Pricing Strategies: A Quick Tutorial

Is the price right?
 [source: AmazonGenius]

Pricing is the moment of truth for any business. Demand for a product is eventually a result of the price being charged for a product, so setting the "right" price is as important as choosing the "right" product to sell that can create a successful business. Pricing is studied more in the field of marketing where pricing is one of the 4 Ps of marketing (others are product, place and promotion).

The focal point of my research so far has been the study of pricing in supply chain contexts such as stockouts, different type of upstream contracts or sourcing, and competition. The more pressing and fundamental issue at the core of pricing is how consumers react to different pricing strategies and what are these?

In order to learn more about pricing strategies, I came across this online tutorial by Houston Chronicle (which is not a place that comes to my mind when I am thinking about literature on pricing). 

The link is : Houston Chronicle. 

Houston Chronicle

I liked the examples, and compartmentalization of topics at this source. I would more likely to call this a wiki on pricing strategies.

With growing technology and big-data pricing is even more challenging and there is more scope for  innovative pricing strategies.

Best 10 Milestone Papers in 10 years of Revenue Management

This was shared on MSOM Informs on Linkedin. I liked the idea of selecting the top 10 papers in last years of revenue management. This not only acknowledges the work of leading researchers but also gives the community a big picture where the field is heading.

All papers are available FREE.

http://www.palgrave-journals.com/rpm/collections/milestones_collection.html

AA and US Airways merger: a curse for consumers?

Last week the department of justice (DOJ) thwarted the merger between AA and US airways that would have made the world's biggest airline company. The move was based on the premise that this will lead to an increase in airfares and consumers will end up paying more. This is because there will be less competition in the airlines sector, and airlines will have a lesser incentive to reduce fares to attract the customers. A simple example is comparison of consumer surpluses in a monopoly with a single durable good compared to a symmetric Cournot duopoly with durable goods, where in a monopoly prices are higher, consumer surplus is lower compared to the duopoly.

Interesting things to observe about the airline industry are:

1. High entry barrier, it takes a lot of capital to setup an airline business.
2. Firms are identical in terms of product, most airlines operate from same terminals and similar airplanes with similar flight times.
3. Price discrimination is usually achieved through segmenting customers based on time of purchase of tickets, type of ticket (refundable, non-refundable, economy, business) etc. 
4. Operating costs such as airline ticket counters, airline staff (pilots, attendants, scheduling and operations) is highly symmetric across airlines and there is a good chance these costs will push down when companies merge. The existence of airline partnerships across the globe is one such measure to reduce these operating costs.
5. Owing to long gestation periods and break-even point, companies try to secure profits by mergers and alliances to avoid bankruptcy and secure cash-flow for operations. In this case both AA and US airways argument was that this merger is beneficial to secure their failing future.

Solution: My view on this is that airlines should be given an opportunity to merge if they are ready to pass on the benefits operational synergies achieved through the merger to consumers. If department of justice can help secure this, then it could be a big win for the sector as well as consumers.

Several articles discusses this issue and its impact on different parties including:

WSJ
Reuters

Importance of Middlemen in Global Sourcing

Supply chains are getting further complicated as the economies are globalizing at levels not seen before. The role of middlemen (or sourcers) has changed from producers who used to supply directly to suppliers to malls or end retailers who specialize in finding 'cheap' production based product 'reliable' supply. A recent article in New York Times on "Linking Factories to the Malls, Middleman Pushes Low Costs" talks about Li & Fung, a hongkong based company who marvels at finding cheap labor and supply across Asia and glove to feed the malls. It owns no clothing factories, sewing machines or fabric mills, with 15,000 suppliers in over 60 countries. 

There are several questions of interest here: 

1. How important are these companies for the benefit of supply chain ? Do they help to improve profits of manufacturers who would otherwise not sell to developed markets?
2. How does costs, reliability, lead times affect the purchasing decisions, prices, and profits in such a complex global supply chain system?
3. What kind of contracts can achieve operational efficiency in the supply chain?
4. With an increasing emphasis on fair-trade and local sourcing, what is the future of such middlemen?

Quote of the day - Multiple Decision Makers

“From the time of Adam Smith’s Wealth of Nations in 1776, one recurrent theme of economic analysis has been the remarkable degree of coherence among the vast numbers of individual and seemingly separate decisions about the buying and selling of commodities. In everyday, normal experience, there is something of a balance between the amounts of goods and services that some individuals want to supply and the amounts that other, different individuals want to sell [sic]. Would-be buyers ordinarily count correctly on being able to carry out their intentions, and would-be sellers do not ordinarily find themselves producing great amounts of goods that they cannot sell. This experience of balance is indeed so widespread that it raises no intellectual disquiet among laymen; they take it so much for granted that they are not disposed to understand the mechanism by which it occurs.” Kenneth Arrow (1973)

I stumbled upon this quote here, while reading for ways to establish uniqueness of an equilibrium.

Optimizing the Learning Curve: Tao Li

Prof. Tao Li at Leavey Business School, SCU [PhD OM, UTD] is working on relationship between pricing and efficiency gains. Pricing is the moment of truth for a firm (Corey, 1991) and when firms improve their processes after some experience, this should translate into prices they offer. This effect on price is further amplified when firms sell products through retailers and not directly due to the double marginalization effect.

Ultimately the question is how can this effect be mitigated, and available tools to coordinate supply chain are contracts, information sharing, and transfer of ownership etc. Prof. Li et al. studied this coordination game in light of contracts that will help company leverage the efficiency gains and improve their profits. 

This is a very interesting and fundamental topic that concerns supply chains. More details are in the paper which I leave for readers to explore. 

This research also made it to highlights at Leavey and the article is below.

How Pricing Can Be Connected to Efficiency Gains

When a company launches a new product, there is nearly always some inefficiency in the manufacturing process at first. And, typically, with the passage of time, there is a learning curve in which the firm figures out how to manufacture the product more efficiently.

The normal pricing inefficiency that exists in any relationship between manufacturer and retailer, known as “double marginalization” because both parties are affected, becomes more severe as the learning curve makes manufacturing more efficient.

Tao Li, a new assistant professor of operations management and information systems, has been looking into how revenue-sharing agreements between manufacturers and retailers can make the supply chain more efficient and boost profits.

“Other approaches to supply-chain efficiency, such as quantity discounts, two-part tariffs and buy-back programs don’t really coordinate the chaos,” Li says. “But we found that by using a revenue-sharing contract, it’s possible to control the supply-chain chaos so that both the manufacturer and retailer are better off.”

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“It is a game played by both the manufacturer and the retailer.”

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The findings are reported in a working paper titled “Dynamic Pricing, Procurement, and Channel Coordination with Stochastic Learning,” which Li co-authored with Xiuli He of the University of North Carolina at Charlotte, and Suresh P. Sethi, at the University of Texas at Dallas.

In this sort of supply chain situation, the key issue is double marginalization, which refers to the pricing inefficiency that occurs when the manufacturer sets a wholesale price based on anticipated manufacturing costs and the retailer sets a retail price based on anticipated demand.

That disparity can become worse as the learning curve makes the manufacturing process more efficient and less costly at the same time demand for the product is easing after the typical flurry of sales when the product was first introduced.

Li says that academic studies to this point have focused on the learning curve issue from the manufacturer’s perspective. In the paper he and his colleagues wrote, he says, “we look at it as a game played by both the manufacturer and retailer.”

Additionally, they look at it over two different periods: when the product first comes out, and later, when manufacturing efficiency has peaked but demand is falling off.

(Yet another consideration, originally taken up in this paper but subsequently broken out into a second one, is how to factor in the question of whether the retailer has the ability to carry over inventory from the first period to the second, which could add another distortion to the supply-chain efficiency.)

What Li and his colleagues found was that a well-constructed revenue-sharing agreement between the manufacturer and retailer can smooth out the disparities in the process.

As an example of how that might work, Li outlined a contract arrangement in which the retailer and manufacturer split sales revenues 50-50 in the first period of a contract, then the retailer takes a 60 percent share in the second period.

(He notes that negotiated rates aren’t always optional because large retailers, such as Target and WalMart have the clout to get themselves a larger share, which creates another form of distortion.) Li also said that the retailer may not necessarily be better off by getting a larger share of the revenue in the second period.

When the arrangements are optimal, the result is likely to be that the manufacturer’s share of the retailer’s revenue allows it to charge a lower wholesale price at the outset, which means the retailer can charge a lower sales price, perhaps stimulating additional consumer demand.

In the second period, when sales drop, the retailer gets a bigger cut, while the manufacturer’s margin is improved by greater production efficiency. Lower wholesale and retail prices then create a better chance of growing total sales.

“Reducing wholesale prices improves the efficiency of the supply chain,” Li says, “and that grows the pie of total sales. Once the pie becomes larger, both the manufacturer and retailer are better off.”

[source: http://www.scu.edu/business/mindwork/winter13/optimizing-the-learning-curve.cfm]

[More details and articles here: http://www.scu.edu/business/mindwork/winter13/upload/SCU-Minds-Work-Winter2013.pdf]

Climate Change and Conflicts: A Statistical Study

I came across an article on BBC [Rise in violence 'linked to climate change'] which talks about research by a team of US scientists who establish the relation between climate change and conflicts. After this, I looked for this publication to see which statistical tools they were using to establish causality. The article is published in science magazine [link]. The model they use is a time-series model given by

conflict_variableit = β × climate_variableit + μi + θt + ϵit

, where locations are indexed by i, observational periods are indexed by t, β is the parameter of interest and ϵ is the error. If different locations in a sample exhibit different average levels of conflict - perhaps because of  cultural, historical, political, economic, geographic or institutional differences between the locations - this will be accounted for by the location-specific constants μ (“fixed effects”). Time specific constants θ (a dummy for each time period) flexibly account for other time-trending variables such as economic growth or gradual demographic changes that could be correlated with both climate and conflict. 

This is a very simple model, still very powerful in determining correlation between conflict and climate change. What needs to be done is collect data (most difficult part) and then a regression to check if 'β', μi and θt are significant, and the researchers successfully prove that. However, the paper ends with the important part of 'causation', where the field is still in infancy to establish a clear cause which relates climate change and conflicts. There are many competing plausible theories, and there is still a lot of scope and research left to unravel that mystery. Why I find this interesting is because correlation and causation are confused very easily, and this study is an example where the way BBC reports the findings is very different from the way authors report in publication. Authors (Hsiang et al.) are reporting the quantitative influence of climate change on conflicts, not a causal link between the two variables, whereas BBC reports it as a causal link with rise in violence linked to climate change. One can watch this video to see what it means to differ between correlation and causation.

Professor of Marketing Makes Sense of Consumer Behaviors [UTDallas News]

Professor of Marketing Makes Sense of Consumer Behaviors

Aug. 1, 2013

Dr. Dmitri Kuksov

Which designer purse will become the next “it” bag?

Many have concluded that fashion hits such as Hermes’ famous Birkin bag are random and impossible to predict.

New research by Dr. Dmitri Kuksov, professor of marketing in the Naveen Jindal School of Management, concludes that the randomness is no accident.   

Dmitri Kuksov and his co-author Kangkang Wang, who is currently a professor at the University of Alberta, challenge prevailing notions about how products rise to must-have status in their article, “A Model of the 'It' Products in Fashion.” The article appeared in the journal MarketingScience earlier this year.

The article explores the “it” bag phenomenon, in which purses by Fendi, Prada, Dior and other designers have become the must-have bags in various years. The authors quote observations that fashion hits are the results of “dumb luck.”

Kuksov, who joined the UT Dallas faculty last year, said the standard explanation is often that success is random because nobody can predict which manufacturer will create the best product.

His research agrees that the selection of a fashion hit is random. But, he said the unpredictability comes by design.

Dr. Dmitri Kuksov

TITLE: Marketing professor

RESEARCH INTERESTS: Pricing strategies, branding, customer satisfaction

PREVIOUSLY: Associate professor of marketing, Olin School of Business, Washington University in St. Louis

Fashion editors, bloggers and celebrities play a role in determining fashion’s must-have products, the study found. These influential “consumer coordinators,” as the study calls them, make the process unpredictable.

“What we say in contrast is that randomness is due to the explicit strategy by the editors and other consumer coordinators,” Kuksov said. To illustrate his point, his article begins with a quote from William Shakespeare’s Hamlet:“Though this be madness, yet there is method in’t.”

To maximize the probability that a product becomes a fashion hit, the price must be right. Kuksov said high-end consumers prefer prices to be out of reach to lower-end consumers. But he said his research made a surprising finding that pricing lower-end customers out of the market is not optimal for generating maximum profits in a competitive market. Kuksov’s study found that the best price is one that also generates sales among the lower-end consumers.

Dr. Hasan Pirkul, Jindal School dean and Caruth Chair of Management, said that Kuksov brings a strong quantitative marketing research background to UT Dallas.

“Dr. Kuksov brings a unique perspective to his research with his expertise in both marketing and mathematics,” Pirkul said. “His research on fashion’s “it” products is an example of his important contributions to our understanding of the status goods market.”

Kuksov joined UT Dallas after teaching at Washington University in St. Louis. He earned a PhD in marketing from The University of California, Berkeley and a PhD in mathematics from Brigham Young University. Kuksov, who enjoys science fiction and movies, earned his bachelor’s degree in math from Moscow State University.

He said one of the reasons he was drawn to UT Dallas was because of its focus on quantitative research and engineering and its quest to become a Tier One university.

“UT Dallas is fast-growing and improving in all dimensions,” he said.

[Reposted article from utdallas.edu site [here]]