Customer-Choice Models

Customer-Choice Behaviour

A key unrealistic assumption in the models considered so far:

demand for each of the classes is completely independent of
the capacity controls being applied by the seller.

That is, it is assumed that the likelihood of receiving a request

for any given class does not depend on which other classes are
available at the time of the request.

For example,
the likelihood of selling a full-fare ticket may very well depend
on whether a discount fare is available at the same time
and
the likelihood that a customer buys at all may depend on the
lowest available fare.
Customer-Choice Models

Customer-Choice Behaviour

When customers buy a higher fare when a discount is

closed, it is called buy-up (sell-up from the firm’s
viewpoint).

When the customers choose another flight when a

discount is closed, it is called diversion.
Customer-Choice Models

Modified Littlewood’s rule is obtained by incorporating the

buy-up factors.

Let q be the probability that a customer for class 2 will buy

class 1 if class 2 is closed.

It is optimal to accept class 2 if and only if

p2 ≥ qp1 + (1 − q)p1 P(D1 ≥ x),

where the left (right) hand side is the (expected) return for
accepting (rejecting) the request of class 2 when the remaining
available capacity is x.

Exercise. Does the single-period (newsboy) formulation give

the optimality condition above?
Customer-Choice Models

Questions to be answered or issues to be claried

by working with the newsboy formulation:
In the textbook, P(D1 > x) is used on the right hand side of
the inequality given as the Modified Littlewood’s rule.
Why don’t we consider the potential demand of class 2
(that will buy up when class 2 is closed) on the right hand
side of the modified Littlewood rule in addition to D1 ?
Do the class-1 customers qualify for class 2 or not?
If they do, they can switch to class 2 even if both classes
are open for sale.
Is it possible to offer only class 2 at some point in time?
Referring to the DP formulation in Section 2.6.2, can we
show that it is optimal to always offer class 1? What are
the conditions to guarantee this?
Customer-Choice Models

Comparison of Littlewood’s rule with its modified version:

p2 ≥ qp1 + (1 − q)p1 P(D1 ≥ x)

= p1 P(D1 ≥ x) + qp1 (1 − P(D1 ≥ x))

≥ p1 P(D1 ≥ x).

The right hand side of the modified rule is greater than the right
hand side in Littlewood’s rule, which means that the modified
rule is more likely to reject class 2 demand.

This is intuitive because, with the possibility of customers

upgrading to class 1, we should be more eager to close class 2.
Customer-Choice Models

Remark.
The difficulty with the modification of Littlewood’s rule to
incorporate buy-up factor is that

it does not extend to more than two classes

-at least not in an exact way-

because the probability that a customer buys class i given that j

is closed depends not only on i and j but also on which other
classes are also available.
Customer-Choice Models

Extension of EMSR-b Heuristic (for continuous case)

The modified equation for determining the protection level yj :

j
X
pj+1 = qj+1 p̂j+1 + (1 − qj+1 )p̄j P( Dk ≥ yj ),
k =1

where

qj+1 is the probability that a customer of class j + 1 buys

up to one of the classes j, j − 1, ..., 1,

p̄j is the weighted-average fare as defined for EMSR-b,

p̂j+1 is an estimate of the revenue received given that a

class j + 1 customer buys up to one of the classes j, j − 1,
..., 1.
Customer-Choice Models

Note that p̂j+1 > pj+1 .

For example, p̂j+1 = pj if customers are assumed to buy up to

the next highest price class.

If buy-up probabilities qj+1,k can be estimated somehow

to satisfy
k
X
qj+1 = qj+1,k ,
j=1

then qj+1 p̂j+1 on the right hand side of the inequality could be
replaced with
k
X
qj+1,k pk .
j=1
Customer-Choice Models

The net result of the extension of the traditional EMSR-b is

to increase the protection level yj ,
to close down class j + 1 earlier than one would do under
the traditional one.
Customer-Choice Models

Customer-Choice Models
In each period, there is at most one arrival.
The probability of arrival, λ, is assumed to be the same for
all time periods (for ease of exposition).
N = {1, ..., n} is the entire set of classes.
p1 ≥ p2 ≥ ... ≥ pn .
p0 = 0 denotes the revenue of the no-purchase choice.
In each period t, the seller chooses a subset St ⊆ N of
classes to offer.
When the set of classes St is offered in period t,
the probability that a customer chooses class j ∈ St is
denoted by Pj (St ).
P0 (St ) is the no-purchase probability.
Customer-Choice Models

For every S ⊆ N, the probabilities satisfy

Pj (S) ≥ 0 for all j ∈ S,

X
P0 (S) + Pj (S) = 1.
j∈S

Q(S) is the probability of purchase and R(S) is the expected

revenue for set S:
X
Q(S) = Pj (S) = 1 − P0 (S),
j∈S
X
R(S) = 0 × P0 (S) + Pj (S)pj .
j∈S
Customer-Choice Models

Example 2.5 (pp. 65 in the textbook)

Consider set S = {Y , K } in Table 2.9.

The segments Business 1 and Business 2 can not qualify
for both SA stay and 21-day advance-purchase restrictions
on K , so these segments buy the Y fare.
That is, PY (S) = 0.1 + 0.2 = 0.3.
Leisure 2 and 3 qualify for both restriction of K and
purchase K . That is, PK (S) = 0.2 + 0.3 = 0.5.
Leisure 1 can not qualify for the SA stay restriction of K
and is not willing to buy Y , so these customers do not
purchase at all. That is, P0 (S) = 0.2.
Customer-Choice Models

Example 2.5 (cont’d)

Note that
X
Q(S) = Pj (S) = 0.8,
j∈S

R(S) = PY (S)pY + PK (S)pK + (1 − Q(S)) × 0

= (0.3)800 + (0.5)450 + (0.2)0
= 465.
Customer-Choice Models

Dynamic Programming Formulation

Stage (t): periods, t = 0, ..., T .
State (x): remaining capacity, x = 0, 1, ..., C.

The value function vt (x) denotes the maximum expected

revenue obtainable from periods t, t − 1, ..., 1 when the
remaining capacity is x at time t.

For t = 1, ..., T and x = 0, 1, ..., C,


X
vt (x) = max λPj (S)(pj + vt−1 (x − 1))
S⊆N 
j∈S
+(λP0 (S) + 1 − λ)vt−1 (x)}.
For x = 0, 1, ..., C, v0 (x) = 0.
For t = 0, 1, ..., T , vt (0) = 0.

The second and third eqn.s above: boundary conditions.

Customer-Choice Models

Remark.
The key difference in the customer-choice model above
compared to the traditional independent-class models
we studied previously in Sections 2.2.2 and 2.5 is that

the seller precommits to the open set of classes S

in each period

while in the traditional models

we assume the seller observes the class of the request and
then makes an accept or reject decision based on the class.
Customer-Choice Models

The reason for the difference is that,

in the traditional class-based models, the class of an arriving
request is completely independent of the controls.
That is, it does not matter whether the seller precommits to the
set of open classes or not.

However, in the choice-based model, the class that an arriving

customer chooses depends (through the choice probabilities
Pj (S)) on which classes S the seller reports as being open.

Hence, the formulation is max E(·) instead of E(max(·));

S is chosen prior to seeing the realization of the choice
decision.
Customer-Choice Models


X
vt (x) = max λPj (S)(pj + vt−1 (x − 1))
S⊆N 
j∈S
+(λP0 (S) + 1 − λ)vt−1 (x)}
 
X 
= max λPj (S)(pj − ∆vt−1 (x)) + vt−1 (x),
S⊆N  
j∈S

where

∆vt−1 (x) = vt−1 (x) − vt−1 (x − 1)

is the marginal cost of capacity in period t − 1 (the next period).

Customer-Choice Models

The DP formulation is rewritten in a compact form as follows:

 
X 
vt (x) = max λPj (S)(pj − ∆vt−1 (x)) + vt−1 (x)
S⊆N  
j∈S

= max {λ[R(S) − Q(S)∆vt−1 (x)]} + vt−1 (x).

S⊆N

It is shown in Proposition 2.3 (pp. 68 in the textbook) that not all

of 2n − 1 subsets of N need to be considered for optimization,
but the search can be reduced to only those sets that are
efficient with respect to the trade-off between R(S) and Q(S).

Proposition 2.3 An inefficient set is never an optimal solution

to the DP formulation.
Customer-Choice Models

For Example 2.5, it is seen in Figure 2.7 that the efficient sets
are S1 = {Y }, S2 = {Y , K } and S3 = {Y , K , M}.

Applying Theorem 2.3 (pp. 69 in the textbook) to Example 2.5,

the optimal policy is given as follows.
With very large amounts of remaining capacity, S3 is
optimal: all three fare classes are opened.
As capacity is consumed, at some point we switch to only
offering S2 : class M is closed, and only Y and K are
offered.
As capacity is reduced further, at some point we close
class K and offer only class Y (set S1 is used).
Customer-Choice Models

It can be optimal to offer the highest fare Y and the lowest fare
K , but not the middle fare M.

This is because opening M causes some buy-down from Y to

M, whereas K is sufficiently restricted to prevent buy-down.
Only when capacity is plentiful, M is opened.

Consider the case of customer type Bus. 2.

Customer-Choice Models

Consider the following ordering for efficient sets

{Sk : k = 1, ..., m}}:

Q(S1 ) ≤ Q(S2 ) ≤ ... ≤ Q(Sm )

R(S1 ) ≤ R(S2 ) ≤ ... ≤ R(Sm ).

See Figure 2.7 for the example problem.

Recalling that S1 = {Y }, S2 = {Y , K } and S3 = {Y , K , M},

Q({Y }) ≤ Q({Y , K }) ≤ Q({Y , K , M})

R({Y }) ≤ R({Y , K }) ≤ R({Y , K , M}).

Then, the optimality equation can be written as

vt (x) = max {λ[R(Sk ) − Q(Sk )∆vt−1 (x))} + vt−1 (x).

k =1,...,m
Customer-Choice Models

Theorem 2.3 An optimal policy for the DP formulation is to

select a set kt∗ (x) from among the m efficient, ordered sets
{Sk : k = 1, ..., m}}:

kt∗ (x) = argmaxk =1,...,m {λ[R(Sk ) − Q(Sk )∆vt−1 (x)]} .

For a fixed t, the largest optimal index kt∗ (x) is increasing

in the remaining capacity x.
For a fixed x, the largest optimal index kt∗ (x) is increasing
in time t.

The proof is involved but derives from the fact that ∆vt−1 (x) is
decreasing in x (see Appendix 2.A).

For Example 2.5, kt∗ (x) = 3 for large x and kt∗ (x) = 2 for
smaller x and kt∗ (x) = 1 for even smaller x values.
Customer-Choice Models

Definition 2.2 A control policy is called a nested policy

if
there is an increasing family of subsets S1 ⊆ S2 ⊆ ... ⊆ Sm
and there is an index kt (x) that is increasing in x
such that set Skt (x) is chosen at time t when the remaining
capacity is x.

This is a natural generalization of nested allocations for the

traditional single-resource models of Sections 2.2.2 and 2.5
and implies an ordering of the classes.
Customer-Choice Models

Consider the traditional independent-demand model with n = 4

classes.
Zj = {1, ..., j} for j = 1, 2, 3, 4 are the efficient sets.
From the analysis in the previous sections,
the optimal policy in period t is to open the classes in set
Zj as long as the remaining capacity in period t takes
∗ (t), y ∗ (t)].
values in (yj−1 j

kt∗ (x) = j for yj−1

∗
(t) < x ≤ yj∗ (t).

Instead of j, kt (x) = k can be used as subscripts of Zj and yj (t).

Nesting by fare definition for independent-demand models is in

accordance with the generalization in Definition 2.2.

See the figure on the next page.

Customer-Choice Models
Customer-Choice Models

If the optimal policy is nested in this sense (Definition 2.2),

then we can define optimal protection levels

yk∗ (t) for k = 1, ..., m

such that

classes lower in the nesting order than those in Sk are closed

if the remaining capacity is less than or equal to yk∗ (t) at time t.
Customer-Choice Models

For the independent-demand models,

the result follows by answering the following question:

"Should we choose x or x − 1 as the protection level of classes

j, ..., 1 in period t (if we are to choose one of these two
alternatives)?"

Recall the figure given on the next page.

Customer-Choice Models
Customer-Choice Models

The question to be raised to find yk∗ (t) for the customer-choice

models is the following:

"Should set Sk +1 be kept open or set Sk be offered at time t

when the remaining capacity is x?"
Customer-Choice Models

Should set Sk +1 be kept open or set Sk be offered at time t

when the remaining capacity is x?
Which one should be preferred?
If Sk is offered, then the optimal expected revenue is
λ[R(Sk ) − Q(Sk )∆vt−1 (x)] + vt−1 (x).
If Sk +1 is offered, then the optimal expected revenue is
λ[R(Sk +1 ) − Q(Sk +1 )∆vt−1 (x)] + vt−1 (x).

Set Sk is offered if
λ[R(Sk +1 ) − Q(Sk +1 )∆vt−1 (x)] + vt−1 (x)
< λ[R(Sk ) − Q(Sk )∆vt−1 (x)] + vt−1 (x)
or
R(Sk +1 ) − Q(Sk +1 )∆vt−1 (x)
< R(Sk ) − Q(Sk )∆vt−1 (x).
Customer-Choice Models

For k = 1, ..., m − 1,
 
∗ R(Sk +1 ) − R(Sk )
yk (t) = max x : < ∆vt−1 (x) .
Q(Sk +1 ) − Q(Sk )

The result follows because ∆vt−1 (x) is decreasing in x (see

Appendix 2.A).

See the figure on the next page.

Nested booking limits: bk (t) = C − yk −1 (t).

Customer-Choice Models
Customer-Choice Models

Homework.
a) Draw an example figure to compare the behaviours of
R(Sk ) − Q(Sk )∆vt−1 (x) and R(Sk +1 ) − Q(Sk +1 )∆vt−1 (x)
as a function of x.

b) On the figure, identify the x (remaining capacity) values for

which
opening set Sk is preferred to keeping set Sk +1 open,
keeping set Sk +1 open is preferred to opening set Sk .

c) Determine yk∗ (t) and show it on the figure. Write down an

expression for yk∗ (t) based on the comparison of
R(Sk ) − Q(Sk )∆vt−1 (x) and R(Sk +1 ) − Q(Sk +1 )∆vt−1 (x).

d) Justify your analytical observations above by working with

the numerical values in Table 2.10 in the textbook given for
Example 2.5 for some period t.
Customer-Choice Models

From Table 2.9 (pp. 66 in the textbook),

R(S3 ) − R(S2 ) 505 − 465

= = 200,
Q(S3 ) − Q(S2 ) 1 − 0.8

R(S2 ) − R(S1 ) 465 − 240

= = 450.
Q(S2 ) − Q(S1 ) 0.8 − 0.3

By comparing these values with the ones given in Table 2.10

(pp. 72 in the textbook) for Example 2.5 for some value of t,
it is observed that
the optimal protection level for set S1 is y1∗ (t) = 3,
it is y2∗ (t) = 12 for set S2
and y3∗ (t) = 20 = C for set S3 .
Customer-Choice Models

Nesting by revenue (fare) order need not be the optimal policy

in general.

Talluri and van Ryzin (2004) give conditions that guarantee a

given choice model will always have nesting by revenue (fare)
order.
Comparison of Optimality Conditions

Comparison of Optimality Conditions

Independent-Demand Model vs. Customer-Choice Model

or
Nested-by-Revenue-Order vs. Choice-based Control

What is the use of customer-choice model

for independent-demand case?
Let Zk = {1, ..., k } be the set of the k highest classes in
revenue order.
Zk s would be the efficient sets for independent-demand
case.
Comparison of Optimality Conditions

It is optimal to open class k + 1 if and only if

+1
kX
{λ Pj (Zk +1 )(pj − ∆vt−1 (x))} + vt−1 (x)
j=1
k
X
≥ {λ Pj (Zk )(pj − ∆vt−1 (x))} + vt−1 (x).
j=1

Recall the DP formulation for customer-choice behaviour

for writing each side of the inequality above.
The left and right hand sides are for offering sets Zk +1 and Zk ,
respectively.
Comparison of Optimality Conditions

Rearranging the terms, the following inequality is obtained:

Pk +1 (Zk +1 )(pk +1 − ∆vt−1 (x))

k
X
≥ (Pj (Zk ) − Pj (Zk +1 ))(pj − ∆vt−1 (x)).
j=1

Pj (Zk ) − Pj (Zk +1 ) is the change (usually an increase for most

choice models) in purchase probability for class j, j = 1, ..., k ,
as the result of not offering class k + 1.
Comparison of Optimality Conditions

Optimality condition for customer-choice model:

Pk +1 (Zk +1 )(pk +1 − ∆vt−1 (x))

k
X
≥ (Pj (Zk ) − Pj (Zk +1 ))(pj − ∆vt−1 (x)).
j=1

This optimality condition reduces to the following optimality

condition for independent-demand model:

it is optimal to open class k + 1 if and only if

pk +1 − ∆vt−1 (x)) ≥ 0.

The reduction is due to Pj (Zk ) − Pj (Zk +1 ) = 0 for all j = 1, ..., k .

Comparison of Optimality Conditions

Pk +1 (Zk +1 )(pk +1 − ∆vt−1 (x))

k
X
≥ (Pj (Zk ) − Pj (Zk +1 ))(pj − ∆vt−1 (x)).
j=1

The left hand side in the optimality condition above is the

probability of selling class k + 1 times the "net gain" from
selling it (fare pk +1 minus the opportunity cost ∆vt−1 (x) of
using a unit of capacity for class k + 1).

The right hand side in the optimality condition above is the sum
over all the other class j in Zk of the change in purchase
probability times the net gain from selling j.

Left hand side: gain from class k + 1.

Right hand side: improvement by closing class k + 1.