Multipart tariffs constitute another widely practiced technique of nonlinear pricing, under which the price of each unit may vary with the total number of units purchased. To some degree, multipart tariffs can be viewed as an enhancement of the bundling marketing strategy analyzed earlier in Section 4.1. By an enhancement we mean that instead of limiting the pricing strategy to a fixed price for a certain number of goods bundled together in a single package, multipart tariffs consist of a fixed fee and per-unit prices that may vary with the amount consumed.

Multipart tariffs in general, and two-part tariffs in particular, are widely used. Here is a list of examples with which the reader should be familiar:

• Phone companies generally charge a fixed monthly fee for maintaining a line connection and in addition charge for each minute of each phone call.

• Credit card companies charge merchants and often consumers fixed annual fees in additional to per-transaction fees.

• Membership discount retailers, such as shopping clubs, require paying an annual membership fee before consumers are allowed to enter the store (and then pay separately for each item they actually buy).

• Bars and nightclubs tend to collect a “cover” charge in addition to charging for each drink separately.

• Amusement parks tend to charge an entrance fee in addition to charging for each ride separately.

• […]

What This Book Will NOT Teach You

The key to successful profit-maximizing pricing is knowing your potential customers. If a firm does not manage to learn the characteristics of all its potential customer types, such as consumers' willingness to pay, the firm will not be able to properly price its products and services.

This book will not teach you how to identify the characteristics of your consumers. Although several econometric techniques for identifying these characteristics are described in Chapter 2, a comprehensive analysis of this subject is beyond the scope of this book. The two main reasons for not attempting to include these techniques in this book are (a) consumers' preferences in general, and willingness to pay in particular, vary all the time when new competing products, services, and brands are introduced to the market, which means that (b) the most efficient way of learning about customers is by trial and error, or simply experimenting with different tariffs while recording how consumers respond. That is, as this book shows, successful pricing techniques should not only be profitable, they should also induce consumers to reveal their characteristics.

What This Book Attempts to Teach You

Revenue and profit are affected by a wide variety of observable and unobservable parameters. Therefore, even if various pricing techniques are well chosen and properly used, there is still no guarantee that the firm will be profitable.

Bundling and tying are widely used instruments for implementing price discrimination. Market segmentation is therefore accomplished by offering consumers a variety of packages to choose from. When bundling is used, by choosing different packages, consumers implicity reveal their willingness to pay for different quantity levels of the same good. That is, consumers with a high preference for large quantities will choose large bundles, whereas consumers with a low preference for large quantities will choose small bundles, or simply buy one unit, if available. Similarly, when tying is used, consumers implicitly reveal their preferences for some other types of goods, which are tied to the sale of the original good. Both the bundling and tying pricing techniques constitute special cases of nonlinear pricing under which the price of each unit may vary with the total number of units purchased.

The terms bundling and tying are used interchangeably both in the academic literature and by pricing experts. In this book, however, we draw a sharp distinction between these two marketing instruments. We will be using the following terminology:

DEFINITION 4.1

1. (a) We say that a seller practices bundling if the firm sells packages containing at least two units of the same product or service.

2. (b) We say that a seller practices tying if the firm sells packages containing at least two different products or services.

Service providers, particularly providers of services related to travel, engage in advance booking that use a wide variety of advance reservation systems. From consumers' perspective, this practice seems to be beneficial for the following two reasons:

• Value of time and capacity constraint: Advance reservations save considerable amount of time for consumers as otherwise they would have to travel several times to the theater, airport, train station, or hotel, just to find out that these services may have already been fully booked.

• Purchase of complementary services: Travel arrangements almost always consist of a wide variety of complementary services that must be booked from multiple providers (flights, trains, hotels). In addition, travelers must alter their work schedule, which may include asking for vacation time or a leave of absence. Advance reservations ensure the fulfilment of these multiple obligations at the same time.

Whereas both of the above examples demonstrate why advance booking is beneficial to consumers, the purpose of this chapter is to show that advance booking also enhances the profit of service providers. Moreover, this chapter suggests several algorithms under which advance booking becomes the major strategic tool for making YM most profitable. Perhaps the most interesting feature of advance reservation systems is that they can be used to identify and sort consumers according to their willingness to pay without having to formally ask them to reveal their preferences.

The pricing techniques described throughout this book are based on the presumption that buyers always optimize their selections among the different payment plans and quality classes that are offered by one or more sellers. By optimizing, we mean that buyers operate according to well-defined objectives, such as expenditure minimization, maximization of value versus price, and minimization of expected price in case of uncertainty. Sadly enough for academic economists, consumers do not always behave this way. More precisely, consumers often end up selecting a payment plan, a brand, or a quality level that seems to violate consumers' objective functions as commonly assumed by economists.

The development of profitable marketing and pricing strategies requires an understanding of the manner in which consumers choose among alternatives. This chapter is devoted almost entirely to consumers who seem to be optimizing in ways different from those we have assumed so far in this book. The basic idea is that firms should often take into account what sometimes looks like an irrational behavior on the part of consumers and set their price menus accordingly. In fact, in many instances firms can actually take advantage of certain “odd” consumer behaviors and extract an even higher surplus from these consumers compared with the surplus that can be extracted from consumers who behave according to the way economists want them to behave.

This chapter introduces basic pricing techniques. By basic we refer to techniques that are limited to simple one-time purchases of a single good only. That is, the simple techniques studied in this chapter do not address more sophisticated markets in which products and services are differentiated by the time of delivery, the length of the booking period, quantity discounts (bundling), and services that are tied with other products and services. In fact, some of basic pricing techniques described in this chapter can also be found in most intermediate college microeconomics textbooks. Clearly, readers must first understand these basic techniques before proceeding to more sophisticated ones analyzed in later chapters.

The basic question that must be addressed before managers select a price is whether competition with other firms prevails, or whether the firm can disregard any potential and existing competition and act as a single-seller monopoly. Most of the algorithms in this book are designed for a single seller simply because the introduction of competition diverts attention from learning the logic behind proper yield management. Clearly, prices should be lowered when a firm observes competition from rival firms. In view of this discussion, we divide this chapter into the analysis of basic monopoly pricing and only then proceed to analyze pricing under competition. The analysis of competition will be brief because there is a large number of market structures that must be considered.

Refunds are widely observed in almost all privately provided services and also to some degree in retail industries. Refunds are heavily used by travel-related service providers. Most noticeably, refunds are heavily used by airlines where cheaper tickets allow for a very small refund (if any) on cancellations and no-shows, whereas full-fare tickets are either fully refundable or are subject to low cancellation penalty rates.

In Chapter 7, we analyze service providers who face consumers who value advance reservation systems because they enable them to guarantee that the service will be available at the contracted delivery time. However, the drawback of the advance reservation system, to both consumers and service providers, is that consumers may either cancel their reservations or simply may not show up at the time when the contracted service is scheduled to be delivered. This will leave some capacity unused, thereby resulting in a loss to service providers. Clearly, this loss can be minimized if service providers do not provide any refund to consumers who either cancel or do not show up.

In this chapter, we show how service providers can enhance their profit and extract higher surplus from consumers by offering refunds to consumers who either cancel their reservations or simply do not show up. For most parts of this chapter, we will not distinguish between a cancellation and a no-show. However, for the sake of completeness, the following definition clarifies the difference between these two terms.

This book focuses on pricing techniques that enable firms to enhance their profits. This book, however, cannot provide a complete recipe for success in marketing a certain product as this type of recipe, if it existed, would depend on a very large number of factors that cannot be analyzed in a single book. However, what this book does offer is a wide variety of pricing methods by which firms can enhance their revenue and profit. Such pricing strategies constitute part of the field called yield management. As explained and discussed in Section 1.3, throughout this book we will be using the term yield management (YM) to mean profit management and profit maximization, as opposed to the more commonly used term revenue management (RM).

Services, Booking Systems, and Consumer Value

Before we discuss pricing techniques, we wish to characterize the “output” that firms would like to sell. Therefore, Subsection 1.1.1 defines and characterizes the type of services and goods for which YM turns out to be most useful as a profit-enhancing set of tools. Clearly, this book emphasizes services that constitute around 70% of the gross domestic product of a modern economy. Subsection 1.1.2 identifies dynamic industry characteristics that make YM pricing techniques highly profitable. These characteristics highlight the role of the timing under which the potential consumers approach the sellers for the purpose of booking and purchasing the services sellers provide. Subsection 1.1.3 discusses the difficulty in determining consumer value and willingness to pay for services and products.

To the Reader

There are two main purposes for adding this extra chapter.

1. (a) To provide abbreviated solutions for all exercises appearing at the end of each chapter.

2. (b) To provide some suggestions to instructors and to the general reader regarding which topics to emphasize, and to comment on the general logic behind the specific ordering of the topics covered in each chapter.

I emphasize abbreviated solutions because I see no need to repeat all the steps developed in the body of each chapter. All I want is to provide the reader with some feedback on whether they can independently solve the kind of problems analyzed in this book. However, students should be required to submit their homework in greater detail than that given in this manual, using all the steps developed in the body of each chapter.

Some instructors may not like the fact that the solutions for all exercises are provided as this will require them to write more exercises for homework and exam purposes. However, I can assure the instructors that even if they do not assign any formal homework, students will learn much better if they can train themselves by looking at the solutions to the problems they are supposed to know how to solve.

We define overbooking as a strategy whereby service providers accept and confirm more reservations than the capacity they allocate for providing the service. Thus, the overbooking strategy may result in service denial to some consumers if the number of actual show-ups at the time of service exceeds the allocated capacity. Overbooking should be considered an integral part of the advance booking strategy of service providers. In this chapter, we demonstrate how service providers can increase their profits by using overbooking. Thus, in this chapter, we relax Assumption 7.3, which so far has ruled out the use of the overbooking strategy.

From a practical point of view, the dynamic booking models analyzed in Chapter 7 can be modified to accommodate overbooking by letting the booking capacity K exceed the available capacity level during all booking periods. However, maintaining the same “artificially high” capacity level throughout the entire booking process need not be optimal because it may be more profitable to reduce the amount of overbooking as the reservation period gets closer to the service delivery time. In other words, it may be profitable to allow for a large overbooking level at the beginning of the booking process, but lower levels toward the end, when the service provider can more accurately estimate the final number of reservations made and the expected number of show-ups. Despite this discussion, in this chapter, we do not attempt to integrate overbooking with the dynamic booking models of Chapter 7. Instead, we develop an independent model for computing the profit-maximizing booking levels.

Services constitute what economists call nonstorable goods. Electricity, telephone, transportation, banking, and most other services are consumed at the time of purchase. This nonstorability characteristic of services may lead to congestion of service systems when the demand for the service is unevenly distributed among different periods or seasons. The demand for telephone services is at the highest level during daytime, during weekdays, and tends to be lower during nights, weekends, and some holidays. The demand for air travel for most places tends to be relatively high during the summer, whereas the demand for transportation to ski resorts is greatly enhanced during the winter. Electricity use follows a daily cycle related partly to the use of appliances and lighting devices. In addition, it also follows a yearly cycle because of climatic changes. Thus, the demand follows several, sometimes overlapping, periodic cycles.

Peak-load pricing techniques are commonly observed in vacation-related services (airline, restaurant, and hotel industries) as well as in utility services (phone and electricity). The utilization of peak-load pricing techniques is profitable in industries with the following main characteristics:

1. (a) Demand varies significantly among the different seasons.

2. (b) Services are time-related and perishable in the sense that they cannot be postponed or delivered earlier than the scheduled time of delivery.

3. (c) Service providers must acquire a significant amount of costly capital.

4. (d) The acquired capital cannot be easily liquidated and cannot be easily rented out or sold to other firms.