Revenue Management &

Dynamic Pricing
Krishna Mohan T V
Assistant Professor
Operations, Supply Chain Management & Quantitative Techniques
✉ krishnamohan@iimbg.ac.in
Basic Price Optimization
Lecture 3

2
 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?
3
 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?
4
 Harrah’s Case
• 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
programs 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?

5
 1. Objectives and effectiveness of various
DBM programs incorporated by Harrah’s
1. New business program
2. Loyalty program – frequency upside
3. Loyalty program – Budget upside
4. Retention program
5. Total Rewards program

6
 1. Objectives and effectiveness of various
DBM programs incorporated by Harrah’s
1. New business program.
• To convert first time customers into long term customers by sending
them offers that are redeemable
• Exhibit 2b provides the data
• Compare number of customers retained and their predicted worth
• No information on profitability

7
 1. Objectives and effectiveness of various
DBM programs incorporated by Harrah’s
2. Loyalty program – frequency upside
• Objective: to increase trip frequency
• In June 1999, they identified the customers who could increase the number of trips to
Harrah’s and send them redeemable offers in July, August and September
• Cash and food-based offers
• Exhibit 2c: avg. theoretical win increased from $8000 per month to $50000 per month
• Incremental revenue = $50000(1-comp%) -$8000(1-comp%) =$32860
• Incremental cost = 130 (avg. guest) * redemption % * trips/guest * cost of program = 130*
0.47 * 1.2 * (x+40) – 31 * 0.1 * 1 * x
• With x probably less than 40, profits $25,000 per month
8
 1. Objectives and effectiveness of various
DBM programs incorporated by Harrah’s
3. Loyalty program – Budget upside
• Objective: To capture a large share of customers' gambling budget
• Customers mailed a coupon form November to April
• Exhibit 2d
• Increased redemption and average trips per month
• Program generated $9437 per month
• Hotel % - 0, as customers targeted do not stay overnight. So, the effectiveness is
limited.

9
 1. Objectives and effectiveness of various
DBM programs incorporated by Harrah’s
4. Retention program
• Exhibit 2e
• 8000 customers send a direct offer redeemable in each months of February-April
• Cash coupon varying with customer worth
• Customer number increase in the offer period

10
 1. Objectives and effectiveness of various
DBM programs incorporated by Harrah’s
5. Total Rewards Program
• Exhibit 2f
• Introduced in July 1999 for 100 customers
• Effectiveness measured by looking at play consolidation before and after the program
• Some positive impact, but nothing extraordinary

11
 2. Metric
• Theoretical win over observed play
• Observed play affected by luck: casino maty spend more on a customer with less economic
value
• Enabled opportunity-based customer segmentation
• Historical visit patterns were effectively analyzed
• Customer felt they are treated well
• Casino could conduct marketing experiments: worked on the complimentary benefits
• Total Gold program: rewarding credits

12
 3. Integration of various elements of marketing strategy

• New organizational structure

• Individual properties have to give their ownership
• Use of more marketing tools at local level
• Target marketing
• Brand campaigning
• Transaction data used effectively
• Leveraged infrastructure: opened new Casino all over
• Patented the process
13
 4. Sustainability of Harrah’s Strategy
• Harrah’s was able to make a differentiated position in the market
• The intensity of distribution is high
• Trump card a competitor: they were also applicable across Casinos
• The investment and network requirements
• Ethical issues?

14
 Common Price-Response Functions

1. Linear price-response function

2. Constant-elasticity price-response function
3. The logit price-response functions

15
Linear Price-Response Function
• General formula: d(p) = D – m(p)…(8)
• D>0, m>0
• P – satiating price
• Slope : -m for 0 < p < P , 0 for p ≥ P
• Elasticity : mp/(D – mp)
• Range of elasticity:
0 at p = 0, ∞ as p → P, 0 for p > P
16
Linear Price-Response Function: Characteristics

• Convenient and easily tractable

• Not a realistic global representation of price response
• Do not take into consideration the base price, i.e., linear price-response
function assumes the change in demand for a small price increase will be the
same irrespective of the base price
• This is unrealistic like in situations when a competitor offers a close
substitute, the effect of price change may be higher when the base price is
close to competitor’s price
17
Constant-elasticity price-response function
• Constant-elasticity price-response function has a point-elasticity that is same at all prices :
d ’(p)p/d(p) = - ∈ for all p>0 … (9)
• The price response function is
d(p) = Cp -∈ … (10)

C >0 and is defined as d(1)

• Slope of the price-response function
d ’(p) = -C ∈ p -(∈ +1)
18
Constant-elasticity price-response function
• Neither finite nor
satiating
• Demand never drops
to zero as well
reaches infinity when
price tends to zero
• Not a good global
assumption for price-
response
19
Constant-elasticity price-response function & Revenue

• Let R(p) be the revenue of a seller facing constant- elasticity price- response
R(p) = p C p -∈
= Cp(1 - ∈ )
• Taking the slope ,
R’(p) = (1 - ∈) C p -∈
= (1-∈) d(p)

20
Constant-elasticity price-response function & Revenue

• As d(p)>0, (1-∈) term determines the

slope
• ∈ < 1 , revenue always increase with
price
• ∈ =1, no change in revenue with
price
• ∈ > 1, revenue decrease with price,
max. revenue when p→0
• A seller can maximize revenue either
by dropping price near to zero or
increasing the price to infinity21
Constant-elasticity price-response function & WTP

w(x) = ∈ x –(∈+1)

22
 Logit Price-Response Function
• When the price of a product is well above (below) the market price, a small decrease
(increase) in price relative to the market price won’t impact much. But when the
price is near to market price even a small increase(decrease) in price will lead to
decrease(increase) in demand.
• Price elasticity is low in both the cases
• Linear and constant-elasticity price-response functions fail to capture this type of customer
behavior
• What would be the nature of the price-response function that captures this
behavior?

23
Logit price-response function
• Reverse S-shaped or sigmoid
price-response curve
• At the area of market price,
the demand is very much
sensitive to price
• Empirical research shows that
this general form fits a wide
range of markets
24
 Logit price-response function
• Logit price-response function
𝑪𝒆−(𝒂+𝒃𝒑)
𝒅(𝒑) = ...(11)
𝟏+ 𝒆−(𝒂+𝒃𝒑)
• a, b, C – parameters
• C >0, Size of overall market
• b > 0 , price sensitivity, more the value of b the market approaches perfect competition
• a any value, but usually taken >0
𝒂
• Approximately at the market price, the curve is steepest, 𝒑
ෝ = −( )
𝒃 25
Logit price-response function
• Logit price-
response function
for C =20,000 and
p = $ 13,000

26
Logit price-response function & WTP
• WTP distribution
for logit price
response function
with b =0.0005
(y-axis has been
scaled by a factor
of 20,000)
• The highest point
(mode) of WTP
logit distribution
function,
𝒂
𝒑ෝ = −( )
𝒃
27
 Logit price-response function: Properties

𝑪𝒆−(𝒂)
Demand at 0 𝒅(𝟎) =
𝟏 + 𝒆−(𝒂)

−𝑪𝒃𝒆−(𝒂+𝒃𝒑)
Slope 𝒅′(𝒑) =
𝟏 + 𝒆− 𝒂+𝒃𝒑 𝟐

𝒃𝒑
Elasticity ε(𝒑) =
𝟏 + 𝒆− 𝒂+𝒃𝒑

𝑲𝒆−(𝒂+𝒃𝒙)
WTP Distribution 𝒘(𝒙) =
𝟏 + 𝒆− 𝒂+𝒃𝒙 𝟐

28
 Price Response with Competition
• Competition an important component in pricing
• Levels at which competition can be included in Pricing and
Revenue Optimization
1. Incorporating competition in the Price-Response Function
• Past responses might have taken care of competition
1. If disruption happens, relay on fast “feed-back loop”
2. Consumer-Choice Modeling
3. Anticipating Competitive Response
• RM works better than finding the best response 29
 Consumer Choice Modelling
• A situation where several competitors provide a similar product or service to
a population of customers
• Each competitor sets a price
• Each customer has a vector of WTP, one for each product associated with
the “brand-value” of the product
• Customer Surplus = Customer WTP – Price of product
• Each customer purchases the product with the highest positive surplus; at
zero surplus the customer may refrain from purchasing 30
 Exercise 7
• A customer is shopping for a laptop. The price of laptops and the customer’s WTP
are given. Find the Laptop the customer will choose based on consumer choice
modelling
Model Price WTP Surplus Note: neither the
low priced one
Orange Rs. 1,19,600 Rs. 1,20,000 400 (Zeus)) nor the one
with highest WTP
XP Rs. 78,000 Rs. 80,000 2000
(Orange) is selected.
Bell Rs. 82,300 Rs. 75,000 -7300
Stylo Rs. 85,600 Rs. 90,000 4400 (Highest surplus, hence the choice)
Zeus Rs. 72,000 Rs. 75,000 3000 31
 Consumer Choice Modelling & Market Share

• Each customer will have different set of reservation prices for different
alternatives
• Market share of alternative i =
Fraction of buyers for whom wi - pi > wj - pj for all j
• Consumer choice modelling predict the market share of each alternative
given all of the prices

32
 Consumer Choice Modelling & Market Share
• p =(p1,p2,…, pn) be the price vector and μi the market share of alternative i
• Let there be market share function μi = fi(p) for all i. The function has the following
characteristics
• 0≤ fi(p) ≥ 1, market share of each alternative is between 0 and 1
• σ𝒏𝒊=𝟏 fi(p) =1, every buyer chooses one alternative
𝛛𝒇𝒊 𝑷
• 𝛛𝒑
< 0, increase in price of product decreases its market share
𝒊
𝛛𝒇𝒊 𝑷
• 𝝏𝒑𝒋
> 0, for i≠j, increase in price of a product increases market share of other products
as they are substitutes
33
 Consumer Choice Modelling & Market Share
• Given the market share function, the demand of a product is given by
• di(p) = D μi = D fi(p) …(12)
• Most widely used consumer choice function:
The multinomial logit (MNP)
𝒆−(𝒃𝒑𝒊)
μi(𝒑) = 𝑛
σ𝑗=1 𝒆−(𝒃𝒑 ) ...(13)
𝒋

• bj – measure of price responsiveness of alternative

• When competitive prices are constant MNL reduces to logit price response function
34
 Exercise 8
Compute the market share of all laptops (use equation (13))
Model Price bj µi(p)
Orange $400 2.5 0.31

XP $650 3.077 0.11

Bell $500 2.4 0.25
Stylo $750 2.4 0.14

Zeus $1200 1.25 0.19

35
 Consumer Choice Modelling & Market Share

• When competitive prices are constant (stable) MNL reduces to the logit
function
− 𝑏𝑖𝑝𝑖
• Let 𝐾 = σ𝑛𝑖=2 𝑒
𝑫𝒆−𝒃𝟏𝒑𝟏 𝑫𝒆−𝒃𝟏𝒑𝟏 /𝑲 𝑫𝒆−𝒃𝟏𝒑𝟏 𝒆−𝒍𝒏(𝑲) 𝑫𝒆−(𝒂+𝒃𝟏𝒑𝟏)
• 𝒅𝟏(𝒑𝟏) = 𝒆−𝒃𝟏𝒑𝟏 +𝑲
= 𝒆−𝒃𝟏𝒑𝟏
=
𝒆−𝒃𝟏𝒑𝟏 𝒆−𝒍𝒏(𝑲) +𝟏
=
𝒆−(𝒂+𝒃𝟏𝒑𝟏) +𝟏
…(14)
𝑲
+𝟏

• a = ln(K)

36
 Consumer Choice Modelling: Characteristics
• Strengths
• Vast literature available on consumer-choice modeling, and the issues involved with estimating the
parameters of consumer-choice models have been much studied.
• Statistical software packages such as SAS include procedures for estimating the parameters of the logit
or the probit market-share functions
• Weaknesses
• Customers may not purchase at all
• Huge discounts may attract more customers to the market
• The theory requires information of all competitor’s prices, but in practice only a few are analyzed.
• Competitive index price prepared by weighing the prices offered by major competitors are used as a
single price in multinomial logit.
37