Capacity Allocation

RM Course
Instructor: Derya EREN AKYOL
Capacity allocation is the problem of determining how many
seats / hotel rooms / rental cars to allow to low-fare
customers to book when there is the possibility of future
high-fare demand.

ASSUMPTION of two main segments:

o 1. early-booking, low-fare leisure customers
o 2. later-booking, higher-fare business customers
Capacity allocation is also an issue for any revenue
management company that has the opportunity to restrict
early low-price bookings in order to reserve capacity for later
higher-price bookings. (Phillips,2005)
 RISKS
SPOILAGE
• There is a tradeoff between setting the booking
• limit too high and setting it too low.
• If we set the discount booking limit too low, we
will turn away discount customers but not see
enough full-fare demand to fill the plane
• The plane will depart with empty seats even
though we turned away bookings
• This is called spoilage, since the empty seats
become spoiled inventory when the flight departs
 RISKS
DILUTION
• If we allow too many discount customers to book,
we run the risk of turning away more profitable
full-fare customers
• This is called dilution, since we diluted the
revenue we could have received from saving an
• additional seat for a high-fare booking
• The challenge of capacity allocation is to balance
the risks of spoilage and dilution to maximize
expected revenue
 The Two Class Problem
• In the two-class capacity allocation problem, a flight
(or other product) with fixed capacity serves two
classes of customers:
• Discount customers who book early
• Full-fare customers who book later
• Discount customers each pay a fare pd
• Full-fare customers each pay a higher fare pf
• pf >pd
• The static two-class capacity allocation
problem is:
–How many discount customers (if any)
should we allow to book?
OR
–How many seats (if any) should we
protect for full-fare customers?
The goal of two-class capacity allocation is to
determine a discount booking limit—the maximum
number of discount bookings that will be allowed.

When there are only two classes, the protection

level for full-fare bookings is equal to the capacity
minus the booking limit:
•y =C–b
• where y is the protection level; C is the capacity; b is the
discount booking limit
Figure 1. The Decision Tree for the two-class problem
Ff(x): The probability that full fare demand is less than or
equal to b
Fd(x): The probability that discount demand is less than or
equal to b
Flight total capacity: C

The problem is to decide how much discount class demand to

accept before seeing the realization of full fare demand.

That is whether or not to increase the booking limit by one

seat.
In other words, what would be the change in expected revenue
if we increase the booking limit from b to b+1?

Explanation of the Decision TREE

If discount demand dd is less than or equal to b, there
will be no effect on expected revenue. The net change
in expected revenue is zero.
• When discount demand dd is greater than b, there will
be interesting effect!!!(occurs with probability 1-
Fd(b)). Then increasing the booking limit from b to b+1
results in an additional discount passenger.

• BE CAREFUL!!!
• The net effect on revenue depends on full fare
demand. If full fare demand is greater than C-b (occurs
with probability 1-Ff(C-b)), the resulting change in total
revenue is Pd-Pf (less than zero). Why? Write your
comments through teams!
• If discount demand dd is greater than b and
full fare demand is less than the protection
level, C-b. In this case, we accept an additional
discount passenger but do not displace a full
fare passenger. The gain is Pd.
• Spoilage is reduced.
• The expected change in revenue from
changing the booking limit from b to b+1 is
E[h(b)]=Fd(b)0+[1-Fd(b)]{1-Ff(C-b)](pd-pf)+Ff(C-
b)Pd}
=[1-Fd(b)]{Pd-[1-Ff(C-b)]Pf}

If this term is >0, we can increase expected

profitability by increasing the booking limit from
b to b+1.
 Littlewood’s Rule (works for 2-
class problem)
1-Ff(C-b*)=Pd/Pf
1-Ff(y*)=Pd/Pf
Where y* is the optimal protection level for
full fare demand.
The probability that full fare demand will
exceed the protection level is Pd/Pf
∗ −𝟏𝟏 𝑷𝑷𝒅𝒅
𝒚𝒚 = 𝑭𝑭𝒇𝒇 (𝟏𝟏 − )
𝑷𝑷𝒇𝒇
Remember the inverse of a function!!!
 NOTE:
If P=F(X)
−1
𝑋𝑋 = 𝐹𝐹 (𝑝𝑝)
 Relation to Newsvendor Problem
• Littlewood's rule has a close relationship to
the so-called critical fractile (or critical ratio)
solution to the optimal replenishment
problem for perishable goods.
• Both capacity allocation and replenishment of
perishable goods are themselves special cases
of a classic problem known as the newsvendor
problem.
The newsvendor problem considers the
situation in which a purchaser needs to order a
quantity ofsome good in the face ofuncertain
demand. The problem got its name from the
example of a newspaper salesperson who needs
to determine how many newspapers to
purchase at the beginning of the day to satisfy
the day's uncertain demand.
The key to this decision is that the newsvendor
faces different "costs" if he purchases too much
or too little. If he buys too many newspapers,
then at the end of the day he will have unsold,
worthless copies that he discards.
The solution to the newsvendor problem can be expressed in
terms of the overage cost and the underage cost of the decision.

The overage cost is the cost per unit of purchasing too many
items; the underage cost is the unit cost of purchasing too few.

𝑼𝑼
𝑭𝑭 𝒀𝒀 =
𝑼𝑼 + 𝑶𝑶
O=Pd (if we keep the discount level too low and keep
the full fare level high, but not see enough full fare
demand, the revenue loss is Pd)
U=Pf-Pd (if we keep the discount level too high, and
see high full fare demand, our loss is Pf-Pd)
Y: the optimal order quantity for the newsvendor
 −𝟏𝟏
𝑷𝑷𝒅𝒅
𝒀𝒀 = 𝑭𝑭 (𝟏𝟏 − )
𝑷𝑷𝒇𝒇

In order to calculate the inverse of different functions,

you will need statistical tables.

Question: What will be decison if we have more than 2

classes?
Let us discuss it next week. If you have any comments,
please write online!!! If you can draw figures, please
convey me by email or through TEAMS.