The impact of differentiation price and demand leakage on a firm’s profitability

Purpose – The purpose of this paper is to study the impact of differentiation price which has been utilized to segment demand, but results in imperfect segmentation. The use of a differentiation price is among the most widely used Revenue Management (RM) techniques to segment a firm’s demand to augment profitability. Design/methodology/approach – Mathematical models are developed for a firm’s RM which use a differentiation price to categorize its market demand into two segments. Three distinct demand situations are considered: price-dependent deterministic demand, price-dependent stochastic demand whose distribution is known and price-dependent stochastic demand whose distribution is unknown. Models are analyzed to determine optimal joint control of a firm’s pricing and inventory decisions for each market segment. Findings – The analysis of the firm’s RM model has shown that revenue is jointly concave in pricing and order quantity. In most demand situations, closed-form mathematical expressions for optimal pricing and inventory are obtained. Research limitations/implications – In RM models developed in this paper, a firm only selects a differentiation price. Thus, an optimal selection of the differentiation price along with the pricing and inventory decisions may lead to an additional profitability which has not been explored in this research. Practical implications – The findings reported are relevant to RM managers and practitioners and help them to calibrate their optimal revenues by segmenting markets using a differentiation price. Social implications – This paper provides a quantitative perspective of a firm’s decision on the use of the differentiation price and the market response. Originality/value – The paper provides a firm’s optimal decision on pricing and inventory when it experiences demand leakage due to categorizing its market demand into two segments using a differentiation price.