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How customisation of pricing and item


availability information can improve
e-commerce performance
Hisashi Kurata and Carolyn M. Bonifield
Received (in revised form): 15th February, 2006

Temple University, Japan Campus, Azabu Hall 1F, 2-8-12 Minami Azabu, Minato-ku, Tokyo 106-0047,
Japan. Tel: 81-3-5441 9864; Fax: 81-3-5441 9811;
E-mail: hisashi_kurata@hotmail.com

Hisashi Kurata received a PhD from the


School of Business Administration, The University of Wisconsin-Milwaukee. He earned an
MS in Management Science from Pennsylvania
State University, and a BA in Economics from
the University of Tokyo. His research interests
include supply chain management, marketingmanufacturing interface, and retail operations.
Carolyn M. Bonifield is an assistant professor
at the School of Business Administration,
University of Vermont. She earned a PhD
from the University of Iowa. Her research
interests include the role of affect in consumer
decision making, post-purchase decision making, and framing.

ABSTRACT
KEYWORDS: inventory-dependent demand,
pricing, E-business, item availability, air or
hotel industry

Two characteristics of e-commerce, the ability to


micromarket (ie, customising a marketing plan
according to customers purchasing patterns) and the
ability to selectively offer item availability information
(ie, manipulating whether or not to display the total
number of items available to customers), considerably
increase firms potential to improve their performance.
This paper considers e-business in the hotel and
airline industries, which has two customer segments:
one is the leisure segment, which focuses more on

price, and the other group is the business segment,


which focuses heavily on schedule. We propose an
analytical model that determines the optimal pricing
and demonstrates that e-business can improve its
revenue by taking into account customer segmentation
when offering item availability information to
customers. We provide numerical examples that
demonstrate that accuracy in segmenting customers
and the size of each segment will influence the
performance of customised marketing planning. We
also present managerial implications derived from
these analytical findings.
Journal of Revenue and Pricing Management (2007) 5,
305314. doi:10.1057/palgrave.rpm.5160054

INTRODUCTION
Booking or purchasing services via the internet
is common for various service industries,
including airlines, hotels, rental cars, theatres,
and restaurants. The pricing decision for
services, relative to manufacturing firms, is
particularly challenging for a variety of reasons
including difficulty in determining fixed and
operating costs, the intangible nature of
services, and perishability, which translates into
inability to inventory services. As for types of
pricing decisions, for instance, Talluri and van
Ryzin (2004, Chapter 1) present recommendations for how to set posted prices, how to price
across product categories, how to price over
time, and how to discount. Clearly, price
significantly influences consumers decisions.

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Customisation of pricing and item availability information

In addition to pricing, the firm has the


ability to present the number of available items
to the potential customer. For example,
imagine a common scenario where an individual is looking on the internet for a discount air
ticket for his/her business trip. If he/she knows
that only a few seats remain on the desired
departure date, he/she may quickly decide to
make a reservation in order to avoid losing his/
her chance to go on the trip. As this example
implies, the number of remaining items that a
seller offers to customers (we call this item
availability) may influence the customers decision process and change the demand rate. That
is, item availability is one choice factor in
addition to traditionally well-discussed marketing activities such as price, promotion, and instore display.
This paper addresses e-business in the
service industry, such as hotels or airlines.
These areas have the following common
characteristics: the capacity of service
offered is fixed, fixed and operation
costs are exogenously decided or are of lesser
concern compared to revenue, customer
purchasing (or reservation of service) is
often conducted via the internet, a customised marketing plan is easily offered, and the
date/timing of service is important for
customers.
Our model considers two types of customer
segments: one is a group of customers who pay
more attention to timing of service than to
price. For example, it is common for business
travellers to buy expensive tickets to meet their
schedules. We call this customer segment a
business (traveller) segment. The other segment is
composed primarily of leisure travellers. For
example, the highest priority for a college
student who wants to go on a trip during
summer break is to search for a highly
discounted air ticket. Usually such a leisure
traveller has high flexibility in schedule but is
very interested in price discounts. Hereafter,
we call this segment the leisure (traveller) segment.
Note that business versus leisure segmentation
is a common approach for revenue manage-

ment (see Talluri and van Ryzin, 2004,


Chapter 10).
The goal of this paper is to determine the
optimal pricing under the item availability
effect for an e-commerce transaction, particularly in the airline or hotel industries, assuming
that e-business can assess customers behaviour
(ie, sensitivities to price and item availability)
and manipulate information for both price and
item availability to a specific customer according to the segment to which the customer
belongs (hereafter we call this ability to offer
individually customised marketing micromarketing). We will answer the following business
issues:
(1) Optimal pricing under item availability effect:
Using an analytical model, we determine
the optimal pricing under item availability
effect on sales when the e-business can
access the information on the customer
purchasing behaviour. Sensitivity analysis to
the optimal revenue explores how management can handle its customers so as to
improve its business performance.
(2) Comparison of segmentation versus non-segmentation strategy. We compare two scenarios for e-business. One is a scenario
where e-business does not utilise segmentation information and offers the same
pricing and item availability plan to the
entire market (hereafter called this a
homogeneous scenario). The other is a case
where e-business applies obtained behaviour information to develop a customised
pricing and item availability plan to a
specific customer. That is, each customer
receives a different marketing offer from
the e-business (hereafter, we call this a
customised scenario). We compare the performance of the two scenarios. We also
investigate how accuracy of the segmentation decision and market share of each
segment influences the performance of the
customised scenario.

In the remainder of this section, we review


existing papers related to this study. From the

306 Journal of Revenue and Pricing Management Vol. 5, 4 305314 & 2007 Palgrave Macmillan Ltd, 1476-6930 $30.00

Kurata and Bonifield

operations management side, several papers


have already explored the effects of inventory
level on demand. For example, Baker and
Urban (1988) investigated the optimal ordering
decision for inventory-dependent demand
where deterministic demand rate is a polynomial function of the stocking level. They
developed a nonlinear programming algorithm
to search the solution. Datta and Pal (1990)
analysed the inventory model in which the
demand rate is a linear function of the
inventory level. Using an optimisation approach, they determined the maximum expected profit and the optimal order cycle time.
Hwang and Hahn (2000) explored inventory
management for perishable items with an
inventory-dependent demand. Their profit
maximisation model determines the optimal
order-up-to level and the optimal order cycle.
These operations papers focus on the optimum
search, but rarely refer to consumer behaviour
and heterogeneity, which are important to
develop an effective marketing strategy for a
retail business.
Individually customised marketing decisions
have been addressed in the literature by
marketing researchers. Using a game theoretic
framework, for example, Chen et al. (2001)
investigated how a firms ability to predict
purchasing behaviour of individual customers
(which they called targetability) influenced the
performance of individually customised marketing. Their finding is that higher targetability
results in higher profit for the firm offering
micromarketing. This is consistent with our
numerical result that examines the effect of
segmentation correctness on revenue.
Note that our assumption that the information about the number of remaining items
offered by a retailer influences customers
purchasing decisions is explained by consumer
behaviour and applied psychology research.
Brehm (1966) proposed reactance theory,
which means that when an individuals behavioural freedom is threatened, the person reacts
to restore his/her endangered freedom. Clee
and Wicklund (1980) discussed psychological

reactance from a marketing perspective. They


provided an example in which consumers
regard the product as more attractive under
conditions of product scarcity. Inman et al.
(1997) empirically studied how the presence of
a restriction (eg, purchase limit) increases the
perceived deal value and encourages consumer
choice.
The remainder of this paper is organised as
follows. The next section explains the fundamental concepts of demand-dependent inventory, e-commerce, and response function. We
develop an analytical model to determine the
optimal price over time under the item
availability effect on demand. Then we compare the aforementioned two scenarios and
analyse the difference. In addition, we propose
several numerical examples that may offer
additional insights on the effects of a customised marketing plan on e-business. Finally, we
conclude this paper.
MODEL
This section explains the fundamental concepts
for our model formulation and analysis.
Unique characteristics of e-commerce
Compared to traditional brick-and-mortar
stores, e-commerce has several unique characteristics. For example, Viswanathan (2005)
lists customisation, interactivity, multimedia
abilities, global accessibility, inexpensive accessibility to information, and real-time interactions. This research focuses on the following
two unique characteristics of e-business: (1) an
e-business can perfectly control offers of
inventory level information about the item to
customers, and (2) an e-business can easily trace
the purchasing history and information search
process of a customer.
As for the first characteristic, it is common
for e-stores to offer the number of available
items on a website when a customer is
searching product/service information for the
item that he/she is interested in (eg, Amazon.com often displays item availability information
such as Only 5 left in stockorder soon).

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Customisation of pricing and item availability information

Clearly, an e-business can control whether to


display the item availability information to
customers. If an e-business does not display
certain items, it is impossible for customers to
know the actual number of available items,
whereas it is difficult for a traditional store to
perfectly hide inventory information from
customers. As earlier mentioned, item availability is one of the marketing factors that
might stimulate customers purchasing decisions. In particular, manipulating the intensity
of item availability offers to business customers
who put strong emphasis on date and time can
be an effective strategy for e-business.
The second characteristic, e-commerces
accessibility to customers behaviour, is closely
related to micromarketing, a stores ability to
offer the customer a specifically customised
marketing action that might be effective with
this particular customer. One good example of
a micromarketing application is the Retail
Service offered by Catalina Marketing (Catalina Marketing, 2005), which develops marketing actions for their customers according to
their past shopping patterns. Micromarketing is
also frequently applied in e-business: e-commerce websites often show recommended
items to the customer based on his/her
purchasing history (eg, Amazon.com recommends a newly released sci-fi movie DVD to
customers who bought a science fiction video
or book in the past). Our model assumes that
e-business can access the customers information search and purchasing records and determine which segment a customer who is
currently looking at its website belongs to, a
leisure segment or a business segment.

enough to avoid negative demand. We use a


linear response model. In addition to analytical
tractability, we can present the plausibility of a
linear demand function as follows. A linear
demand function often achieves a satisfactory
fit to the given dataset (see Simon, 1989). Also,
our model follows a tradition of microeconomics analysis (for example, Tirole, 1988;
Wolfstetter, 1999) and marketing research
about brand management and pricing, such as
Raju et al. (1995) and Sayman et al. (2002).
Note that inventory-dependent demand described by equation (1) was often applied for
existing inventory-dependent demand papers,
such as Datta and Pal (1990) and Sarker et al.
(1997). Demand in equation (1) behaves as an
increasing function with respect to time, as
shown in Figure 1.
Revenue functions
A revenue p(p, x) at a specific time t, where
retail price p p(t) and inventory level x x(t),
is determined as follows.

pp; xjxxt pd pm  ap  bx
The total revenue P over period from t 0 to
t T is determined as,

tT
Z

pddt

t0

tT
Z

pm  ap  bxdt 2

t0

subject to x. d m ap bx, and an


initial inventory level is x(t 0) x0.
3.5
3.0

Demand function
We assume the following relationship between
inventory level x, retail price p, and demand
rate d

d m  ap  bx

2.0
1.5

Demand

2.5

1.0

0.5
0.0

where a>0 is a given price sensitivity, b>0 is a


given sensitivity of item availability, and m is a
given market size. We assume that m is large

2.0

1.6

1.2

0.8

0.4

0.0

Remaining Time

Figure 1: Demand change over time

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Solving the optimal control model above,


we can obtain the following generic solution
for our revenue maximisation.
Proposition 1: Optimal solutions
(a) For the optimal control model in (2), the
optimal multiplier, inventory trajectory, and
price at time t are defined as:

m  a  bx0
1  ebT
b

15

10
0.0

0.5

1.0

t (time)
p (price)

x (inventory)

(b) The total revenue at time T is determined


as
P

20

Figure 2: Trajectories of the inventory level x and


retail price p over time

l ebt p
x a=bebt  1 x0
m a  bx0
p
a

Price/Inventory level

Kurata and Bonifield

Proof: See Appendix.


We know from Proposition 1 that the
optimal inventory level x decreases in t, while
the optimal price p is constant over time.
Figure 2 illustrates the change of x and pover
time.
A constant optimal price is plausible. This is
because, from our observation of pricing
behaviour in e-business in the hotel and air
industries (eg, Expedia.com, Orbitz.com, etc.),
it is rare that e-business changes its retail price
day by day. In contrast, the price is usually kept
constant over time once it has been decided.
Another possibility is that fixing the price at a
specific level over time is a common pricing
strategy in the hotel and air industries. For
example, discount airlines often use price
appeals in their advertising, such as selling a
$99 ticket between two major cities. Moreover,
our optimal price equation (4) describes a
realistic pricing situation in which, if many
customers are eager to get accommodations on
the day of a special event, such as Indianapolis
hotels on the day of the Indy 500 race, or New
Orleans hotels on the days of Mardi Gras, then

the price will initially be set very high (ie, high


m and small a will increase p).
The effect of parameter value changes on
the optimal profits is summarised below.
Proposition 2: Sensitivities of the
optimal revenue
(a) P increases in m and T.
(b) P decreases in a, b, and x0.

Proof. See the Appendix.

CUSTOMISED SCENARIO VERSUS


HOMOGENEOUS SCENARIO
This section explores how e-business can
improve its revenue by offering customised
pricing and item availability information to
customers when dividing its customers into
two segments: a business segment and a leisure
segment. Note that, for the homogeneous
scenario, the e-business offers the same price
p and normal item availability information to
all its customers while, for the customised
scenario, management offers high price pB (>p)
and intensive information about item availability to the business segment and low price pL
(op) and weak item availability information to
the leisure segment. Figure 3 visualises the
difference between the two scenarios with
respect to the pricing and item availability
information decision.

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Customisation of pricing and item availability information

Homogeneous scenario
Customers

Business segment

Price p
e-business

Normal item
availability offer
Leisure segment

Customized scenario

Customers

Price pB

e-business

Intensive item availability


offer for Business segment

Business segment

Price pL
Leisure segment

Weak item availability offer


for Leisure segment

Figure 3: Homogeneous scenario versus customised scenario

Modelling two scenarios


The sensitivities of price and item availability
between business and leisure segments in the
customised scenario are considered to have the
following relationship:

aB oaL

and

bB 4bL

We assume that, for the homogeneous scenario,


the sensitivities are determined as a weighted
average of the two segments in the customised
scenario. That is,
a mB aB mL aL =mB mL
and b mB bB mL bL =mB mL
Note that the sensitivity parameters have the
following relationship:
aB oaoaL

and

 L
bB 4b4b

The total revenues for homogeneous and


customised scenarios are defined as follows.
hom
Phom
Phom
total PB
L

 0 1  ebT
mB  a  bx


b

 0 1  ebT
mL  a  bx


b
cus
cus
Pcus
total PB PL

mB  aB  bB x0 1  ebB T
bB
mL  aL  bL x0 1  ebL T

bL

To quantify the difference in revenues


between the two scenarios, we determined

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Kurata and Bonifield

DP as
hom
DP Pcus
total  Ptotal

Note that if DP>0, then we conclude that it


is profitable for e-commerce to utilise consumer behaviour information to determine
optimal profit and item availability customisation. However, if DPo0, then there is no need
to consider segmentation for the e-business.
Proposition 3 addresses whether customisation
is beneficial or not.
Proposition 3: Effect of a and b on DP
(a) DP 0 when only information of a is
customised.
(b) DPX0 when only information of b is
customised.
(c) DP is maximised at the b which satisfies

qPhom
B

qb

Phom
L

Pcus
B

Pcus
L


bB  bL

Proof: See the Appendix.


Proposition 3 suggests that a customised
model outperforms a homogeneous model if
the e-business offers customised item availability information to customers. However, segmentation with respect to customer price
sensitivity does not make a customised model
better than a homogeneous model. Note that
there often exists a situation where e-commerce is allowed to customise item availability
offers, but retail price is supposed to be the
same throughout the market. One well-cited
pricing mistake is that Amazon.com offered a
higher price to channel loyal customers than
the price for channel switchers, and this kind of
price discrimination was claimed to be unfair
(Streitfeld, 2000). That is, one must be aware
that sometimes price discrimination according
to how much a customer is willing to pay for
the item (ie, first degree price discrimination) is
not suitable for e-commerce, even if price
discrimination is not problematic in several
traditionally acceptable situations, such as a

discount for bulk-purchasing (ie, second degree


price discrimination) or discounts for seniors
and students (ie third degree price discrimination). Thus, our business implication is that ecommerce can raise its revenue by customising
item availability offers only without risking
price discrimination. We shall note that,
although our analysis shows that e-commerce
can raise revenue as long as management can
categorise customers into either the business or
leisure segment, the remaining question is how
to segment. Possible approaches are usage of
demographic information or application of
specific statistical methods to customers panel
data. However, segmentation techniques are
not the objective of this research. We will leave
the details of customer segmentation to Wedel
and Kamakura (1999).
NUMERICAL EXAMPLES
The purpose of numerical examples is twofold:
visualisation of our analytical discussion might
support readers understanding, and some
business questions are hard to explore via the
analytical approach so that numerical examples
can give us insight on such tough questions.
Particularly, this section tries to answer the
following questions:

(1) Does the difference in total revenue between the two scenarios (ie, DP) change if a
segmentation share (ie, the ratio of mB and
mL) changes?
(2) How will the profitability of the customised model be undermined if segmenting
customers to two groups is not accurate
enough?

Arbitrary parameter settings in this section are:


mB0 mL0 100; aB 1.4; aL 1.6; mB 0.6;
mL 0.4; x0 30; and T 10.
As for the first question, Figure 4 illustrates
the effect of the business segment share on the
difference in revenue between two scenarios.
Note that the business segment share SB is
defined as SB mB/(mB mL).
We know from Figure 4 that when the two
segments are of similar size (ie, SBE0.5), the

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Customisation of pricing and item availability information

29

450

Profit

28
28

350

27

300

Average profit

29

400

27
0

250
0

10

20

30

40

50

60

70

80

90

100

Share of Business segment (%)


Customized scenario

10

20

30

40

50

60

70

80

90

26
100

Percentage of segmentation accuracy


Average profit

Homogeneous scenario

Figure 4: Effect of segment share on the difference


between the two scenarios

customised scenario greatly outperforms the


homogeneous scenario, whereas if one segment
is much larger than the other (ie, SBE0 or
SBE1), the advantage of information customisation is dampened. This is intuitive: segmentation has meaning in business strategy
only when more than one segment of significant size exists in a market.
As for the second question, we assume that
each customer has his/her own reference price
pR and if the price offered by the e-commerce
is less than or equal to this reference price, he/
she will buy; otherwise, no purchase occurs.
R
Let pR
B and pL be the reference prices of a
customer belonging to the business segment
and leisure segment, respectively. We assume
that the reference prices follow a uniform
R
R
distribution: pR
B BU(mB HR, mB HR) and
R
R
R
pL BU(mL HR, mL HR), where HR represents the half-range of the uniform distribution.
Note that the uniform distribution corresponds
to our linear response function. Assumption (5)
results in pB>pL. Thus, the distribution of
reference prices belonging to the business
segment is located higher on the price axis
than that of the leisure segment. Under this
setting, a customers choice works as follows. If
pL is mistakenly offered to a business traveller
whose reference price is pR, then he/she will
buy if pLppR and the retailer receives pL as
revenue. However, compared to the case where
the e-business correctly offers pB to the business
traveller, the retailer loses pBpL as the cost of

Figure 5: Effect of segmentation accuracy on the


customised scenario performance

inaccurate segmentation. Also, if pL>pR, the


customer does not buy so that the retailer
receives zero revenue. Note that the same
outcome happens for the case that pB is
mistakenly offered to a leisure customer.
As shown above, the accuracy of the
segmentation decision plays an important role
in the performance of the customised scenario.
If mistakes happen quite often in segmentation,
the e-business may lose large amounts of
revenue. Figure 5 is the outcome of a
simulation analysis of the effect of segmentation
accuracy on performance. In this simulation
example, we change the percentage of wrong
segmentation from 0 to 100 per cent, with
pB 27.4, pL 24.0, and HR 5.0. Note that
the basic parameter setting in Figure 5 is the
same as that of Figure 4.
What we know from Figure 5 is that the
average revenue for the customised scenario
increases in proportion to the accuracy of the
segmentation decision (ie, percentage of correct segmentation). In other words, as firms
make more segmentation mistakes, more lost
sales occur to the e-business and we can
reasonably imagine that customers lost due to
segmentation errors might switch to another
retailer. This numerical result is consistent with
the analytical result by Chen et al. (2001). As
we have discussed before, the customised
scenario theoretically outperforms the homogeneous scenario. However, in a real customised marketing strategy, perfectly correct
segmentation is hard to achieve: some custo-

312 Journal of Revenue and Pricing Management Vol. 5, 4 305314 & 2007 Palgrave Macmillan Ltd, 1476-6930 $30.00

Kurata and Bonifield

mers are mistakenly categorised into the wrong


group. Our numerical example shows that a
reliable segmentation method is critical for the
implementation of a customised marketing
strategy.
CONCLUDING REMARKS
Two characteristics of e-commerce, the ability
to micromarket (ie, to customise a marketing
plan according to customers purchasing patterns) and the ability to offer item availability
information, considerably increase the potential
to improve a firms performance. We have
analysed revenue management issues for ebusiness in the hotel or airline industry, in
which there are two segments: price-conscious
customers (leisure travellers) and schedule-conscious customers (business travellers). We provide
an analytical model that determines the optimal
pricing under item availability effect over time.
We then show how firms can improve their
total revenue in the e-business area by taking
into account customer segmentation and
offering customised item availability information to customers. Our numerical examples
demonstrate that the accuracy of segmenting
customers and the size of each segment will
influence the performance of customised
marketing planning.
Finally, several viable directions for future
research exist. First, as analytical research, we
have formulated a linear response function.
This linear assumption should be confirmed or
adjusted by empirical research that can determine a specific shape of customers response
function to price and item availability. Second,
some e-business firms offer item availability
information, but the timing of purchase is less
important (ie, sales of books or CDs). In our
paper, one of the primary ways that industries
segment is business versus leisure segments. It
would be interesting to analyse another type of
business situation that differs in terms of its
segments. Third, to focus on our main research
goal, our model does not include some other
common occurrences for hotel or airplane
sales, such as overbooking, lost sales due to

limited capacity, and cancellation of booking.


Including these factors may enrich our discussion.

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APPENDIX

Proof of Proposition 1. Set Hamiltonian as


H pm  ap  bx lm ap bx
where l is a Lagrange multiplier. The conditions for optimality are:
Hp m  ap  bx  ap  l 0
l 0 Hx bp  l

A:1

Proof of Proposition 2 From the structure of


Equation (4), it is obvious that P increase in m
and T, but linearly decreases in a and x0. As for
the sensitivity of b, set G(b)
((ma/b)x0) and
H(b)
(1ebT). Clearly, both G(b) monotonously decreases in b, while H(b) monotonously increases in b. Also, limb-0G(b)
N>0, limb-NG(b) x0o0, limb-0H(b)
0, and limb-NH(b) 1>0. We are assuming
plausibly that m is large enough compared to
Hj(b), which is bound between 0 and 1. Hence,
if so, the change of H(b) with respect to the
change of b can be ignored when compared to
qG(b)/qb (ma)/b2. Thus (qH(b)/qb)/
(qG(b)/qb)D0 At this time,
qGb
qHb
Hb Gb
qb
qb
qGb
1ma
H1 b
1  ebt

qb
b2

qP =qb

A:2

Solving (A.2) with respect to l, we obtain


l ebt p

Then, ((q2P)/(qb2)D(2(ma))/(b3))(1ebt)>0.
As a result, P is convex in b. &

A:3
Proof of Proposition 3

From (A.1) and (A.3),


m  ap  bx aebt 0
That is x. aebt

A:4

From (A.4) and the initial condition x(0) x0,


we obtain
x a=bebt  1 x0
Plug (A.3) and (A.5)
p (m abx0)/a. Finally,
P

tT
Z

pddt

t0

aebt dt

tT
Z

A:5
into

m  a  bx0
a

(A.1),


t0

m  a  bx0
1  ebT
b

&

(a) Proposition 2 mentions that P is linear in a


so that, obviously, DP 0.
(b) From Proposition 2, P is concave in b so
that, from the definition of a concave
function, DPX0.
(c) The slop of the line connecting the two
cus
points, Pcus
B and PL , is defined as
cus
Pcus
B  PL
bB  bL
It is obvious that when the slop of the


tangent line attaching to Phom
total (b) at b is
equivalent to the slop of the line connectcus
ing Pcus
B and PL , DP is maximised. &

314 Journal of Revenue and Pricing Management Vol. 5, 4 305314 & 2007 Palgrave Macmillan Ltd, 1476-6930 $30.00

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