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Article history: We jointly determine the price and the inventory allocation for a perishable product
Received 1 September 2007 with a predetermined lifetime. We assume that the price of the product increases as the
Accepted 1 July 2008 time when it perishes approaches as in the airline industry. Demand for the product is
Available online 17 October 2008
price sensitive. To maximize the expected revenue, we developed a discrete time
Keywords: dynamic programming model to obtain the optimal prices and the optimal inventory
Pricing allocations for the product with a two period lifetime. We, then, proposed three
Inventory allocation heuristics when the lifetime is longer than two periods. The computational results
Revenue management showed that the expected revenues from the proposed heuristics were very close to that
Perishable products
of the optimal solution. We extended these results to (i) the case where the price for the
Periodic review
product consistently decreases; and (ii) the case where the price for the product first
increases and later decreases.
& 2008 Elsevier B.V. All rights reserved.
0925-5273/$ - see front matter & 2008 Elsevier B.V. All rights reserved.
doi:10.1016/j.ijpe.2008.07.018
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140 E.P. Chew et al. / Int. J. Production Economics 120 (2009) 139–150
dynamic pricing problem where prices have to be and full-price reservations, lost or turned-down
selected from a finite set of prices and provided reservations, no group reservations, no diversion or
a systematic analysis of the pricing policy and the displacement, no bumping procedure (there is no over-
expected revenue. booking), effectively nested asset control, and a dynamic
The literature on capacity allocation decisions assumes decision rule.
that prices are exogenously determined and consider The remainder of this paper is organized as follows: In
a pure inventory problem. A two class, single leg Section 2, we present the assumptions and notation.
seat inventory control problem was considered by Little- A discrete time dynamic programming model is then
wood, 1972. He proposed a marginal seat revenue developed. In Section 3, we first consider the product with
principle where booking requests from a lower fare class a two period lifetime. The optimal price and the optimal
can be rejected if the seat can be sold later in a higher inventory allocation are obtained. For the product with a
fare class. Bhatia and Parekh (1973) and Richter (1982) lifetime of longer than two periods, three heuristics are
employed the marginal seat revenue principle to proposed to determine the prices and the inventory
determine the optimal booking limits in a nested fare allocations. Computational results are provided in
inventory system. Belobaba (1987, 1989) extended Little- Section 4. Two different extensions for the model are
wood’s principle to multiple-fare classes and proposed discussed in Section 5.
an expected marginal seat revenue (EMSR) method.
The EMSR method did not produce the optimal booking
limits except for two fare classes; however, more 2. A discounted stochastic dynamic programming model
classes are easy to implement. The methods for obtain-
ing the optimal booking limits for a single flight leg
We consider a perishable product with an M period
were developed by Curry (1990), Wollmer (1992) and
lifetime where MX2. Index k ¼ 1,y,M denotes the ages of
Brumelle and McGill (1993). These studies also showed
the products. A periodic review policy is assumed. The
that Belobaba’s heuristics is sub-optimal. A through
initial inventory level Q (e.g. the seat capacity in an
review for perishable assets revenue management
airplane) is given at the beginning of Period 1. No
can be founded in Weatherford and Bodily (1992).
replenishment is allowed throughout the lifetime. At
Independently, Liang (1999) and Feng and Xiao
Period k, only the product of age k is sold. The price for
(2001) studied a continuous-time, dynamic seat inven-
the product at Period k is represented by pk. Demand for
tory control problem. They proved that a threshold
the product in Period k is denoted by tk following a
control policy is optimal. Zhao and Zheng (2000)
stochastic additive demand function t k ¼ mðpk Þ þ k for
considered a more general airline seat allocation
k ¼ 1,y,M.
model that allows diversion upgrade and no-shows.
m(pk) is the mean demand at Period k and
They showed that a similar threshold control policy
mðpk Þ ¼ bk ak pk , where ak ; bk X0. ek is an i.i.d. random
is optimal.
variable with a known probability density function f k ðk Þ
In this paper, we describe the development of a
and is bounded in ½min max
k ; k . In addition Eðk Þ ¼ 0.
discrete time dynamic programming model to deter-
The linear demand function has its limitations because
mine the price and the capacity allocation for a perishable
it assumes that the expected demand is a strictly linear
product without replenishment. A periodic review
function of the price. However, this demand function has
policy is employed. The price for the product is assumed
been employed extensively in literature relating to pricing
to increase as the time when the product perishes
and inventory problems (Abad, 1996; Birge et al., 1998;
approaches, as in the airline industry. Similar assum-
Lau and Lau, 1988; Polatoglu, 1991; Thowsen, 1975).
ptions apply to rooms at hotels, cabins on cruise
The additional notation employed in this paper is:
liners, and cars at rental agencies (McGill and van
Ryzin, 1999; Weatherford and Bodily, 1992). In order
Sk inventory assigned to satisfy demand in Period k
to consider more general cases, this assumption is
xk inventory level at the beginning of Period k,
relaxed in Section 5. The expected demand for the product
x1 ¼ Q
is a linear function of the price. At the beginning of
a one period discounted factor
each period, given the inventory level of the product,
the optimal price and the optimal capacity allocation
pk is confined to the finite interval ½pmin max
k ; pk where
are determined for the objective of maximizing the
pk obk þ k =ak . The upper bound pk prevents nega-
max min
max
expected revenue.
tive demands. Moreover, price intervals at different
In the context of the taxonomy of revenue manage-
periods are non-overlapping with p1 o opM .
ment problems, proposed by Weatherford and Bodily
If tk 4Sk , the excessive demand is lost.
(1992), the problem, we studied and described in this
We developed a dynamic programming model that
paper, is considered an A1-B1-C3-D1-En-F3-G1-H1-I1-
computes the expected revenue over M periods.
J1-K1-L1-M2-N3 PRAM problem, i.e., discrete resource,
Vk(xk) the maximum expected revenue for the remain-
fixed capacity, prices that are set jointly with the
ing periods when starting at Period k and with the
allocation decision, buildup willingness to pay (relaxed
inventory xk, is computed:
in the extension), as many discount price classes as
there are prices, random and independent reservation V k ðxk Þ ¼ Max½jk ðxk ; pk ; Sk Þ þ aEðV kþ1 ðxkþ1 ÞÞ
demand, a certain show-up of people with discount pk ;Sk
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3.1. When the lifetime of the product is two periods From Lemma 1, V 2 ðx2 Þ is monotonically increasing with
respect to x2. In addition, V 2 ð0Þ ¼ 0 can be obtained from
The optimal prices and the optimal inventory alloca- (A.12) (see Appendix A). Hence, there exists a unique S1*
tions are obtained by solving the dynamic programming that satisfies p1 V 02 ðQ S1 Þ ¼ 0, given a particular
model developed in Section 2. We start from the last p1. &
period and employ backward recursive induction.
From Theorem 1, the optimal allocation S1* is unique for
For Period 2, the noise variable e2 is assumed to follow
a given p1. We assume that only a finite set of prices is
an IFR distribution (has an increasing hazard rate), where
applicable (in practice, prices usually take discrete values
the hazard rate l(e2) is defined by f 2 ð2 Þ=ð1 F 2 ð2 ÞÞ. The
in a bounded interval). A procedure to compute the
unsold products at the end of the last period are of no
optimal p1* and S1* is provided:
salvage value. The optimal price p2* satisfies the following
optimality properties:
(1) Compute the S1* that maximizes J 1 ðx1 ; p1 ; S1 Þ for every
Lemma 1. At Period 2, p1 in ½pmin max
1 ; p1 .
(i) The expected revenue J2 ðx2 ; p2 Þ is concave with respect Select p1* and S1* with the maximum J 1 ðx1 ; p1 ; S1 Þ.
to p2 for a given x2.
(ii) The optimal price p2* is a non-increasing function of x2 3.2. Proposed heuristics for MX3
under the condition that lð2 ÞX1=a2 pmin2 .
(iii) The maximum expected revenue V2(x2) is concave with When the lifetime of the product is longer than two
respect to x2. periods, it is hard to efficiently obtain optimal prices and
(iv) The maximum expected revenue V2(x2) monotonically the optimal inventory allocation from the dynamic
increasing with respect to x2. programming model. As the concavity of J 1 ðx1 ; p1 ; S1 Þ with
respect to S1 does not always hold, the optimal solutions
have to be computed by enumeration. Thus, the solution
Proof. See Appendix A.
time may be too long to be of practical interest. To
The concavity of J2 ðx2 ; p2 Þ with respect to p2 for a given overcome this problem, we propose three heuristics to
x2 enables efficient algorithms such as a gradient search to compute the prices and the inventory allocations.
be employed to obtain p2*.
Let V 02 ðx2 Þ denote the first order derivative of V2(x2) 3.2.1. Heuristic 1 (H1)
with respect to x2; J 1 ðx1 ; p1 ; S1 Þ stands for the total In order to develop simple heuristics, we first assume
expected revenue for the two periods. Once p2* that the inventory allocated to a period is not carried
and V2(x2) are obtained, the following theorem computes forward to the next period even if there is an excess of
the optimal inventory allocation S1* to maximize inventory. Under this assumption, the revenue at each
J 1 ðx1 ; p1 ; S1 Þ. period is independent and determined by the amount of
the inventory allocation for the period and its prices. Thus,
Theorem 1. Given p1, there exists a unique S1* that the problem is to determine how much inventory to be
maximizes the expected revenue J 1 ðx1 ; p1 ; S1 Þ. allocated for each period and how to price it. The optimal
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142 E.P. Chew et al. / Int. J. Production Economics 120 (2009) 139–150
inventory allocation and the optimal price at each period to determine the price and the inventory allocation for the
can be obtained from Lemma 1. Denote Rk ðxk Þ as the next period.
optimal revenue for a given inventory level xk at Period k. The proposed methodology is motivated by the EMSR
The solution approach is: method (Belobaba, 1989). However, in the EMSR method,
the price at each period is predetermined and given, while
(1) Compute Rk ðxk Þ for each xk ¼ 1,y,Q and k ¼ 1,y,M. in our heuristics, the price is dynamically obtained from
P PM
(2) Solve Maxx1 ;...;xM M
k¼1 Rk ðxk Þ subject to k¼1 xk ¼ Q and
H2 at the beginning of each period.
the solution xk* (k ¼ 1,y,M) is the optimal inventory
allocation Sk for the corresponding period. 3.2.4. Computational complexity of the proposed algorithm
(3) Compute the optimal price pk* (k ¼ 1,y,M) that The computational complexity of the exact algorithm
maximizes the expected revenue at each period from (the dynamic programming model) is determined by
Lemma 1. the number of stages and the number of states to be
considered in each stage. In each stage, all the possible
Note that the above mathematical programming pro- inventory allocations must be considered to compute
blem can be solved efficiently by dynamic programming. the corresponding revenue. Thus, the number of states in
To obtain a better solution, we can implement these each stage is O(Q). We repeat this for every stage where
heuristics on a rolling time horizon basis; after the end of the number of stages is M (product’s lifetime). Thus, the
each period when demand has been realized, given the computational complexity of the exact algorithm is O(QM).
known remaining inventory level, the mathematical The computational complexity of H1 (the first heuristic
programming problem is solved again to obtain the new algorithm) is O(MQ). The computational complexity of H2
prices and inventory allocations for the remaining periods. is O(MQ2), since the algorithm requires O(Q2) computa-
tions for each of the neighboring lifetime pairs (M1).
Lastly, the computational complexity of H3 is O(MQ2)
3.2.2. Heuristic 2 (H2) since H3 requires an execution of H2 for pre-processing.
Drawing on insights from the two period problem
analyzed in Section 3.1, simple heuristics are provided to
4. Performance analysis of the proposed heuristics
determine the allocation and the price at each period. The
algorithm starts from the last period. This is because the
customers at the last period will pay a higher price and In this section, we compute the expected revenue from
this demand should be satisfied with a higher priority. The the proposed heuristics and the optimal revenue from the
inventory allocation and the price for Period M, pM, and SM dynamic programming model. A comparison of both ways
are first computed by solving a two period problem for for the expected revenue is provided to study the
Periods M1 and M. With the remaining capacity QSM, performance of the proposed heuristics. However, the
the inventory allocation and the price for Period M1 are computation time of the dynamic programming model
determined then again by solving a two period problem increases exponentially with an increase of the product’s
for Periods M2 and M1. Similarly, Sk and pk for Period k, lifetime M (in fact, for a single parameter combination
where k ¼ M2,y,3 are computed by solving a two when M ¼ 3, it took more than 8 hours to run the
period problem for Periods k1 and k. Finally, S1, S2, p1, numerical experiment using a AMD Dual Core 2.5 GHz
and p2 are simultaneously determined. computer with 2 GB RAM). In order to examine (measure)
the performance of the proposed heuristics for a large M,
an upper bound for V1(Q) is also computed in Section 4.3
3.2.3. Heuristic 3 (H3) and compared with the maximum expected revenue.
Denote Bjk as the optimal protection level for Period j
from Period k and Gk( ) as the cumulative density
4.1. The experimental design
function for tk, where t k ¼ mk ðpk Þ þ k and ek has a known
probability density function f k ðk Þ.
In this numerical study, demand at Period k is price-
At the beginning of Period k (k ¼ 1,y,M), we first
sensitive and follows an additive stochastic demand
obtain the prices for the remaining Mk+1 periods
function, i.e., t k ¼ mðpk Þ þ k , where mðpk Þ ¼ bk ak pk . The
(pk,y,pM) from H2 where pko?opM. Given the prices,
noise variable ek follows a truncated normal distribution
the inventory allocation at Period k is then computed:
and is bounded by ½3sk ; 3sk where sk is the standard
deviation of the normal distribution.
(1) Start from j ¼ M. We are particularly interested in the effects of demand
Compute Bjk that satisfies Bjk ¼ G1 j ½1 pk =pj for all variability on the revenue increase. Thus, sk is set to
koj. different levels referring to different levels of demand
Similarly, for j ¼ M 1; :::; k þ 1, compute Bjk for all variability.
koj. Table 1 summarizes the experimental variables and
(2) From Bjk obtained in (1), the inventory allocation for their respective values employed in this study. Seven
P j
Period k is obtained from Sk ¼ Maxð0; Q M j¼kþ1 Bk Þ. constants and their respective values are also provided in
Table 2.
At the end of Period k (after tk has been realized), with For each scenario, we replicated the numerical ex-
the remaining inventory, the above procedure is repeated periments 100 times. We computed the maximum
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E.P. Chew et al. / Int. J. Production Economics 120 (2009) 139–150 143
Table 1 Table 4
Variables used in the numerical studya The total demand during the product’s lifetime
Parameters Low level () High Level (+) (s1, s2, s3) Total demand during the product’s lifetime
Table 2
Constants used in the numerical study Table 5
The average demand when n-N
Parameters Values
(s1, s2, s3) Average demand
b1 20
b2 20 (,,) ½18; 30
b3 20 (,,+) ½22; 30
M 3 (,+,) ½22; 30
a1 4 (+,,) ½22; 30
a2 2 (,+,+) ½26; 30
a3 1 (+,,+) ½26; 30
(+,+,) ½26; 30
(+,+,+) 30
Table 3
½pmin max
k ; pk in each period shown in Table 5. The order quantity Q must be within the
interval of the average demand to avoid excessive
Low level () High Level (+)
inventories and stockouts. The numerical results for such
Period 1 ½2:5; 3:5 ½2:5; 2:5 order quantities are obtained, and they are summarized in
Period 2 ½5; 7 ½5; 5 Tables 6, 7 and 8.
Period 3 ½10; 14 ½10; 10 The expected revenues from the proposed heuristics
are close to that from the dynamic programming model.
H2 provides near-optimal solutions (in the practical point
revenues under the three proposed heuristics. The
of view: the difference in the expected revenue is less than
Common Random Number technique was employed for
1%, except for few cases). H1 also provides good solutions,
synchronization.
and H3 provides similar results except for low sk levels.
Table 6
Revenue comparison between Heuristic 1 and dynamic programming
Q ¼ 18 3.9
Q ¼ 19 1.6
Q ¼ 20 1.8
Q ¼ 21 1.4
Q ¼ 22 1.3 0.4 3.1 0.5
Q ¼ 23 1.5 0.5 2 0.3
Q ¼ 24 1.4 1.2 1.6 0.2
Q ¼ 25 1.3 1.1 1.4 0.1
Q ¼ 26 1.3 1.3 1.5 0.3 2.6 0.8 0.9
Q ¼ 27 1.1 0.8 1.1 0.4 2.8 0.6 0.8
Q ¼ 28 1.3 0.9 1 0.2 2.3 2 1.6
Q ¼ 29 1.5 0.4 0.8 0.3 2.2 0.9 0.5
Q ¼ 30 1.3 0.7 0.8 0.4 2.5 1.1 0.5 1.5
a
Difference in revenue ¼ jrevenue from H1revenue from dynamic programmingj
revenue from H1
100%.
Table 7
Revenue comparison between Heuristic 2 and dynamic programming
Q ¼ 18 3.4
Q ¼ 19 1.4
Q ¼ 20 1.5
Q ¼ 21 1
Q ¼ 22 0.7 0.2 2.7 0.3
Q ¼ 23 0.8 0.3 1.3 0.5
Q ¼ 24 0.8 0.5 0.7 1
Q ¼ 25 1.1 0.3 0.7 0.9
Q ¼ 26 1.1 0.5 0.6 0.8 1 1.9 0.1
Q ¼ 27 0.8 0.6 0.8 0.9 1.4 1.5 0.1
Q ¼ 28 0.9 0.8 0.6 0.8 1 1.5 1.1
Q ¼ 29 1.1 0.3 0.2 1.1 1.1 1.6 0.4
Q ¼ 30 0.9 0.5 0.4 1.1 0.9 1.7 0.4 0.5
a
Difference in revenue ¼ jrevenue from H2revenue from dynamic programmingj
revenue from H2
100%.
Table 8
Revenue comparison between Heuristic 3 and dynamic programming
Q ¼ 18 10.9
Q ¼ 19 7.9
Q ¼ 20 8.3
Q ¼ 21 6.7
Q ¼ 22 5.3 4.9 2.3 5.1
Q ¼ 23 3.8 3.4 1.1 3.8
Q ¼ 24 2.9 2.4 0.7 2.3
Q ¼ 25 4.1 3.7 2 3.5
Q ¼ 26 2.1 2.1 0.4 0.6 0.8 0.5 0.1
Q ¼ 27 2.3 1.6 0.5 0.5 1.1 0.7 0.5
Q ¼ 28 2.8 1.7 0.8 1.1 1 3.2 1.4
Q ¼ 29 3.2 2.1 0.9 1.4 1.2 0 0
Q ¼ 30 3.7 2.4 1.2 1.9 1.7 0.3 0.3 1.1
a
Difference in revenue ¼ jrevenue from H3revenue from dynamic programmingj
revenue from H3
100%.
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Table 9
Revenue comparison between V1(Q) and VUP
Q ¼ 18 13.2
Q ¼ 19 12.6
Q ¼ 20 10.8
Q ¼ 21 9.2
Q ¼ 22 7.6 9.6 6.8 8.8
Q ¼ 23 6.3 8 6.6 8.6
Q ¼ 24 5.1 6.7 5.9 7.4
Q ¼ 25 3.9 5.5 4.7 6.2
Q ¼ 26 3.1 4.3 3.7 5 3.5 4.7 4.1
Q ¼ 27 2.2 3.5 2.9 4 2.6 3.8 3.2
Q ¼ 28 1.6 2.6 2.1 3.2 1.9 2.9 2.4
Q ¼ 29 1.1 1.9 1.6 2.4 1.4 2.2 1.9
Q ¼ 30 0.6 1.4 1.1 1.8 0.9 1.7 1.3 2.1
a
Difference in revenue ¼ ðthe upper boundthe maximum revenueÞ
the upper bound
100%.
problem) to be significantly higher than the average the structure of an optimal policy and the optimal
demand. For such large values of Q, the upper bound revenue. However, no theoretical result was presented.
obtained in this study is reasonably close to the optimal Recently, Chew et al. (2005) developed a discrete time
revenue from the dynamic programming model. Hence, dynamic programming model for perishable products
this upper bound can effectively be applied to analyze the with a lifetime of multiple periods. Under the assumption
performance of heuristics solutions. of ‘‘alternative’’ source, the optimal expected profit is
concave with respect to the inventory level. From this
property, they computed the optimal expected profit
5. Extensions
efficiently and employed this value as an upper bound
for the optimal expected profit under the assumption of
The model we developed in Section 3 can be applied to
lost sales. The computational results showed that the ratio
the airline industry where prices for tickets typically rise
of the optimal profit, under the lost sales assumption, to
as the flight time approaches. However, this clearly does
the optimal profit under the ‘‘alternative’’ source assump-
not apply to all circumstances of perishable product
tion, was between 91% and 97% under different levels of
pricing, e.g., (i) monotonically marked down prices for
demand variability.
fashion apparel which perish when the appropriate
season passes by; and (ii) the price for a product first
increases and later decreases following an increase–
5.2. When the product price follows an
decrease pattern. For example, consider a food product
increase–decrease pattern
for a special holiday; some of the customers are willing to
pay a higher price closer to the holiday. This behavior
In this section, the price for a product is assumed to
disappears immediately after the target day.
first increase and later decrease following an increase–
decrease pattern. Demand for the product is price
5.1. Markdown pricing sensitive. At the beginning of each period, given the
inventory of the product, the optimal price and the
In the fashion industry, consumers are unwilling to pay optimal allocation are determined for the objective of
higher prices toward the end of a season because they will maximizing the total revenue. Again, we employed a
enjoy the product for a shorter period of time. Hence, the periodic review policy.
companies often employ successive markdowns to sell The proposed model stems from many real problems in
season appropriate fashion apparel as the appropriate industries. For example, the prices of a product for a
season passes. Similar examples can also be found in the specified holiday will follow an increase–decrease pattern.
consumer electronics industry. Because customers are willing to pay a higher price closer
Bitran and Mondschein (1997) considered a periodic to the holiday, continuing lower prices may hurt potential
pricing review policy where the revisions of prices are revenues. Thus, retailers will employ higher prices. After
allowed only at a given finite set of opportunities (times) the holiday, retailers employ discounted prices to attract
and the prices do not increase. This policy can be applied customers and to reduce the inventory. Consequently,
for seasonal products in the retail industry where prices markup and markdown prices are mixed in the selling
are successively discounted as the season progresses. The periods. This price pattern can also be seen in the airline
authors considered a Poisson demand process and industry which often introduces a cheaper ‘‘last minute
provided empirical results to develop conjectures as to discount’’ airfare.
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146 E.P. Chew et al. / Int. J. Production Economics 120 (2009) 139–150
Customers will hardly be willing to buy a product where jk ðxk ; pk ; Sk Þ represents the expected revenue at
whose price oscillates, from their point of view, randomly Period k.
over the season (Bitran and Mondschein, 1997). Thus, we (
pk E½minðt k ; Sk Þ koR
assume that only one switch is allowed during the selling jk ðxk ; pk ; Sk Þ ¼
periods. pk E½minðt k ; xk Þ RpkpM
Compared with previous models which allow the The recursive function for the inventory level is shown:
movement of price in one direction only (either markup (
or markdown), the proposed model permits price to move ½xk Sk þ ðSk t k Þþ koR
xkþ1 ¼
in both directions. This gives management flexibility in ½xk t k þ RpkpM
obtaining the higher revenues. If only the markdown
policy is allowed, once a higher price is forfeited, it will no We denote J k ðxk ; pk ; Sk Þ as the total expected revenue for
longer be offered even if the product is being sold the last k periods.
successfully. J k ðxk ; pk ; Sk Þ ¼ jk ðxk ; pk ; Sk Þ þ aEV kþ1 ½ðxkþ1 Þ
This pricing pattern has also been considered for new
Note that Sk ¼ xk when k ¼ R,y,M. Hence, jk ðxk ; pk ; Sk Þ
products’ introductions (Dolan and Jeuland, 1981; Jeuland
and Jk ðxk ; pk ; Sk Þ can be simplified and written as jk ðxk ; pk Þ
and Dolan, 1982; Kalish, 1983). Kalish and Sen’s (1986)
and J k ðxk ; pk Þ, respectively, for k ¼ R,y,M.
intuitive explanation for such a pricing pattern is that if
The values xk and Vk(xk) are computed recursively
early adopters have a strong positive effect on late
backward in time starting from Period M to Period 1.
adopters, a low introductory price should encourage them
The boundary condition V M ðxM Þ ¼ MaxpM ½jM ðxM ; pM Þ
to adopt this product. Once a product is established, the
is the maximum expected revenue at Period M for a
rises in price are attributed to strong demand. Subse-
given xM where SM ¼ xM. Conversely, V 1 ðx1 Þ ¼ Maxp1 ;S1 ½j1
quently, when demand saturates and begins to decrease,
ðx1 ; p1 ; S1 Þ þ aEðV 2 ðx2 ÞÞ is the maximum expected revenue
the price is also decreased in order to increase the sales
over M periods when the initial inventory at Period 1 is Q,
and reduce the remaining inventories.
i.e., x1 ¼ Q.
Under the above mentioned pattern, the prices for
the new products during their life times must be
5.2.2. Joint allocation and pricing decisions
determined carefully. It is profitable to reserve enough
In this section, we determine the inventory allocation
inventories of a new product for future customers (late
and the price for a perishable product with an M period
adopters) who will pay a higher price; however, when the
lifetime where the price for the product increases during
price begins to fall, the remaining inventory accelerates
the first R periods and decreases during the remaining
the reduction of price (and the expected revenue).
MR periods. First, we consider a special case of R ¼ 2 and
Thus, the price and the inventory allocation for the
then we discuss more general cases for RX3.
products at each period must simultaneously be deter-
(i) When R ¼ 2: In order to solve the dynamic
mined in order to maximize the total revenue over the
programming model developed in Section 5.2.1,
selling periods.
J k ðxk ; pk ; Sk Þ must be shown to be concave with respect to
pk for a given xk. In addition, Vk(xk) must be concave with
5.2.1. A dynamic programming model respect to xk and monotonically increasing with respect to
We consider a perishable product with an M period xk for k ¼ 2,y,M. We start from the last period and
lifetime. Let k ¼ 1,y,M denote the ages of the product. At employ the backward recursive function to show that
Period k (k ¼ 1,y,M), only products of age k are sold. The these properties hold. At the last period, J M ðxM ; pM Þ is
price for such a product increases during the first R concave with respect to pM for a given xM and VM(xM) is
periods and then decreases in the remaining MR periods. concave with respect to xM as shown in Lemma 1. For
Hence, for the first R1 periods, some capacities have to Period k ¼ M1,y,2, the optimality properties are proven
be reserved for future customers who will pay a higher by Lemma 2.
price. During the remaining MR+1 periods, older pro-
Lemma 2. When k ¼ M1,y,2 we have the following:
ducts will be offered at discounted prices and the
capacities will not be reserved. This implies that Sk ¼ xk
(i) The expected revenue J k ðxk ; pk Þ is concave with respect
when k ¼ R,y,M.
to pk for a given xk.
pk is confined to the finite interval ½pmin k ; pk
max
where
(ii) The optimal price pk is a non-increasing function of xk
pmax
k oðb k þ min
k Þ=a k . The upper bound p max
k prevents
under the condition that lðtÞX1=ak ðpmin apmax
kþ1 Þ.
negative demands. We also assume that pmax i opmin
iþ1 for
k
(iii) The maximum expected revenue Vk(xk) is concave with
i ¼ 1; :::; R 1 and pmax j op min
jþ1 for j ¼ R; :::; M 1.
respect to xk.
If tk4Sk, the excessive demand is lost.
(iv) The maximum expected revenue Vk(xk) monotonically
We developed a dynamic programming model to
increasing with respect to xk.
compute the expected revenue over M periods.
The Vk(xk), the maximum expected revenues for the
remaining periods, starting from Period k and with the Proof. See Appendix A.
inventory xk, are computed: The concavity of Jk ðxk ; pk Þ with respect to pk for a given
xk enables efficient algorithms such as the gradient
V k ðxk Þ ¼ Max½jk ðxk ; pk ; Sk Þ þ aEðV kþ1 ðxkþ1 ÞÞ
pk ;Sk search method to be employed to obtain pk at Period k
ARTICLE IN PRESS
E.P. Chew et al. / Int. J. Production Economics 120 (2009) 139–150 147
(k ¼ M,y,2). Furthermore, the optimal price p1 and the The first and second partial derivatives of J 2 ðx2 ; p2 Þ with
optimal inventory allocation S1 at Period 1 are obtained respect to p2 are shown:
from Theorem 1. Z x2 b2 þa2 p2
(ii) When RX3: The computation time for dynamic qJ 2
¼ ðb2 2a2 p2 þ 2 Þf 2 ðx2 b2 þ a2 p2 Þ
programming increases significantly with the increase of qp2 min
2
2 op2 op2
pmin
max
properties were obtained. Since such properties did not p2 ¼ p^ 2 ^ (A.5)
>
>
hold when the lifetime of the product was longer than two : pmax p^ 2 Xpmax
2 2
periods, we proposed three heuristics to obtain the
inventory allocations and the prices. The computational Taking the first order derivative of p^ 2 ðx2 Þ with respect to x2
results showed that the expected revenues from the based on (A.4) and rearranging the terms, we obtain
proposed heuristics were very close to the maximum
dp^ 2 ðx2 Þ
total revenue from the dynamic programming model. For a2
the numerical study, an upper bound for the maximum dx2
total revenue was also provided. The difference between 1 F 2 ½x2 b2 þ a2 p^ 2 ðx2 Þ a2 p^ 2 ðx2 Þf 2 ½x2 b2 þ a2 p^ 2 ðx2 Þ
¼
the upper bound and the maximum total revenue 2F 2 ½x2 b2 þ a2 p^ 2 ðx2 Þ þ a2 p^ 2 ðx2 Þf 2 ½x2 b2 þ a2 p^ 2 ðx2 Þ
decreased when the initial inventory level increased. (A.6)
Finally, we considered two different extensions of the
Given that
model. In the first extension, the price for the product was
assumed to decrease during the product’s lifetime. The f 2 ðx2 b2 þ a2 p^ 2 ðx2 ÞÞ
lðx2 b2 þ a2 p^ 2 ðx2 Þ ¼
optimal markdown prices can be obtained from Chew et 1 F 2 ðx2 b2 þ a2 p^ 2 ðx2 ÞÞ
al. (2005). In the second extension, we assumed that the 1
X
price for the product first increased and later decreased. a2 pmin
2
The optimal inventory allocation and the optimal price at
each period were obtained when the price increased p^ 2 Xpmin
2 and the denominator of (A.6) is non-positive,
during the first two periods and then decreased. hence 1pa2 ðdp^ 2 ðx2 Þ=dx2 Þp0. Therefore, it follows
that p2 is a non-increasing function of the inventory
level x2.
Acknowledgment (iii) Next, we prove that V2(x2) is concave with respect to
x2.
This work was supported by the Korea University Grant
Let V2(x2) be defined as follows:
K0715071 and Jungseok Logistics Foundation Grant.
8 min
< V 2;1 ðx2 Þ obtained when p2 ¼ p2
> x2 Xxn2
2 ox2 ox2
xm
^ n
Appendix A V 2 ðx2 Þ ¼ V 2;2 ðx2 Þ obtained when p2 ¼ p2
>
: V ðx Þ obtained when p ¼ pmax x pxm
2;3 2 2 2 2 2
Consider the following cases: for cases (1) and (2) are the same. The same is true for the
(1) x2 Xxn2 gradients at xm N for cases (2) and (3). Hence V2(x2) is
Z x2 b2 a2 pmin
concave with respect to x2.
2
V 2;1 ðx2 Þ ¼ pmin min
2 ðb2 a2 p2 þ 2 Þf 2 ð2 Þ d2 Property (iv) is directly obtained from (A.8), (A.10), and
min
2
Z max (A.13). &
2
þ pmin
2 x2 f 2 ð2 Þ d2 (A.7)
x2 b2 a2 pmin
2
Proof of Lemma 2. We show by induction that J k ðxk ; pk Þ is
concave with respect to pk and then prove that Vk(xk) is
The first and second order derivatives with respect to x2 concave with respect to xk.
are shown: First we assume that V kþ1 ðxkþ1 Þ is a continuous function
dV 2;1 and concave with respect to xkþ1 . The first derivative of
¼ pmin min
2 ½1 F 2 ðx2 b2 a2 p2 ÞX0 (A.8)
dx2 V kþ1 ðxkþ1 Þ with respect to xkþ1 is assumed to be positive.
V kþ1 ðxkþ1 Þ is represented as follows:
2
d V 2;1
¼ pmin min
2 f 2 ðx2 b2 a2 p2 Þp0 V kþ1 ðxkþ1 Þ
dx22 8
>
> V ðx t k Þ obtained when pkþ1 ¼ pmin xk Xt k þ xnkþ1
> kþ1;1 k
> kþ1
Thus, V 2;1 ðx2 Þ is concave with respect to x2 when x2 Xxn2 . >
>
kþ1 oxk ot k þ xkþ1
t k þ xm
< V kþ1;2 ðxk t k Þ obtained when pkþ1 ¼ p^ kþ1 n
bk þak pk
kþ1
(3) x2 pxm2 þ V 00kþ1;2 ðxk bk þ ak pk k Þf k ðk Þ dk
xk xnkþ1 bk þak pk
Z x2 b2 a2 pmax Z xk bk þak pk
2
V 2;3 ðx2 Þ ¼ pmax
2 ðb2 a2 pmax
2 þ 2 Þf 2 ð2 Þ d2 þ V 00kþ1;3 ðxk bk þ ak pk k Þf k ðk Þ dk
min xk xm bk þak pk
2 kþ1
Z max #
2
þ pmax
2 x2 f 2 ð2 Þ d2 (A.12) þV 0kþ1;3 ð0Þf k ðxk bk þ ak pk Þ
x2 b2 a2 pmax
2
Note that (A.16) expresses the stationary point p^ k as a concavity. At the thresholds xm n
k and xk , V k ðxk Þ is contin-
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