ISB PPRO Session 1

Kalyan Talluri

Imperial College Business School, London

kalyan.talluri@imperial.ac.uk

13 January 2020
 About myself

• Kalyan Talluri
• kalyan.talluri@imperial.ac.uk
• Room No:AC 3 L1, Room No. 3103
• Tel: 2318-7375
• Professor of Operations Management, Imperial College Business School,
London
• Director, MSc in Business Analytics
• Background
• Ph.d Operations Research (MIT)
• Worked at an airline (Scheduling, Revenue Management)
• Taught at various B-schools, UPF (Economics Department) in Barcelona
• Research interests: Pricing and Revenue Management, Transportation,
Service Analytics
 PPRO Part 1

Revenue Management (RM): pricing, dynamic pricing, designing sales mechanisms,

controlling inventory/sales at a price, controlling supply at a price . . .
Session 1 Introduction/background; practice dynamic pricing manually
Session 2 Segmentation and product design for RM: How to design RM products?
Controlling RM sales
Session 3 Pricing Optimization (Vertigo) ; Segmentation fences exercise; RM for a single
resource exercise—Optimization of hotel room sales (Berkshire Manor exercise)
Session 4 Various types of dynamic pricing: Markdown pricing, Surge pricing, e-commerce
pricing (repricing)?
Background1
• Notes on math prep (on LMS)
• Notes on (static) price optimization (on LMS)

1
Prep notes that I expect you to read on your own.
 About this course
This is a data & quant course, but . . . not just about numbers:
• Typical data we deal with:
• Operational data: Current and historical sales with timings, capacities
• Variable (marginal) costs2
• Industry/competitior data
• Other co-variates (special days future conditions, current conditions)
• Models
• Customer behavior
• Firm objectives and processes
• Industry (competition)
• Objectives: Profit, revenue, break-even, penetration, short-term/long-term
• Output:
• Design of products: mechanisms, conditions (eg: auctions or
posted-prices? refunds, cancellation penalties? . . . , in general design of
conditions of sale)
• Price/prices → Numbers potentially changing over time
• Assortments (with fixed prices) or allocations of a fixed inventory to the
products (airlines, hotels)

2
As we shall see, fixed or sunk costs are usually irrelevant for us operationally
 Data for pricing

Most firms have data on their own sales

This is the central source, but we use many auxiliary sources in practice (weather,
economy, competitor prices, etc.)
 What this course is about . . .

Prices/Assortments/Allocations → Revenue (profits)

Reflection time—we cannot avoid pricing:

• How many prices did you come into contact over the last three days?
• How did you decide whether to purchase or not?
• How did the firm decide to set the price? Change the price? Prices are usually
set by processes, models, intuition, rules . . .
Price: Universal mechanism of commerce
 Price is a number set in a particular
context
This class is about the firm side, “setting” a price; “Pricing Mechanisms”, Pricing
algorithms and technologies
• Of course, that means we have to think about how customers purchase as a
function of price! Or . . . choose from a given assortment
What do we mean by pricing mechanisms or “pricing in context”?
• Price may be a single simple number, but can be complex
• Price ∼ (Product + . . . + . . . )
• Is the Coca-Cola at the theater same as at the vending machine? Yes and
no!
• Is the flight ticket purchased 50 days in advance the same as the one
purchased the day prior to flying?
Price is not a static number (many industries)
• Can change frequently
• Models based: Algorithmic pricing (eg: surge pricing of Uber)
Revenue Management: What sale conditions to set? How to manage/optimize prices?
Which assortment to offer?
The process from the firm’s side
 Starting point: customer

Need a simple model of how a customer purchases (assume customer buys at most
one unit). Think auctions!

Consider an English auction: What is a good model of the customer’s decision

process?
 Customer purchase concepts

Main concept (synonyms) on the customer-side

• Maximum Willingness-to-pay
• Valuation
• Reservation price
• Utility
One plausible Customer decision model: Customer has a valuation for a single product
or service. Then, in a posted price setting:
• Purchase if [valuation ≥ price]
• Do not purchase if [valuation < price]
Main complexity of pricing: Valuation is “private information”; varies from customer
to customer. So we need self-selecting mechanisms.
 . . . a travel product I am selling

A 5-day exclusive Caribbean Cruise on a small yacht

The product is all-inclusive, airfares, transfers etc.

 Write down your valuations for this travel
product I am selling

Please write down on the cards

• How much you are willing to pay for this (for your vacation this summer)
• Be honest please (This is just a game!)
• Write in $ (USD): 70 INR = 1 USD
 Now do the following
• Groups of 3 or 43
• Go to: http://www.bizsimz.com/rmsim/
• Click on [ + Register] (enter team name and some email/password)

Simulation ID: 107, password: ISB, . . .

3
Single laptop per group with latest Adobe Flash, 11.5—(a) you have to Allow Flash (b) allow images (c)
allow pop-ups. In Chrome, click on the button next to the URL
 Once you register

• Enter the valuations of your team, one by one.

• Click submit valuation after entering each team member’s valuation
• Finished? Games → Select Game → static1
 Simulation 1

Capacity of 30 (identical) cabins

• Based on your valuations we will generate a random arrival stream of customers
• Number of customers will vary for the different weeks of the cruise
• Each customer will look at your posted-price and: (a) Buy or (b) Walk-Away
• The group that gets the maximum value, wins
 Simulation 2

Groups can change their prices anytime

 Simulation 3

• Capacity limit of 10 (identical cabins)

• Can you do better by changing prices?
• What do you have to “manage” here?
 Motivations for changing prices

Main reasons
• Heterogenous customers
• different valuations (however, often is private information)
• different purchase preferences
• Supply constraints
• Valuations changing over time
• Seasonality (peak vs. off-peak)
• Product life-cycle
• New products
• Competitor pricing
 What is RM? Two flavors

Flavor 1: Price-controlled (Dynamic pricing)

• Single changing price; at any point in time all customers face same price; but
the price can change over time (“Dynamic Pricing”)
• Motivation: Limited inventories, fixed deadlines, changing customer valuations,
competitor
• Uber’s surge pricing: price changes over time as a function of demand and
supply
• Fashion retail markdown-pricing, perishable grocery item pricing
Flavor 2: Capacity-controlled Revenue Management
• Multiple products with fixed prices that share the same inventory ← The
“product design” process
• Customers face a menu of choices and choose one of the products (“Revenue
Management”)
• Firm controls which products are “available” at every point in time
Session 2, 16 Jan 2020
 Agenda

• Revenue Management (RM) Product Design—guiding principles and framework

• Key Concept of Incentive Compatibility when pricing a product range
• Process and control of Revenue “Management”
Posted on LMS
• HW 1 (Due 25 Jan)
• HW 1 data files and case description
 HW1 (due 25 Jan) and prep for next week

HW1 individual
• Go through notes in the pricing concepts; Solve the sample exercises at the end
• Read and answer the Vertigo case in case packet
HW1 group
• Data but essentially a qualitative exercise—design RM products
• If time permits I will ask a few teams to discuss in class for 5 minutes each (can
give feedback and comments)
 Last class: Two flavors of Differentiated
Pricing

Flavor 1: Price-controlled (Dynamic pricing)

• Single changing price; at any point in time all customers face same price; but
the price can change over time (“Dynamic Pricing”)
• Motivation: Limited inventories, fixed deadlines, changing customer valuations,
competitor
• Uber’s surge pricing: price changes over time as a function of demand and
supply
• Fashion retail markdown-pricing, perishable grocery item pricing
Flavor 2: Capacity-controlled Revenue Management
• Multiple products with fixed prices that share the same inventory
• Customers face a menu of choices and choose one of the products (“Revenue
Management”)
• Firm controls which products are “available” at every point in time
 What is “product design” in RM?

Based on consumer behavior, product, industry and competitive environment, we can

either
• Dynamically Price: You change prices (as a function of remaining sale time,
remaining capacity)
• Design products for consumer self-selection: You post the following schedule on
your web
• AP-product: INR 8000 if purchased 14 days in advance
• Regular: INR 15000 regular price
Now, for the latter, if you have limited capacity, you will also need control mechanisms.
 Necessity (and risk) of good product
design in managing an operational
fixed-cost business
• Flight with 80 seats daily schedule
• Fixed Costs: Crew, fuel: $10000
• Marginal costs: $0 (peanuts?)
• Customers
• Business (B) have valuations $300, market size 30
• Leisure (L) have valuations $100, market size 80
• Best single price:
• Maximum single price revenue:
• RM strategy: Create 2 RM products
• Price at $300, $100
• Control sales—limit L sales to 50 (need restrictions!)
• Revenue:
shows also the dangers or risk of RM. Q: How to separate segments effectively?
The Revenue Management Process
 The Revenue Management Process
consists of the following steps

• Step 1: Design RM products

• Step 2: Quantify uncertainty
• Estimate price sensitivity
• Forecast market size
• Step 3: Optimize
• Optimize prices for each RM product
• Optimize inventory allocations (amount to sell at each price/product)
• Step 4: Control sales and monitor performance
In today’s session we focus on Steps 1 and 4
Examples that we see: self-selection
menus
 Another example of self-selection menus

A menu of add-ons and restrictions, and customers choose themselves. We cannot

observe true valuations/preferences, so let them choose.
 Examples in daily life: timing

Main drivers: inventory, competition price, knowledge of when

different segments buy (?)
 Examples in daily life: timing

• Those who purchase early in the season pay full price

• Those who wait can get a discount
• Notice . . .
• The product is not exactly the same
• Late buyers take the risk of a stockout

Main drivers: decrease in valuations, inventory

 Examples in daily life: timing

Depending on the demand the prices for a taxi ride could go up

Main drivers: supply and demand

 Examples in daily life: coupons

• One with a coupon gets 40

• Walk-in customers who did not take the effort to look for a coupon pay full price

Main drivers: segmentation based on effort to acquire coupons

 Examples in daily life: opaque

• Customers can get 30 to 50% off airline seats or hotel rooms

• Caveats
• They do not know the exact hotel name or location before they purchase
• Only approximate zone (hotel)
• Approximate hour or date (airline)
• They will be charged the full amount and it is non-refundable

Main drivers: segmentation based on willingness to compromise on location

 Some common themes behind these
Revenue Management products

• Heterogeneity in willingness-to-pay (WTP)

• Heterogeneity in latent purchase characteristics/time-of-purchase/flexibility
• Correlation between WTP and some feature to hook to; Examples:
• Identify dimensions important to high WTP customers
• Create degraded cheaper products without these features
 Thinking behind product design

Examples
• Round-trip tickets are much cheaper (20 to 30 %) if your trip crosses a
Saturday night
• Business customers (consultants, high WTP) fly to client-base on Monday
and return by Friday
• Leisure customers (low WTP) holiday combining weekends
• Note: Sold in parallel; customers self-select
• Flexible tickets cost 2 to 5 times inflexible tickets (no changes, cancellation fees)

• Business customers (consultants, high WTP) have a need to cancel their

tickets or change flights
• Leisure customers have their plans relatively fixed
• Similarly, advanced-purchase discounts
 More challenging

People wishing to travel from

DEL to HYD last week of Jan

People wanting to travel from DEL to HYD on

26 Jan

People who have to travel on

26 Jan DEL to HYD after 7 PM

• Reasonable assumption: The smallest segment is willing to pay more (why?)

• Question: How to isolate the segment?
Key concepts for RM Product Design: Segmentation, Fences and Incentive
Compatibility
Methodologies: Segmentation, Fences, Incentive Compatibility
 Segmentation
Segmentation is one of the fundamental techniques of marketing

Typical goal of segmentation is to create a “product line” to match product to a

customer segment (and their WTP!)
 Segmentation
Segmentation is an art

Market
Segment 1
A person can potentially
belong to multiple segments

Segment 2

Person 1 Person 1

Person 1

Person 1

Person 2 Segment 3
Person 2

to be effective, it has to be “actionable”

• able to target (or identify the segment)
• meaningful (lead to higher revenue)
Segmentation requires a deep understanding of customers, their preferences, WTP,
competing products.
 Drivers of Segmentation

Segmentation is an art

Purchase behavior
Channels used
Flexibility
Information about their own usage
Urgency/need
Loyalty

Behavioural Geographic
Lifestyle
Dislikes

Social
Likes

Psychographic Demographic
What to do if the product cannot be
changed?
Be “creative”: Revenue Management
(RM) segmentation
 Dilution and Fences
Dilution: High-WTP customers buy cheaper products
We need “Fences”
• Mechanisms to prevent dilution
• Distinguishing feature of RM products
• Absolutely essential to prevent dilution
Question: What are the fences in this typical (non-RM) product line?
Concept: Incentive Compatible Pricing
 Net-utility model of customer

• Two RM products: Product 1, Product 2

• Firm picks prices p1 , p2
• What does the consumer do?
• A consumer with valuations: v1 , v2 for the products will purchase the one with

max[v1 − p1 , v2 − p2 ]

(If this is ≥ 0)
 Designing product menus: Incentive
Compatibility

A key economic concept to keep in mind in product design with multiple products

Understanding customer segments and our products, features and their prices is a joint
exercise!. Difference in prices cannot be greater than difference in values
 Perfect and imperfect segmentation

Imperfect Segmentation
• Dilution A fraction of the high segment buys the lower-priced product
• Buy-up We shut off the lower-priced product—a fraction of the low segment
buys up
No segmentation based on self-selection is “perfect” — however, if the restrictions are
strong, we can assume perfect segmentation
15-min Exercise
 Design and match
Based on the description, (a) identify segments (b) create products (c) price (d) match

SEGMENTS PROUCTS

Features
Public channels
Compares Name:
No affiliations Label: Transient Price:

Package

Business

Half of team members work with Pink notes to write Segments

• Half the team work with Pink Post-Its to write segments and their features
• Half the team work with Yelow Post-Its to write products and their features
• Round 1: place side by side and match; Round 2: Go back and iterate . . . (Remember IC)
Step 4: Control
 The problem of distribution

There is a difference in complexity of pricing

A large “network” airline (connecting flights) for instance

“controls” 365 × 10000 Origin-Destinations × 15 fare products on
a daily basis
 Control: How to monitor and control
millions of “products”

• Managerial control: On an aggregate level (monthly, unit or product line level)

am I doing OK, or should I be doing something?
• Operational control: On minute-by-minute basis, am I diluting revenue by
selling too cheap? Or am I pricing too high and losing customers?
The former is controlled by reports and metrics and the latter by real-time systems.
Both are challenging tasks.
 Managerial Control: Reports and metrics

Below are the two main avenues. Challenge for for both is to identify “like-for-like”
and determining (a) when to draw an alarm (b) if so finding the root-cause.
• Internal reports and metrics comparing against previous periods/markets.
• Bench-marking reports: compare against industry and competitors.
Key metrics used to control at an aggregate level
• Occupancy: % of capacity being filled (at various levels of operations).
Alternate industry names: Load-factor or Yield
• Average revenue per available unit of capacity. Alternate industry names:
Revenue per seat, RevPAR (Revenue per Available Room)
• Average rate: Average price of each unit sold. Alternate industry names: ADR
(Average Daily Rate).
• Competitor index4 : market-share, yield compared to the competition etc.
Various industry names.
Plus a host of others: website views, searches and metrics.

4
Market research firms supply these numbers in many industries. They are often self-reported on a
participatory basis—you get info on the competitor set if you tell us your own performance.
 Operational control: Real-time control of
sales of RM products
Products are sold via third-party channels, prices are set by algorithms, so we have to
be in control
• Control system (PMS, Res system) allows automation (rules and processes
coded up)
• Decouples the Forecasting + Optimization stages with the actual Sales Control:
Cannot forecast/optimize after every sale (takes 30 to 90 mins to run the
methods) so sales are controlled by some optimized controls, and the
optimization happens occasionally (say during the night)
• Popular control methodologies (Note: Prices are fixed – used only for
accept/deny decisions)
• Bid-price controls
Decision rule
Sell if [Price ≥ Expected marginal value of the last remaining inventory
unit]
No, otherwise
• Nested allocation controls/Nested protections
 Understanding Nested limits
Nested: inventory available to the cheaper product is available to
the more expensive product

Product 1 Product 2 Product 3

 Simulation

• Consider the following Nested Booking Limits for three classes and a capacity of
30; fares Class 1: $100, Class 2: $75, Class 3: $50
Class 1 30
Class 2 18
Class 3 8
• Say the booking requests come as follows during the day:

333333333322222111111111111

• How the GDS changes the controls

Class 1 30 29 28 27 26 25 22
Class 2 18 17 16 15 14 13 ... 10
Class 3 8 7 6 5 4 3 0
 Simulation

• Say the booking requests come as follows during the day:

3322222222222222222222211

• How the GDS changes the controls

Class 1 30 29 28 ? ? ? ?
Class 2 18 17 16 ? ? ? ... ?
Class 3 8 7 6 ? ? ? ?
 Simulation

• Say the booking requests come as follows during the day:

33223322233222222222333111111

• Accepted 6 class 3’s, 12 class 2’s, 6 class 1’s

Rejected 3 class 3’s, 2 class 2’s
• How the GDS changes the controls
Class 1 30 29 28 27 26 25
Class 2 18 17 16 15 14 13 ...
Class 3 8 7 6 6 6 5