Session 3 Handout PDF

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Data Envelopment Analysis

Measurement and Benchmarking
How to evaluate performance of an organization
Manufacturing firm:
A branch of a bank:
Considerations:
1. multiple inputs and outputs
2. Different measurement units (KPIs), non-financial metrics
3. (possibly) conflicting metrics and perspectives
Q: Is there a way to somehow compare efficiency of organizations (or

companies) within an industry?
217
Ways to rank/benchmark
• In some cases, a dominant metric exists
• Hrs/transaction (in call center) , $sales/sq.-ft. (mall and casino)
• Financial approach: convert everything to $.
• Clustering or statistical discrimination (predictive analytics)
Problems:
In most organizations, many different mix of inputs and outputs
Some inputs/outputs cannot be valued in $ (non-profit)
Difference between efficiency and profitability.
One way to cope with these difficulties:
DEA (Data Envelopment Analysis)
(c) Prof Ozge Sahin, 2019 1

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Intuition building.
Cost Profit
Store 1 (Lauren) $10K $30K
Store 2 (Emily) $10K $40K
Which store performs better?
If there is only one input and one output, comparison is easy.
219

Intuition building: Multiple metrics
Cost Profit Satisfaction
Store 1 (Lauren) $10K $30K 90
Store 2 (Emily) $10K $40K 85
Which store performs better?

(The beauty is in the eye of the beholder.)

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Which store performs better? Profit

(The beauty is in the eye of the beholder.)
If you are profit-centric?
If you are service-centric?
If you are using both? Exactly how?

Service
221

Store 3 (John) $15K $25K 87
Can you find a (objective) scoring rule that will rank

store 1 in the top?
Profit
Is there a rule that will rank store 2 in the top?
Is there a rule that will rank store 3 in the top?

Service

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• Developed by Charnes, Cooper, Rhodes (1978)
• Compares each organization (DMU, decision making unit) to other
organizations.
• measures the maximum (more on this later) relative efficiency of
each DMU (compared to others) by dividing the data into 2 groups
Outputs: profit, customer satisfaction (The more, the better)

Inputs: labor hours, FTEs, costs (The less, the better)
Weighted sum of outputs

Efficiency of an organization =
Weighted sum of inputs
How do we set the weights (scores)? This is the crux of DEA.
223
DEA Illustrative Example: Metropolis National Bank

Metropolis National Bank operates five branches around the city of
Baltimore. The five branches offer the same services and rely on identical
mixes of labor and capital. As a result , the cost of operation is the same at
each branch although the volumes of loans and deposit (in $K) processed
differ. The following list summarizes the level of branch performance (per
week).
Deposits Loans Expense

Branch 1 31 10 100
Branch 2 25 15 100
Branch 3 30 20 100
Branch 4 23 23 100
Branch 5 20 30 100

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Deposits
40
B1 B3
30
B5
20 B2
B4
10
0
0 10 20 30 40
Loans
Which of the 5 branches can be considered efficient (i.e., can be ranked
best) with some scoring rules?
Which of the 5 branches can be considered inefficient (i.e., can not be

ranked top regardless of scoring rules?
225

Deposits
Loans Deposits Expense
40
B1 B3 Branch 1 10 31 100
30
Branch 5 30 20 100
B5
20 B2
B4
10
0
0 10 20 30 40
Loans
Can you say Bank 1 is better than Bank 5?
If weight for loan = 1 and weight for deposit =1
If weight for loan = 1 and weight for deposit =2

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Deposits
40
B1 B3 Branch 2 15 25 100
30
Branch 3 20 30 100
B5
20 B2
B4
10
0
0 10 20 30 40
Loans
Is Bank 2 better than Bank 3 in any way?
Are there any weights (on the output) that make B2 the best?
227

Deposits
40
B1 B3 Branch 2 15 25 100
30
Branch 3 20 30 100
B5
20 B2
B4
10
The questions we ask in DEA

0
0 10 20 30 40
Loans
What would be the best scoring rule from the B2’s perspective?
If we use that particular scoring rule, what would be the score (relative
efficiency) for B2, if we use a score within [0,1]?

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What DEA asks…….(If B2 is a client)
Deposits
40
B1 B3
30
B5
20 B2
B4
10
0
0 10 20 30 40
Loans
(1) Which scoring rule will give B2 the best possible score that
ranges between 0 and 1?
(2) What is the score of B2 if we use that scoring rule?
229

Deposits
What DEA asks…….(If B2 is a client)
40
B1 B3
30
B5
20 B2
B4
10
0
0 10 20 30 40
Loans
• DEA takes the view from one particular organization to find the best
scoring rule for that organization.
• DEA will be used to identify the efficient frontier organizations.
• DEA alone does not tell you what is the most fair and precise scoring rule
for benchmarking.

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A DMU is “efficient” (i.e., score of 1) if there is no other unit which is “clearly
better” than the chosen portfolio.
q No branch with same (or more) loan vol. and more deposit vol.
q No branch with same (or more) deposit vol. and more loan vol.
Efficient Frontier:
Deposits the line connecting efficient units
40
B1
B3
30 Organization is on efficient frontier
B2 B5
20 B4
10
Scores 1 (on a [0,1] scale) according to
0 some scoring rules.
0 10 20 30 40
Loans
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DEA: How do we measure the efficiency?

We compare the efficiency of an organization to the efficient frontier
using HCU (Hypothetical comparison unit), which is a combination of
organizations on the efficient frontier.
HCU 2’ DEA efficiency for business unit i:

Length of red line
Deposits
40
B1
Length of dotted line (HCU)
B3
30
20
B2
B4
B5 Branch 2: red line: 29.155
dotted line: 35.206,
10
0 Efficiency=
0 10 20 30 40
Loans

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Question of DEA: What’s the best score for B2?
DEA efficiency for business unit i:

Length of red line 29.155
= = 0.828
Length of dotted line (HCU) 35.206
HCU 2’
Deposits Can we get a better score for B2?

40
B1
30
B3
Why not?
B2 B5
20 B4
10
0
0 10 20 30 40
Loans
233

What about branch 5?
Length of red line 36.06

=
Length of dotted line (HCU) 36.06
Deposits
40
B1
B3
30
HCU5=B5
B2 B5
20 B4
10
0
0 10 20 30 40
Loans

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DEA Formulation
Graphical method cannot apply to cases with multiple inputs and outputs.
Is there a formal approach to measure the efficiency of DMU unit i?
Weighted sum of outputs
Efficiency of an organization =
Weighted sum of inputs
Multiple outputs j (yj): loan volume, deposit volume, profit
Multiple inputs k (xk): operating expense, labor
What is the best scoring rule (weights on inputs and outputs) for this
organization?
If we use that particular scoring rule, what is the relative efficiency of this
organization (on 0-1 scale)?
Decision variables
o j : weight given to output j
ik : weight given to input k
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DEA Formulation for Branch 2:

Metropolis banks II
outputs inputs
Deposits Loans Expense FTEs

Branch 1 31 10 100 5
Branch 2 25 15 100 5
Branch 3 30 20 100 5
Branch 4 23 23 100 6
Branch 5 20 30 100 5
A consultant for B2 chooses

the scoring rule (weights): oD and oL iE iF
1. Gives the best score for B2 (Maximize the score for B2)
2. All organizations’ efficiencies are on [0,1] scale.

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DEA Formulation for Branch 2

Metropolis banks II
25oD + 15oL
Best score for Branch 2 (subject of study) : Maximize
100iE + 5iF
Max 25oD + 15oL
s.t. 100iE + 5iF = 1 [Input scaling]
For all branches (1 through 5): Efficiency of branch i ≤ 1.
For given weights (oD, oL, iF, iE)
31oD + 10oL
e.g., Efficiency of B1 ≤ 1 £1
100iE + 5iF
How to make this into linear?
Similar constraint for B2, B3,….,B5
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DEA Formulation for Branch 2

Metropolis banks II
Max 25oD + 15oL [Max weighted outputs for B2]
s.t. 100iE + 5iF = 1 [Input scaling]
31oD + 10oL - 100iE - 5iF £ 0 [B1 efficiency £ 1]
oD , oL , iE , iF are non - negative

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DEA Formulation for Branch 2 in Excel

Metropolis banks II
Best scoring rule for B2: oL= oD= iE= iF=

The (best) relative efficiency for B2:
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DEA Formulation for Branch 2 in

Excel Metropolis banks II
Weighted input for B2 =1
Weighted outputs – weighted inputs ≤1

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DEA Formulation for Branch 2 in Excel:

Interpreting the sensitivity report
Variable Cells
Final Reduced Objective Allowable Allowable
Cell Name Value Cost Coefficient Increase Decrease
$C$12 Decisions oL 0.003125 0 15 1.666666667 6.935483871
$D$12 Decisions oD 0.03125 0 25 21.5 2.5
$E$12 Decisions iE 0.01 0 0 1E+30 0
$F$12 Decisions iF 0 0 0 0 1E+30
Constraints
Final Shadow Constraint Allowable Allowable
Cell Name Value Price R.H. Side Increase Decrease
$G$16 Input value Efficiency 1 0.828125 1 1E+30 1
$G$17 Efficiency of B1 <= 1 Efficiency 0 0.15625 0 0.033333333 0.18
$G$18 Efficiency of B2 <= 1 Efficiency -0.171875 0 0 1E+30 0.171875
$G$19 Efficiency of B3 <= 1 Efficiency 0 0.671875 0 0.123287671 0.032258065
Which constraints are binding?
In order for B2 to improve its efficiency, whom should it learn from?
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DEA Formulation for Branch 4 in

Excel: Metropolis banks II
Outputs Inputs
Data Branch Loans Deposits Expense FTE
1 10 31 100 5
2 15 25 100 5
3 20 30 100 5
4 23 23 100 6
5 30 20 100 5
oL oD iE iF
Decisions 0.02 0.02 0.01 0 Branch 4
23 23 Efficiency 0.920
Constraints
Input value 0 0 100 6 1 = 1
Efficiency of B1 <= 1 10 31 100 5 -0.18000 <= 0
Efficiency of B2 <= 1 15 25 100 5 -0.20000 <= 0
Efficiency of B3 <= 1 20 30 100 5 0.00000 <= 0
Efficiency of B4 <= 1 23 23 100 6 -0.08000 <= 0
Efficiency of B5 <= 1 30 20 100 5 0.00000 <= 0
Almost identical formulation: Only orange cells change the value.

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Who’s on the frontier and who’s not?

Running DEAs for all 5 branches
Use index( range, branch number) to model varying values.

Use parameter analysis, PsiOptParam(1,5) to run DEA for each of 5 branches.
243
Who’s on the frontier and who’s not?

Running DEAs for all 5 branches
$H$12 Efficiency O_Loans O_Deposits I_Expense I_FTE

1 1.000 0.000 0.032 0.000 0.200
2 0.828 0.003 0.031 0.000 0.200
3 1.000 0.003 0.031 0.000 0.200
4 0.920 0.020 0.020 0.010 0.000
5 1.000 0.033 0.000 0.000 0.200
Efficient branches are _________________________

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Important check points/remarks

A. Choosing inputs and outputs: For each metric,
If “more is better”Þ outputs
If “less is better” Þ inputs
B. The beauty is in the eye of the beholder.

A separate LP solves DEA for each organization (e.g., B2)
- determines the best scoring rule (weights) for a given DMU.
- determines the efficiency if we use the above scoring rule.
If the score =1, the DMU is on the efficient frontier
If the score <1, the DMU is not on the frontier
C. Sensitivity report identifies which organizations to benchmark.
D. But, DEA does not tell you which ranking method is the most fair and/or
adequate to use for benchmarking.
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Another example: Burger Queen

Evaluating 12 fast-food Burger Queen franchises in Maryland.
Should the owner of unit 4 be concerned about the store’s efficiency?
Unit Profit (in $K) Satisfaction (10-point) Cleanliness (100-point) Labor Hrs (In FTE) Op. Costs (in $K)
1 5.98 7.70 92 4.74 6.75
2 7.18 9.70 99 6.38 7.42
3 4.97 9.30 98 5.04 6.35
4 5.32 7.70 87 3.61 6.34
5 3.39 7.80 94 3.45 4.43
6 4.95 7.90 88 5.25 6.31
7 2.89 8.60 90 2.36 3.23
8 6.40 9.10 100 7.09 8.69
9 6.01 7.30 89 6.49 7.28
10 6.94 8.80 89 7.36 9.07
11 5.86 8.20 93 5.46 6.69
12 8.35 9.60 97 6.58 8.75
Which metrics are outputs? Which are inputs?

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Another example: Burger Queen

-------- Outputs -------- ----- Inputs -----
1 5.98 7.70 92 4.74 6.75
2 7.18 9.70 99 6.38 7.42
3 4.97 9.30 98 5.04 6.35
4 5.32 7.70 87 3.61 6.34
5 3.39 7.80 94 3.45 4.43
6 4.95 7.90 88 5.25 6.31
7 2.89 8.60 90 2.36 3.23
8 6.40 9.10 100 7.09 8.69
9 6.01 7.30 89 6.49 7.28
10 6.94 8.80 89 7.36 9.07
11 5.86 8.20 93 5.46 6.69
12 8.35 9.60 97 6.58 8.75
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DEA for Burger Queen Unit 4

-------- Outputs -------- ----- Inputs -----
1 5.98 7.70 92 4.74 6.75
2 7.18 9.70 99 6.38 7.42
3 4.97 9.30 98 5.04 6.35
4 5.32 7.70 87 3.61 6.34
5 3.39 7.80 94 3.45 4.43
6 4.95 7.90 88 5.25 6.31
7 2.89 8.60 90 2.36 3.23
8 6.40 9.10 100 7.09 8.69
9 6.01 7.30 89 6.49 7.28
10 6.94 8.80 89 7.36 9.07
11 5.86 8.20 93 5.46 6.69
12 8.35 9.60 97 6.58 8.75

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DEA for Burger Queen Unit 4

Maximize: weighted Outputs for Unit 4
Decision variables:
Constraints: Weighted inputs for unit 4 = 1

Efficiency of unit 1 £ 1
……………………….
Weights are non-negative.
How do we incorporate “Efficiency of unit i £ 1” in LP?
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Using the results: Eff.-Profit Matrix

High Profit
Under-performing Best practice

potential leaders comparison group
Low High
Eff. Eff.
Under-performing Candidates for

possibly profitable closure
Low Profit

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Data Envelopment Analysis Discussion

Strength
§ can handle multiple input and output models

§ does not require an assumption on functional form relating inputs to
outputs (how outputs are created is not needed)
§ each organization is compared with peers.
Limitations
• measures relative (not absolute) efficiency (to be exact, provide the

nO
upper bound of efficiency for a given organization.)å Oij w j
j =1
• does not tell you how to improve efficiency in detail.
nI
Weights: unit-dependent, vague interpretation of what it actually means.
•
å I ij v j
§ oA=0.03 and oB=0.01 ¹ A is 3 times more important than B.
j =1
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Applications from Practice and Research
• How efficient are referral hospitals in Uganda? A data
envelopment analysis and tobit regression approach
• http://bmchealthservres.biomedcentral.com/articles/10.1186/s12913-
016-1472-9
• A Novel Approach to Measuring Efficiency of Scientific
Research Projects: Data Envelopment Analysis
• http://onlinelibrary.wiley.com/doi/10.1111/cts.12303/full
• Information technology project evaluation: An integrated data
envelopment analysis and balanced scorecard approach
• http://www.sciencedirect.com/science/article/pii/S0957417410000515
• Operationalizing opportunities in entrepreneurship research:
use of data envelopment analysis
• http://link.springer.com/article/10.1007/s11187-009-9227-1

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NON-LINEAR OPTIMIZATION
Unconstrained optimization
Constrained optimization
Quadratic programming
Applications
254
Non-linear problems
What if the functional relationship is non-linear?
Non-proportional relationships between decisions and the
metric.
Profit = 100 quantity

Gas Bill = 100 + Usage1.5
ì0.15 * Income for below $100K
Tax = í
î15K + 0.20 (Income - 100K) for above $100K
Solving a nonlinear programming model is often much more difficult

(if it is possible at all) than solving a linear programming model.

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Non-proportional Relationships
Diminishing rate of returns
x , ln x, piece linear, 1 - e-X/RT etc.
e.g., quantity discount,
risk aversion
Increasing marginal rates

eX , x2 , piece linear etc.
e.g., tax rates, gas bills
compound interest.
Others.
quadratic, polynomial , trigonomet ric.
What types of problems are solvable?
256
Solvable non-linear problems

A. Minimizing “convex” function with linear (or “nice”) constraints
How do you know when the function is convex?

Visually:
B. Maximizing “concave” function with linear (or “nice”) constraints
How do you know when the function is concave?

Visually:
Linear function is convex and concave!
Nice constraints: facilitate hill climbing algorithms

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Convexity
• What is a convex set?
• What is a convex function?
258
Example: x2
• A continuously differentiable function of one variable is convex
on an interval if and only if the function lies above all of its
tangents: f(x)>=f(y)+f’(y)(x-y)
• A twice differentiable function of one variable is convex on an

interval if and only if its second derivative is non-negative.
• A continuous twice differentiable function is convex if and only

if its Hessian matrix is positive semi-definite.

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Function Convex/Concave/Neit
her
|x|
ex
1/x
ax+b
260
Concave functions
• A function f is called concave if –f is convex.
• Geometry: For a convex function f lies below the line joining
f(x) and f(y) and for a concave function f lies above the line.

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Properties of convex/concave functions

•
262
Properties of convex/concave functions

•

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Examples of properties here
264
Problem Statement
• Generic formulation
• No constraints on the decision variable x

• Decision variables x are continuous

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Example 1: EOQ
A retailer is planning her yearly inventory strategy for a
commodity which sells a steady rate thorough the year and for
which she estimates a yearly demand of D units. The storage
cost is $S per unit and the cost of ordering is $C per order.
Assuming that there is no lead time, how many orders and of
which size must be placed to reduce the total
inventory costs ?
266
Example 1: Model
• Suppose the retailer places an order size x, then must place D/x
orders at a cost C * (D/x)
• The average inventory is x/2 therefore the holding costs are
S * x/2
• Optimization problem
In reality, must have the constraint x >=0 but ignored it since one
expects the solution to be in [0, ]

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EOQ Model
• Check convexity
• Find minimizer
268
Example 2: Least squares estimates

• The interest rate in the market follows the model
where rn is the 1 year T-bill rate at the beginning of period n and

epsilon is a normal random variable with zero mean and variance .
The past observed interest rates for 2006 are
Calculate the least squares estimates.

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Example 2: Least squares estimates

• The objective consists of adjusting the parameters of a model
function to best fit a data set.
• The goal is to find the parameter values for the model that
"best" fits the data. The least squares method finds its
optimum when the sum of squared residual is a minimum.
• A residual is defined as the difference between the actual value

of the dependent variable and the value predicted by the
model. Each data point has one residual.
270
Example 2: Model
• The squared error at period t is given by
For t=4,
Optimization problem
minimizea
Unconstrained optimization problem in variables

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Excel Model
𝑟" = 𝑎% 𝑟"&% +𝑎' 𝑟"&' +𝑎( 𝑟"&( +𝛜
272
Constrained Optimization
• We now have constraints on the decision variables
• The constraints can be both linear and non-linear.

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Example 3: Execution costs with price impacts

• Suppose an investor owns a block of S shares that we want to sell
over the next N days. The total expected value of our shares is
• Where is the amount that we sell on each day and

are the prices on each day. Moreover, the price on
day t follows the following dynamics
• How should the investor sell his block of shares?
274
Example 3: Execution costs with price impacts

• Decision variables: shares to sell each day t
• Objective function: maximize the sales value
• Constraints:
• Can not sell more that S shares in N days
• Price dynamics follow the given dynamics for each day t
• Non-negativity constraint

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Application: Portfolio Optimization

• A portfolio is “efficient” if there is no other portfolio which is
“clearly better” than the chosen portfolio.
• No portfolio with same (or better) risk and better return
• No portfolio with same (or better) return and better risk
• In the picture, which portfolios are efficient?
• No risk, no gain. (A higher return, a higher risk).
Application: Project portfolio design, assortment design, mutual
fund.
278
Application: Optimizing portfolio

Suppose you want to build a portfolio by allocating funds in
Macys (M), Intel (INTC), Preferred Bank (PFBC)
Suppose that weekly % change in return from 2011 to 2012 are

as follows
p -p
return in week t (%) = t t-1 ´100
p t-1
Date Macys INTC PFBC Macys
Macys INTC
INTC PFBC
PFBC
1/5/2011 23.01 19.79 10 Macys INTC PFBC Avg
Avg
Avg 0.911
0.911 0.556
0.556 0.825
3.625
1/10/2011 22.79 20.2 9.55 -0.95611 2.071753 -4.5 Stdev
Stdev
Stdev 4.436
4.436 3.890
3.890 27.433
5.543
5.543
1/18/2011 22.85 19.95 9.3 0.263273 -1.23762 -2.6178
1/24/2011 22.7 20.56 7.45 -0.65646 3.057644 -19.8925 Correlation Macys
Macys INTC
INTC PFBC
PFBC
1/31/2011 22.53 20.95 8.15 -0.7489 1.896887 9.395973 Macys
Macys
Macys 11 correlation
2/7/2011 24.31 21.03 8.25 7.900577 0.381862 1.226994 INTC
INTC
INTC 0.571
0.571 11
2/14/2011 23.45 21.39 8.05 -3.53764 1.71184 -2.42424 PFBC
PFBC
PFBC -0.387
-0.079
-0.387 -0.226
-0.046
-0.226 11
2/22/2011 23.3 21.12 7.85 -0.63966 -1.26227 -2.48447
2/28/2011 23.06 20.83 7.45 -1.03004 -1.37311 -5.09554
3/7/2011 23.49 20.17 7.25 1.864701 -3.16851 -2.68456 Covariance Macys
Covariance Macys INTC
INTC PFBC
PFBC
3/14/2011
3/21/2011
22.75
23.18
19.26
19.68
7.35 -3.15028 -4.51165 1.37931
7.95 1.89011 2.180685 8.163265
Macys
Macys
Macys
INTC
INTC
INTC
19.359
19.36
9.697
9.70 14.883
14.88
covariance
3/28/2011 24.09 19.05 7.75 3.925798 -3.20122 -2.51572 PFBC
PFBC
PFBC -9.446
-9.45 -4.841
-4.84 740.212
30.72
30.720

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Optimal Portfolio: 2 stocks

You are building a mutual fund using M and INTC stocks.
1. You want to find the optimal allocation that minimize the variance (or
stdev) of the portfolio return.
2. At the same time, you want to make sure that the avg weekly return is
no less than 0.8% per week.
Macys INTC Objective?

Avg 0.911 0.556
Decision variables?
Covariance
Macys INTC
Macys 19.359
INTC 9.697 14.883
How do we write as an optimization problem?
280
Recall mean and variance of a linear

function of RV.
Suppose you allocate 40% to Macys and 60% to Intel.
R = 0.4XM + 0.6XINT
Macys INTC
(i)E[R] =
Avg 0.911 0.556
(ii) Var[R] =
Covariance
Macys INTC
Macys 19.359
INTC 9.697 14.883

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Covariance
Optimizing the portfolio Macys INTC
Macys 19.359
Minimizing the variance of the portfolio return INTC 9.697 14.883
Macys INTC
Constraints:
Avg 0.911 0.556
282
Optimizing the portfolio
Optimal portfolio: fM= fInt=
Var= , Stdev =

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Extending to three stocks

Macys, Intel, Preferred bank.
Suppose you allocate 50% to Macys, 30% to Intel, and 20% to PB.
R = 0.5XM + 0.3XINT + 0.2XB
0.5 0.3 0.2

(i ) E[ R] =
0.911 0.556 0.825
284

Fraction 0.5 0.3 0.2

Fraction Macys INTC PFBC
(i) Var[R] = 0.5 Macys 19.36
0.3 INTC 9.70 14.88
0.2 PFBC -9.45 -4.84 30.72

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Optimizing the portfolio
Similar patterns of calculations regardless of # of stocks.
286

Fraction 0.5 0.3 0.2

(i) Var[R] = Fraction Macys INTC PFBC
0.5 Macys 19.36 9.70 -9.45
0.3 INTC 9.70 14.88 -4.84
0.2 PFBC -9.45 -4.84 30.72

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Non-linear programming
Portfolio Selection
This is the essence of portfolio optimization aka Markowitz
portfolio.
For many stocks, it is tedious to write the variance formula

manually.
Use Excel’s MMULT function (matrix multiplication): Explore on

your own.
288
Application: Price Differentiation

• Suppose demand for a product, D, is the following function of
price, p:
D = 1000 - p
• Suppose this productʼs unit cost to the seller is $200. Imagine
the seller charges $500 per unit. The sellerʼs profit can be
captured graphically as follows:
Demand
800
Profit = (500 – 200) × 500
= $150000
500
Profit is the area
of this rectangle.
Price
200 500 1000

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289
Price Differentiation
• Suppose now:
• We charge two different prices: $300 and $750
• Anybody who is willing to pay $750 or more purchase at $750.
• Anybody who is willing to pay more than $300, but less than 750
purchase at $300.
• The sellerʼs profit will now be as follows:
Demand
800 Profit
700 = (300 – 200) × 450 + (750 – 200) × 250
These customers = $182,500
pay $300 each.
These 250
customers pay
$750 each. Price
200 300 750 1000
290
Price Differentiation
Demand
800
700
500
250
Price
200 300 500 750 1000
With carefully chosen prices and an ability to make customers pay

the highest price they are willing to pay, price differentiation can
help improve the bottom line substantially.

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Limits to price differentiation

• Imperfect segmentation / cannibalization:
• What if we cannot identify the customers who are willing to pay $750
(imperfect segmentation)?
• What if customers who are willing to pay $750 find a way to purchase at
the lower price of $300 (cannibalization)?
• Arbitrage:
• What if there existed a group of speculators who decided to buy at $300
and sell to others at $750?
292
Limits to price differentiation

• Suppose that, due to imperfect segmentation and/or
cannibalization 80% of the customers who are willing to pay
$750 end up paying $300 instead.
Profit before imperfect segmentation / cannibalization
= (300-200) × 450 + (750-200) × 250
= $182,500
Profit after imperfect segmentation / cannibalization

= (300-200) × (450 + 200) + (750-200) × (250 – 200)
= $92,500 < $150,000
• This profit is worse than what we would obtain if we charged a

uniform price of $500!

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293
Tactics for price differentiation

• Group pricing
• Channel pricing
• Regional pricing
• Product versioning
• Time-based differentiation
• Volume discounts
303
What price Vertigo? Optimizing differentiated prices when

supply is constrained
Questions:
• In what ways will CSdF and U2 price discriminate among the
concert-goers who attend the U2 concerts at Stade de France?
• Is there a threat that such price discrimination strategies may

backfire? Put another way, do you foresee any circumstances
under which the efforts to price discriminate may hurt the
gross revenue instead of improving it?

2/6/19
304

• Let us focus on the standing general admission tickets (GA) on
the lawn.
• Suppose no more than 20,000 GA tickets are available.
• There are 10,000 U2.com members in France. They would all

prefer GA tickets. At price p, the demand for GA tickets from
these members is:
10,000 – 125p.
• In addition, the demand for GA tickets from general public is:

40,000 – 200p.
305
What price Vertigo? Optimizing differentiated prices

when supply is constrained
(a) What if U2 wanted to charge a single price for GA tickets? See
worksheet “Single-price solution” in Vertigo.xls.
Optimal price =
# GA tickets sold =
Member attendance=
General public attendance =
Revenue =

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306

307

(b) Does the revenue improve if U2 gives discounts to members?
See worksheet “Two-price solution” in Vertigo.xls.
Optimal member price =

Optimal general public price =
# GA tickets sold =
Member attendance=
Revenue =

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308

309

continued…
• Here are a few takeaways from part (b):
• Who benefits/suffers due to price differentiation?
• What kind of capacity conditions make a discount offer

attractive to the organizer?
• What other reasons (possibly less tangible) make it attractive

to offer the member discount?

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310

(c) U2 feels members should not get more than a €30 discount.
What are the optimal prices now? See worksheet “Two-price
solution w max discount” in Vertigo.xls.

Optimal general public price =
# GA tickets sold =
Member attendance=
Revenue =
What are some other constraints one might want to add?
311


2/6/19
312

(d) Suppose now we could add a seated zone among the GA
tickets. Every two seats take away three units of standing
space.
• Assume that members go for standing tickets only.
• As for general public, their demand for the seated zone is
estimated as 22,000 – 100p, and their demand for the
standing tickets is estimated as 20,000 – 100p.
• How many seats should U2 include?

• What prices should they charge for member, standing-public
and seated-public tickets? See worksheet “Seating zone
solution” in Vertigo.xls.
313

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314

(d) Continued…
Optimal # seats =
Optimal standing-public price
Optimal seated-public price =
# seated tickets sold =
# standing tickets sold to members=
# standing tickets sold to general public=
Revenue =
315

(d) Continued…
What assumptions are we making in this demand model?
Which ones would you rather change?

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316
Segmentation
• When implementing differentiated prices, one of the most
important design decisions is determining the customer
segmentation.
The segments must be such that:

• They must differ from one another in their price sensitivity /
willingness to pay.
• There must be a way to:
• charge different prices to different segments for the same product, OR
• design a product line so that segments will select different products with
different prices, thus enabling price differentiation (i.e., price
differentiation through self-selection).

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2/6/19

Data Envelopment Analysis

Q: Is there a way to somehow compare efficiency of organizations (or

• Financial approach: convert everything to $.

• Clustering or statistical discrimination (predictive analytics)

One way to cope with these difficulties:

DEA (Data Envelopment Analysis)

(c) Prof Ozge Sahin, 2019 1

Measurement and Benchmarking

Which store performs better?

If there is only one input and one output, comparison is easy.

Measurement and Benchmarking

Which store performs better?

(c) Prof Ozge Sahin, 2019 2

Measurement and Benchmarking

Which store performs better? Profit

If you are profit-centric?

If you are service-centric?

If you are using both? Exactly how?

Measurement and Benchmarking

Can you find a (objective) scoring rule that will rank

Is there a rule that will rank store 2 in the top?

Is there a rule that will rank store 3 in the top?

(c) Prof Ozge Sahin, 2019 3

Data Envelopment Analysis

Outputs: profit, customer satisfaction (The more, the better)

Weighted sum of outputs

DEA Illustrative Example: Metropolis National Bank

Deposits Loans Expense

(c) Prof Ozge Sahin, 2019 4

DEA Illustrative Example: Metropolis National Bank

Which of the 5 branches can be considered inefficient (i.e., can not be

DEA Illustrative Example: Metropolis National Bank

If weight for loan = 1 and weight for deposit =1

If weight for loan = 1 and weight for deposit =2

(c) Prof Ozge Sahin, 2019 5

DEA Illustrative Example: Metropolis National Bank

Is Bank 2 better than Bank 3 in any way?

DEA Illustrative Example: Metropolis National Bank

The questions we ask in DEA

(c) Prof Ozge Sahin, 2019 6

DEA Illustrative Example: Metropolis National Bank

(2) What is the score of B2 if we use that scoring rule?

DEA Illustrative Example: Metropolis National Bank

• DEA will be used to identify the efficient frontier organizations.

(c) Prof Ozge Sahin, 2019 7

DEA Illustrative Example: Metropolis National Bank

DEA: How do we measure the efficiency?

HCU 2’ DEA efficiency for business unit i:

(c) Prof Ozge Sahin, 2019 8

DEA: How do we measure the efficiency?

DEA efficiency for business unit i:

Deposits Can we get a better score for B2?

DEA: How do we measure the efficiency?

Length of red line 36.06

(c) Prof Ozge Sahin, 2019 9

DEA Formulation for Branch 2:

Deposits Loans Expense FTEs

A consultant for B2 chooses

(c) Prof Ozge Sahin, 2019 10

DEA Formulation for Branch 2

Similar constraint for B2, B3,….,B5

DEA Formulation for Branch 2