Pricing Decisions: Demand/Price Functions Pricing in Practice

Pricing Decisions
 Demand/Price Functions
 Pricing in Practice
 Cost based
 Value based
 Competition based
 Revenue Management
Thought for the Day
Improving pricing systems may provide the best

return on investment, compared to any other
marketing activity.
ME Pricing 2006 - 2
Demand/Price Functions
Linear Q
Q = a – bp
Quantity
Price
ME Pricing 2006 - 3
Demand/Price Functions
Constant Q
Elasticity
Q = aP–b
Quantity
Price
ME Pricing 2006 - 4
Classical (Theoretical)
Price Analysis for a Monopolist
1. Quantity demanded = f (Price)
2. Profit = Quantity (Price)  [Price – Unit Cost]
3. Find price to maximize profit (Find price where
Marginal Cost = Marginal Revenue).
Core Assumptions:
 focus on short run profit;
 focus on immediate customers;
 price is independent of advertising, promotion, etc.;
 demand and cost functions are known;
 unit cost is constant;
 firm has true control over price;
 competitors are ignored, etc.
ME Pricing 2006 - 5
Pricing Under Different
Elasticities of Demand
dQ P
Elasticity  E 
dP Q
Revenue ( R)  Q.P(Q)
dR dP
Marginal Revenue (MR)   Q. P
dQ dQ
dR  Q dP   1 
 P  1    1 P
dQ  P dQ   E 
ME Pricing 2006 - 6
Pricing Under Different
Elasticities of Demand
To maximize profit for the monopolist, set MR=MC. That is:
1  P 1
 E  1 P  MC  MC  1
  1
E
Therefore, the incremental price that you can get over marginal cost
depends on the elasticity of demand. When E is very large (infinity),
then P/MC = 1, i.e., P = MC. When E is very small, P will be much
larger than MC.
Marketing attempts to lower elasticity to the extent feasible (e.g.,

retail/airline loyalty programs).
ME Pricing 2006 - 7
Profits at different Elasticities (Lo versus Hi)
Example effects of price increases

Before After (Lo) After 2 (Hi)
Price 10.00 10.10 +1% 10.10 +1%
Quantity 100 98 90
Revenue 1,000 989.8 909.0
Total Cost 970 950.6 873.0
Profit 30 39.2 +31% 36.0 +20%
ME Pricing 2006 - 8
Pricing in Practice
Cost-Oriented Pricing (e.g., learning curve analysis)

Costs influence prices because they
influence supply.
Demand-Oriented Pricing (e.g., elasticity analysis

Customers influence prices through value-in-use analysis)
their influence on demand.
Competitor-Oriented Pricing (e.g., competitive bidding)

Competitors influence prices through
their actions in the marketplace.
ME Pricing 2006 - 9
Value-in-Use
Example: A chemical plant uses 200 O-rings to seal valves carrying

corrosive materials. Those O-rings cost $5.00 each and must be
changed during regular maintenance every two months.
A new product has 2  the corrosive resisting power. The value-
in-use of the material might be:
1. Annual cost of incumbent

= 200 (rings)  6 changes/year  $5/O-
ring
= $6,000
= 200  3  VIU
 
Rings Changes
–––––––
Year
VIU = $10
ME Pricing 2006 - 10
Value-in-Use Example cont’d
2. Suppose the new material allows a longer time between

shutdowns—4 months vs. 2 months, and the cost of a
shutdown is $5,000.
200  6  5+ 5,000  6 =200  3  VIU + 5,000  3
   
Equipment Shutdown Equipment Shutdown
Cost Cost Cost Cost
Incumbent New
VIU = $35
Suppose number of O-rings is a variable . . .

# = number of O-rings
VIU = Value-in-use
#  6  5 + 5,000  6 = #  3  VIU + 5,000  3
   
Equipment Shutdown Equipment Shutdown
Cost Cost Cost Cost
Incumbent New
or
VIU = $10 + $5,000/#

Suppose the market consists of 5 sizes of plants.

Using method 2, we get:
# Plants # O-Rings/Plant VIU
10 100 $60.00
10 200 $35.00
10 300 $26.70
10 400 $22.50
10 500 $20.00
Market Potential vs. Value-in-Use
How price determines market potential:
Market Potential
Price (units/year)
$20 45,000
25 18,000
30 9,000
40 3,000
• •
• •
• •
60 3,000
What if Shutdown Cost varies with
Enterprise Size?
VIU = f [#(Z)]
where:
#= # (Z)
Z= enterprise size.
 Can add as many variables as are critical

to assessing value and segmentation can
be based on variations in value.
Pricing and Market Penetration
vs. Value-in-Use
Slicing the VIU

Value Salami
Customer Surplus
(Economic Driving Force)
Price
Margin
(Profit)
Cost
Cost of Production
(Loaded)
Value-in-Use Tips
Be sure to include all costs when doing a VIU calculation.

Use costs = (Annual)
 Purchase cost +
 Fabrication cost +
 Finishing cost +
 Inventory cost +
 Maintenance/Service cost
 Scrap adjustment +
 Level-of-requirement adjustment +
 Changeover cost +
 Risk premium
Use the user’s cost of capital when making multi-year calculations.
VIU  be a customer!
Competition-Oriented Pricing:
Competitive Bidding
 Firm is in competition with an unknown

number of suppliers with no (deterministic)
knowledge of their prices.
 Two approaches:
symmetric: (competitors are like me—game
theory/equilibrium analyses)
asymmetric: (my analysis is different than
competitors, who can be represented
probabilistically—decision analysis)
Decision Analysis Approach
Q1: Should I bid at all?

Q2: If Yes to Q1, what should the bid be?
Expected Profit (P) = Win Prob (P) [P – C]
where:
P= Price,
C = Cost of production.
 Every (bid) price has a “Win Prob”.
How can that Win Prob be estimated?
Assume One Competitor
100%
Chance of
Competitor 50%
Bidding X
or Lower
0%

Best Guess
Competitive Bid (X)

Perhaps “Best Guess” k  “Our Cost”, ie, a model of competitive bids.
Perhaps for 2 or more competitors, k varies as ki, i = 1, 2, . . . # competitors,
(ki is highskimmer
ki is lowpenetrator)
How Much to Bid?
100%
Competitive
Bid Our Win
Probability
Probability is this area
0%

Our Bid
Competitive Bid (X)
So, to win, we must bid lower than our (one) competitor.
If there are n competitors, we must be lower than all of them. So,
Win Probability = prob. of bidding lower than Competitor 1
and Competitor 2 and . . . Competitor n.
Question
How can this structure help select a bid price when:
a.the number of competitors is known?
b.the number of competitors is not known for sure?
c.our costs are not known for sure?
Calculating Optimal Bid Price
Likelihood of Winning (%)

100
80
Market Response
60
Market Response
40
Curve
20
0
X
Bid Price
1200
Contribution Margin
1000
800 Revenue - Costs
Contribution 600
400
Margin 200
0
-200
Bid Price
=
-400
800
Expected Contribution
700
Target Price
600
500
Most Profitable Bid
Expected 400 Price calculated
Contribution 300
200
100
0
Bid Price ME Pricing 2006 - 23

Differential Pricing
First Degree — Charge

consumers exactly what they
are willing to pay for product
(e.g., college tuition)
Second Degree —
Offer consumers a menu of
Price options at different prices
Discrimination that correspond to
consumers’ willingness to
pay for the different options
(e.g., volume pricing)
Third Degree — Divide

consumers into distinct
segments, charging different
prices to different segments
(e.g., movie-theater pricing)
Differential Pricing with
Differential Service
Value from….Value to Value from….Value to
ice
e rv vic
e
S r
i ce Se
Serv vice
Ser
Appropriate Appropriate
Low-Value High Value
Low-cost Higher Cost
Customers Customers
Service Level Service Level
Balance the value provided to a customer with the price received from the customer.
Bases for Differential Pricing
 Geographic
 Temporal (time of making reservation)
 Non-linear (Quantity discounts)
 Costs of servicing an account
 Reference accounts
 …….
Temporal Price Discrimination
(Revenue Management)
Revenue management is the art and science of selling the right

product to the right customer for the right price at the right time.
 High fixed cost industries
 Service industry (here, we focus on hotels and airlines)
 Alternative approaches
 Time-of-day pricing
 Time when purchased
 Day of the week pricing
 Seasonal pricing
Why Revenue Management?
1. Use price management, rather than cost cutting to

balance supply and demand.
2. Price according to what the market will bear.
3. Use differential pricing to reach different segments of
customers.
4. Save the “best product” for the most valuable customers.
5. Make decisions based on real-time market information.
6. More fully exploit available resources.
7. Revenue management is a way to bring discipline into
the organization’s decision making process.
Actual Revenue Data for
a Sample Flight
Passengers Revenue ($)

Fare Class Boarded Spilled Total Average Total
Y0 12 0 12 313 3,756
Y1 6 0 6 258 1,548
Y2 10 0 10 224 2,240
Y3 3 0 3 183 549
Y4 30 29 59 164 4,920
Y5 16 5 21 140 2,240
Y6 32 32 64 68 2,176
Total 109 66 175 17,429
Total available seats: 138
Revenue Stream if Low
Price Seats Fill up First

Fare Class Demand Boarded Average Total
Y0 12 0 313 0
Y1 6 0 258 0
Y2 10 0 224 0
Y3 3 0 183 0
Y4 59 53 164 8,692
Y5 21 21 140 2,940
Y6 64 64 68 4,352
Total 175 138 15,984
Revenue Stream if Airline
Knows Exact Demand Pattern

Fare Class Demand Boarded Average Total
Y0 12 12 313 3,756
Y1 6 6 258 1,548
Y2 10 10 224 2,240
Y3 3 3 183 549
Y4 59 59 164 9,676
Y5 21 21 140 2,940
Y6 64 27 68 1,836
Total 175 138 22,545
What is the opportunity cost of not having a revenue

management system?

Implementing Revenue Management
 Estimate demand for each class of service.
 Demand arrives over time—so update

demand function/remaining supply.
 Allocate remaining space to:

 maximize expected profitability
 meet other criteria
subject to situation specific constraints.
Revenue Management Process
3-Step Process
I:Design
II:Seasonal Planning/Allocation
III:Daily Management
Revenue Management Process cont’d
Step I: Design
Specify:
 Number of classes of services
 Design of each service class
 (Average) price/demand curve/class
 Total capacity
Step II: Seasonal Planning/Allocation
 Specify time path of demand arrival/class

 Minimum price difference/class
 Seasonal demand adjustments
 (Incremental) cost of service
Find:
 Optimal number of spaces/class
 Optimal price/class
Step III: Daily Management
 X days before target date
 Current booked-to-date by class
 Update expected demand

Update allocation of product to
class (upgrade/release higher
class of service product)
Example of Revenue Management
in Action
Occupancy
Rate % 1. 60 days before room-night, a
hotel might accept bookings
with some discounts. At the
Decision Points same time, some marketing
strategies could be pursued.
2. At this point, the hotel might sell
rooms only at full rates,
4 70 assuming that the demand curve
will continue.
3. The hotel can use aggressive
Reservation marketing strategies and
Profile discount rooms to reach target
2 3
occupancy.
1 4. The demand curve really picks
up. The 70% target occupancy is
Actual passed 8 days before due date.
Reservations The hotel goes back to full rates.
Leadtime (days) 45 30 15 0
Revenue Management in Practice
Airlines
 Major US domestic carriers:
 Operate 5000 flights per day
 Serve over 10,000 markets
 Offer over 4,000,000 fares
 Schedules change twice each week
 On a typical day, a major carrier will change 100,000 fares
 Airlines offer their products for sale more than one year in
advance
 The total number of products requiring definition and control is
approximately 500,000,000 (various possible routes)
 This number is increasing due to the proliferation of distribution
channels and customer-specific controls
Source: Sabre
Real-Time Transactions Data for
Revenue Management in Airlines
PHG 01 E 08800005 010710 010710 225300 XXXXXXXX 000000 I 01 1V XXXXXXXX SNA US XXX 05664901 00000000 XXXXXXXXX XXX I R 0 0
1 PSG 01 OA 3210 LAX IAH K 010824 1500 010824 2227 010824 2200 010825 0227 HK OA 0 0
PSG 01 OA 9312 IAH MYR K 010824 2330 010825 0037 010825 0330 010825 0437 HK OA 0 0
PSO 01 EV 0409 K
PSG 01 OA 1221 LAX IAH K 010825 0600 010825 1325 010825 1300 010825 1725 HK OA 0 0
2 PSG 01 OA 0409 IAH MYR K 010825 1455 010825 1636 010825 1855 010825 2036 HK OA 0 0
PSO 01 EV 4281 Y
PSG 01 OA 4281 MYR IAH Y 010902 0600 010902 0714 010902 1000 010902 1114 HK OA 0 0
PSG 01 OA 5932 IAH LAX K 010902 0800 010902 0940 010902 1200 010902 1640 HK OA 0 0
PSO 01 EV 0409 K
3 PSG 01 OA 0409 IAH MYR K 010825 1455 010825 1636 010825 1855 010825 2036 HK OA 0 0
PSO 01 EV 4281 Y
PSG 01 OA 4281 MYR IAH L 010903 0600 010903 0714 010903 1000 010903 1114 HK OA 0 0
PSO 01 EV 0409 K
4
PSO 01 EV 2297 L
PSG 01 OA 2297 MYR IAH Q 010903 1140 010903 1255 010903 1540 010903 1655 HK OA 0 0
PSO 01 EV 0409 K
5 PSG 01 OA 1221 LAX IAH K 010825 0600 010825 1325 010825 1300 010825 1725 HK OA 0 0
PSO 01 EV 2297 Q
PSG 01 OA 0981 IAH LAX Q 010903 1420 010903 1608 010903 1820 010903 2308 HK OA 0 0
PSG 01 OA 2297 MYR IAH Q 010903 1140 010903 1255 010903 1540 010903 1655 HK OA 0 0
Source: Andrew Boyd ME Pricing 2006 - 39

Decision Support Systems
for Revenue Management
Source: Andrew Boyd ME Pricing 2006 - 40

Why Revenue Management?
1. Use price management, rather than cost cutting to

balance supply and demand.
2. Price according to what the market will bear.
3. Use differential pricing to reach different segments of
customers.
4. Save the “best product” for the most valuable customers.
5. Make decisions based on real-time market information.
6. More fully exploit available resources.
7. Revenue management is a way to bring discipline into
the organization’s decision making process.
From Revenue Management to
Dynamic Pricing?
 Typically, revenue management and

differential pricing go together, but this is not
necessary
 Do fare classes represent different products, or
different prices for the same product?
 Although revenue management appears to
focus on inventory management and control, it
is really about dynamic pricing based on
evolving demand forecasting.
Lessons
 Pricing offers high leverage in improving profitability.

 Understanding elasticity of demand for different
customer segments is key to making informed price
decisions.
 Revenue management (typically accomplished through
differential and dynamic pricing) is an important
determinant of profitability in high fixed-cost
industries.
Non-Linear Pricing/
Quantity Discounts
 Two-part tariff:
 membership in clubs
 fixed fee + constant variable cost
(razor + blades)
 Block tariff:
 quantity discount
 why?
 when?
Product Line Pricing
 Products in a product line may be related to one

another on the demand side, either as substitutes or as
complements.
 There may be cost interdependencies, such as shared

production, distribution, or marketing expenditures.
 Some products may be sold as a bundle (stereo system

vs. components), thereby creating complimentarity.
 The price of one product in a line may influence the

buyer’s subjective evaluation of other products in the
line.

Pricing Decisions: Demand/Price Functions Pricing in Practice

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Pricing Decisions

Improving pricing systems may provide the best

To maximize profit for the monopolist, set MR=MC. That is:

Marketing attempts to lower elasticity to the extent feasible (e.g.,

Example effects of price increases

Cost-Oriented Pricing (e.g., learning curve analysis)

Demand-Oriented Pricing (e.g., elasticity analysis

Competitor-Oriented Pricing (e.g., competitive bidding)

Example: A chemical plant uses 200 O-rings to seal valves carrying

1. Annual cost of incumbent

2. Suppose the new material allows a longer time between

200  6  5+ 5,000  6 =200  3  VIU + 5,000  3

Suppose number of O-rings is a variable . . .

#  6  5 + 5,000  6 = #  3  VIU + 5,000  3

VIU = $10 + $5,000/#

Suppose the market consists of 5 sizes of plants.

# Plants # O-Rings/Plant VIU

How price determines market potential:

 Can add as many variables as are critical

Slicing the VIU

Be sure to include all costs when doing a VIU calculation.

Use the user’s cost of capital when making multi-year calculations.

 Firm is in competition with an unknown

Q1: Should I bid at all?

Expected Profit (P) = Win Prob (P) [P – C]

 Every (bid) price has a “Win Prob”.

How can that Win Prob be estimated?

Competitive Bid (X)

How can this structure help select a bid price when:

a.the number of competitors is known?

b.the number of competitors is not known for sure?

c.our costs are not known for sure?

Likelihood of Winning (%)

Bid Price ME Pricing 2006 - 23

First Degree — Charge

Third Degree — Divide

Value from….Value to Value from….Value to

Revenue management is the art and science of selling the right

 High fixed cost industries

 Service industry (here, we focus on hotels and airlines)

1. Use price management, rather than cost cutting to

Passengers Revenue ($)

Total available seats: 138

Passengers Revenue ($)

Total available seats: 138

Passengers Revenue ($)

What is the opportunity cost of not having a revenue

Total available seats: 138

 Estimate demand for each class of service.

 Demand arrives over time—so update

 Allocate remaining space to:

 Number of classes of services

 Design of each service class

 (Average) price/demand curve/class

Step II: Seasonal Planning/Allocation

 Specify time path of demand arrival/class

Step III: Daily Management

 X days before target date

 Current booked-to-date by class

 Update expected demand

Source: Andrew Boyd ME Pricing 2006 - 39

Source: Andrew Boyd ME Pricing 2006 - 40

1. Use price management, rather than cost cutting to