Pricing and Revenue Optimization

Robert Phillips

• Publisher: Stanford Business Books
• Year: 2005
• ISBN:
  9780804781640
• Edition: 1
• Topic: Business
• Subtopic: Operazioni
• Index: Business

This is the first comprehensive introduction to the concepts, theories, and applications of pricing and revenue optimization. From the initial success of "yield management" in the commercial airline industry down to more recent successes of markdown management and dynamic pricing, the application of mathematical analysis to optimize pricing has become increasingly important across many different industries. But, since pricing and revenue optimization has involved the use of sophisticated mathematical techniques, the topic has remained largely inaccessible to students and the typical manager.

With methods proven in the MBA courses taught by the author at Columbia and Stanford Business Schools, this book presents the basic concepts of pricing and revenue optimization in a form accessible to MBA students, MS students, and advanced undergraduates. In addition, managers will find the practical approach to the issue of pricing and revenue optimization invaluable.

Solutions to the end-of-chapter exercises are available to instructors who are using this book in their courses. For access to the solutions manual, please contact [email protected].

1	BACKGROUND AND INTRODUCTION
	What is a cynic? . . . A man who knows the price of everything and the value of nothing
	Oscar Wilde (1892)

This is a book about pricing—specifically, how companies should set and adjust their prices in order to maximize profitability. It takes the view that pricing decisions are commonplace, that they can be complex, and that they are usually critical determinants of profitability. Despite this, pricing decisions are often badly managed (or even unmanaged). While most companies have pretty good prices in place most of the time, very few have the processes and capabilities needed to ensure that they have the right prices in place for all their products, to all their customers, through all their channels, all the time. This is the goal of pricing and revenue optimization.

Pricing and revenue optimization is a tactical function. It recognizes that prices need to change rapidly and often and provides guidance on how they should change. This makes it distinct from strategic pricing, where the goal is usually to establish a general position within a marketplace. While strategic pricing worries about how a product should in general be priced relative to the market, pricing and revenue optimization is concerned with determining the prices that will be in place tomorrow and next week. Strategic pricing sets the constraints within which pricing and revenue optimization operates.

One of the distinguishing characteristics of pricing and revenue optimization is its use of analytical techniques derived from management science. The use of these techniques to set prices in a complex, dynamic environment is relatively new. One of the first applications of the approach was the development of revenue management systems by the passenger airlines in the 1980s. Since then, the rapid development of e-commerce and the availability of customer data through customer relationship management (CRM) systems has led to the adoption of similar techniques in many other industries, including automotive, retail, telecommunications, financial services, and manufacturing. A number of software vendors provide “price optimization” or “demand management” or “revenue management” solutions focused on one or more industries. In this context, pricing and revenue optimization is increasingly becoming a core competency within many different companies. The purpose of this book is to provide an introduction to this relatively new and rapidly changing field.

In this chapter, we begin by giving some historical context for pricing and revenue optimization. In particular, we give some perspective on why pricing has gone from being a largely ignored and obscure “black art” within many companies to become the subject of intense scrutiny and analysis. We argue that the “pricing problem” has become increasingly difficult and is likely to become even more difficult in the future. We argue further that improving pricing is often one of the highest-return investments available to a company. Hopefully this will whet the reader’s appetite for the more quantitative material to come in the following chapters.

1.1 HISTORICAL BACKGROUND AND CONTEXT

For most of history, philosophers took it for granted that goods had an intrinsic value in the same sense that they had an intrinsic color or weight. A fair price reflected that intrinsic value. Charging a price too much in excess of the intrinsic value was condemned as a sign of “avarice” and often prohibited by law. Prices were set by custom, by law, or by imperial fiat. Sermons were preached inveighing against the sin of charging unfair prices in order to receive excessive profits.¹ The problem of pricing did not really exist until modern market economies began to emerge in the West in the 17th and 18th centuries. With the emergence of these economies, prices were allowed to move more freely—untied to the traditional concept of value. Speculative bubbles such as “tulipomania” in the Dutch republic in the 1630s—in which the price of some varieties of tulips rose more than a hundredfold in 18 months before collapsing in 1637—and the “South Sea bubble” in England in 1720—in which the prices of shares in the South Sea Company soared before the company collapsed amid general scandal—fed a sense of anxiety and the belief that prices could somehow lose touch with reality.² Furthermore, for the first time, large numbers of people could amass fortunes—and lose them—by buying and selling goods on the market. The question naturally arose—what were prices, exactly? Where did they come from? What determined the right price? When was a price fair? When should the government intervene in pricing? The modern field of economics arose, at least in part, in response to these questions.

Possibly the greatest insight of classical economics was that the price of a good at any time in an ideal capitalist economy is not based on any intrinsic “value” but rather on the interplay of supply and demand. This was a major intellectual breakthrough—on par in its way with the Newtonian view of the clockwork universe and Darwin’s theory of evolution. In essence, the price of a good or service was determined by the interaction of people willing to sell the good with the willingness of others to buy the good. That’s all there is to it—neither intrinsic “value” nor cost nor labor content enters directly into the equation. Of course, these and other factors enter indirectly into pricing—sellers would not last long selling goods below cost, and the prices buyers accept are based on the “value” they placed on the item—but these were not primary. There are many reasons why sellers sell below cost when they are in possession of a cartload of vegetables that are on the verge of going rotten—the classic “sell it or smell it” situation—or to attract a desirable new customer. Just so, the “value” that buyers placed on different goods changed with their changing situation and the dictates of fashion. According to modern economics there is no normative “right price” for a good or service against which the price can be compared—rather, there are only the actual prices out in the marketplace, floating freely without an anchor, based only on the willingness of sellers to sell and buyers to buy.

While classical economics solved the problem of the origin of price, it raised as many questions as it answered. In particular, if prices were not tied to fundamental values—if they had no anchor—why did they show any stability at all? Under normal circumstances, prices for most goods are pretty stable most of the time. If prices are based only on the whims of buyers and sellers, why is the price of bread not subject to wild swings like the Dutch tulip market in 1689? Why doesn’t milk cost five times as much in Chicago as it does in New York? How can manufacturers and merchants plan at all and make reasonable profits in order to stay in business? How can an economy based on free-floating prices work at all? And, assuming that such an economy could work, how could it possibly work better than a centralized economy where planners carefully sought to allocate resources across the entire economy?

One of the great achievements of 20th century economics was to show mathematically how a largely unregulated economy could work: that an economy consisting of individuals who supply their labor in return for wages and use their earnings to buy goods to maximize their “utility” combined with firms who seek to maximize profitability can be remarkably stable and efficient.³ Under certain assumptions, this type of capitalist economy can be shown to be at least as efficient as any centrally planned economy. Furthermore, prices in such an economy would generally be stable and reasonably predictable. The price for a product would equal the long-run marginal production cost of that product plus the return on invested capital necessary to produce the product. If someone were selling the product for less, he or she would go out of business because his or her costs would not be covered. If someone tried selling for more, other sellers would undercut his price, consumers would flee to the lower-priced sellers, and the high-price seller would be forced to lower his price or go bankrupt for lack of business. As this happens simultaneously, economy-wide, prices equilibrate and change only due to exogenous shocks, changes in resource availability, taxation or monetary policy, or changes in consumer tastes.

This view of the world is based primarily on the assumption that most markets are perfectly competitive, where the idea of perfect competition can be summarized as follows.

A market structure is perfectly competitive if the following conditions hold: There are many firms, each with an insubstantial share of the market. These firms produce a homogenous product using identical production processes and possess perfect information. It is also the case that there is free entry to the industry; that is, new firms can and will enter the industry if they observe that greater-than-normal profits are being earned. The effect of this free entry is to push the demand curve facing each firm downwards until each firm earns only normal profits, at which point there is no further incentive for new entrants to come into the industry. Moreover, since each firm produces a homogenous product, it cannot raise its price without losing all of its market to its competitors …. Thus firms are price takers and can sell as much as they are capable of producing at the prevailing market price.⁴

There are no pricing decisions in perfectly competitive markets—prices are determined by the iron law of the market. If one merchant were offering a good for a lower price than another, neoclassical economics assumes that either customers would entirely abandon the higher-price merchant and swamp the lower-price merchant or an arbitrageur would arise who would buy all the goods from the lower-price merchant and sell them at the higher price. In either case, a single market price would prevail. Furthermore, if prices were so high that merchants enjoyed higher profits than the rest of the economy, more sellers would enter, lowering the average price until the return on capital dropped to the market level. In this situation, there are no pricing decisions at all: Prices are set “by the market”—as stock prices are set by the New York Stock Exchange or NASDAQ. The price of Microsoft stock is not set by any “pricer” but by the interplay of supply and demand for the stock. Many financial instruments, such as stocks and bonds, satisfy the economic definition of a commodity. Certain other highly fungible goods—grain, crude oil, and some bulk chemicals—also come very close to being commodities. In these markets, there is simply no need for pricing and revenue optimization—the market truly sets the price.

As any shopper can tell you, much of the real world is messier—prices vary all over the place, sometimes in ways that seem irrational. Buyers often behave erratically, sellers do not always seek to maximize short-run profit, neither buyers nor sellers are possessed of perfect information, and opportunities for arbitrage are not immediately seized. Table 1.1 shows prices for a half gallon of whole milk at different markets in a 16-block area of the upper west side of Manhattan on a single day in May 2002. Prices range from a low of $1.39 to a high of $2.00—a variation of $0.61, or 44%. Furthermore, the price varied by more than $0.40 even for two stores on the same block. How could this be? Why would anybody buy milk at a high price when they could walk a block and save 40 cents? Why don’t arbitrageurs buy all the milk at the lower price and sell it at the higher?

TABLE 1.1
Retail prices for a half gallon of whole milk on the Upper West Side of Manhattan, May 2002

Location	Price
74th and Broadway	$1.39
79th and Amsterdam	1.59
77th and Broadway	1.59
74th and Columbus	1.69
73rd and Columbus	1.79
74th and Amsterdam	1.79
75th and Broadway	1.89
71st and Columbus	1.99
78th and Amsterdam	2.00
AVERAGE	$1.75
STANDARD DEVIATION	0.20

The price variation shown in Table 1.1 will hardly come as a shock to most people—after all, both businesses and consumers know that it pays to shop around—suppliers of the same (or similar) products will often charge different prices. Furthermore, there are other ways to pay a lower price for exactly the same product: Wait until it goes on sale, travel to a retail outlet, clip a coupon, buy in bulk, buy it online, try to negotiate a lower price. In fact, it is hardly a secret not only that prices vary between sellers but that a single seller will often sell the same product to different customers for different prices!

The tools that pricers use day to day are far more likely to be drawn from the fields of statistics or operations research than from economics. Marketing science, which deals with the quantitative analysis of marketing initiatives, including pricing, is usually considered part of the broader field of operations research and management science.⁵ Application of these techniques to problems of marketing began to emerge in a significant fashion in the 1960s.⁶ Since then, marketing scientists have developed, ap...