Thursday, October 20, 2011

Pricing and Revenue Management: The Value of Coordination
INSEAD Working Paper 2011/109/DS revised version of 2010/83/DS

The integration of systems for pricing and revenue management must trade off potential revenue gains against significant practical and technical challenges. This dilemma motivates us to investigate the value of coordinating decisions on prices and capacity allocation in a stylized setting. We propose two pairs of sequen- tial processes for making static decisions - on pricing and revenue management - that differ in their degree of integration (hierarchical versus coordinated) and their pricing inputs (deterministic versus stochastic). For a large class of stochastic, price-dependent demand models, these four processes admit tractable solutions satisfying intuitive sensitivity properties. We assess the relative performance of hierarchical and coordinated approaches, revealing the benefits of coordination and the advantages of modeling demand uncertainty in pricing. We use industry data to establish that coordination can yield significantly more revenue than a traditional hierarchical process that first sets prices using a deterministic model and then optimizes booking limit decisions. Yet we also find that most benefits of a fully coordinated process can be obtained using a hierarchical process in which prices are adjusted to reflect demand uncertainty. We conclude that stochastic pricing (i.e., capturing demand risk in pricing decisions) can mitigate the effects of poorly coordinated pricing and revenue management functions.