Reservations: Customer Insurance in the Marketing of Capacity

This paper develops a simple model of pricing and choice of capacity in a market where risk-averse customers are uncertain about their valuation for use of the capacity. As unused capacity has no salvage value, the seller maximizes profit by economizing on capacity through over-booking. Thus each customer faces both uncertainty in his own valuation as well as uncertainty about availability of capacity. Because he is risk-averse, the customer seeks insurance. Provision of insurance is complicated because each customer's realized valuation is private information. Since the seller does not know each customer's type, she must elicit the information. The most profitable pricing strategy takes the form of a reservation that induces each customer to act according to his private information: those with high valuation for use of the capacity exercise while those with lower valuation do not exercise. In this way, the reservation provides partial insurance against the customer's uncertainty in valuation (privately observed contingency) and full insurance against unavailability of capacity (observable by both seller and customer).