Upgrades, Upsells and Pricing in Revenue Management

Abstract

Capacity providers often experience a mismatch between supply and demand that can be partially alleviated while improving revenues by allowing for product upgrades. When prices are fixed and demands are independent, the problem is to decide which customer demands to upgrade to which products and when. We show that a fairness constraint can be imposed without loss of optimality under mild conditions. We also investigate a model that limits upgrades to the next higher quality product, and we provide necessary and sufficient conditions for its revenues to be as high as that of any less restricted upgrade model. Resellers of capacity also have an incentive to use upgrades as a mechanism to entice customers to higher quality products with higher commission margins. We show that this practice can be very profitable and that the profits can be much larger than direct commissions from sales would indicate. We then investigate the case where sellers have pricing flexibility and customer demand is driven by a choice model. We derive pricing formulas under the assumption that demand for products follows a multinomial logit model, and we develop an algorithm for finding a global optimal solution to the capacity constrained profit function. For this model we show that neither upgrades nor upsells improve profits when margins are homogenous and there is complete freedom in selecting prices. However, upgrades can improve revenues significantly when sensible business constraints on prices are imposed and when margins are heterogenous.

Keywords: dynamic pricing, perishable asset, substitutable products, revenue management