industry, it has spread beyond the airlines and is in widespread use at hotels, rentalcar firms, cruise lines, freight transportation companies, and event ticketing agents. Someof the core techniques are gaining acceptance and use well beyond these industries. We will spend four lectures to revenue management. In lecture 6, we will describe the background,history, and business setting of revenue management. • Lecture 7: Discuss capacityallocation, the techniques used to determine which fare classes should be open andwhich closed at any time for a product consisting of a constrained resource.

48. Outline of Next Lectures • Lecture 8: Extendthe analysis to the case of a network, in which an individual product may use manydifferent resources. • Lecture 9:Discuss overbooking—the question of how many units ofa constrained product should be sold when customers may not show or may cancel. • Lecture 10: Markdown managementis an increasingly popular applicationof pricing and revenue optimization. In a markdown industry, a merchant has a stockof inventory whose value decreases over time. His problem is to determine the schedule ofprice reductions to take in order to maximize the return from inventory. Applications arewidespread, from fashion goods, through consumer electronics and durables, to theatertickets. We will describe basic markdown optimization models and some of the challengesin implementing markdown management in the real world. • Lecture 11:Discuss customized prices. Customized pricing is common in business-tobusinesssettings where goods and services are sold based either on long-term contracts oras part of large individual transactions. In these settings, list prices may not exist or mayserve only as “guidelines” off of which discounts are set. The pricing and revenue optimizationchallenge is to determine the discount levels to provide to each customer in orderto maximize the expected profitability of the deal. This requires estimating the tradeoff betweenthe probability of winning the deal and the margin contribution if the deal is won.

49. Outline of Next Lectures • Lecture 12:Discuss the issue of customer perception and acceptance of pricing tactics.Much of the classical theory of pricing is based on the idea that consumers are rational “utilitymaximizers.” Prices are emotionally neutral signals that guide purchasing decisions.However, both common sense and recent research has shown that this view is incompleteat best and misguided at worst. Consumers can care deeply about prices and the way theyare presented. In particular, pricing that is perceived as “unfair” can trigger an emotionalrejection. We will discuss the implication of consumer “irrationality” for PRO.