4.6 Article

Monopoly pricing in vertical markets with demand uncertainty

Journal

ANNALS OF OPERATIONS RESEARCH
Volume 315, Issue 2, Pages 1291-1318

Publisher

SPRINGER
DOI: 10.1007/s10479-021-04067-3

Keywords

Monopoly pricing; Revenue maximization; Demand uncertainty; Pricing analytics; Comparative statics; Stochastic orders; Unimodality

Funding

  1. Alexander S. Onassis Public Benefit Foundation (PhD Scholarship)
  2. NRF 2018 Fellowship, National Research Foundation Singapore (SG) [NRF-NRFF2018-07]

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The paper discusses the issue of monopoly pricing under demand uncertainty, proposing a method to express price elasticity using the mean residual demand function. By systematically comparing demand distributions between different markets, a framework of comparative statics challenges traditional economic insights.
Motivation Pricing decisions are often made when market information is still poor. While modern pricing analytics aid firms to infer the distribution of the stochastic demand that they are facing, data-driven price optimization methods are often impractical or incomplete if not coupled with testable theoretical predictions. In turn, existing theoretical models often reason about the response of optimal prices to changing market characteristics without exploiting all available information about the demand distribution. Academic/practical relevance Our aim is to develop a theory for the optimization and systematic comparison of prices between different instances of the same market under various forms of knowledge about the corresponding demand distributions. Methodology We revisit the classic problem of monopoly pricing under demand uncertainty in a vertical market with an upstream supplier and multiple forms of downstream competition between arbitrary symmetric retailers. In all cases, demand uncertainty falls to the supplier who acts first and sets a uniform price before the retailers observe the realized demand and place their orders. Results Our main methodological contribution is that we express the price elasticity of expected demand in terms of the mean residual demand (MRD) function of the demand distribution. This leads to a closed form characterization of the points of unitary elasticity that maximize the supplier's profits and the derivation of a mild unimodality condition for the supplier's objective function that generalizes the widely used increasing generalized failure rate (IGFR) condition. A direct implication is that optimal prices between different markets can be ordered if the markets can be stochastically ordered according to their MRD functions or equivalently, their elasticities. Using the above, we develop a systematic framework to compare optimal prices between different market instances via the rich theory of stochastic orders. This leads to comparative statics that challenge previously established economic insights about the effects of market size, demand transformations and demand variability on monopolistic prices. Managerial implications Our findings complement data-driven decisions regarding price optimization and provide a systematic framework useful for making theoretical predictions in advance of market movements.

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