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Relative Entropy, Exponential Utility, and Robust Dynamic Pricing

Author

Listed:
  • Andrew E. B. Lim

    () (Department of Industrial Engineering and Operations Research, University of California, Berkeley, California 94720)

  • J. George Shanthikumar

    () (Department of Industrial Engineering and Operations Research, University of California, Berkeley, California 94720)

Abstract

In the area of dynamic revenue management, optimal pricing policies are typically computed on the basis of an underlying demand rate model. From the perspective of applications, this approach implicitly assumes that the model is an accurate representation of the real-world demand process and that the parameters characterizing this model can be accurately calibrated using data. In many situations, neither of these conditions are satisfied. Indeed, models are usually simplified for the purpose of tractability and may be difficult to calibrate because of a lack of data. Moreover, pricing policies that are computed under the assumption that the model is correct may perform badly when this is not the case. This paper presents an approach to single-product dynamic revenue management that accounts for errors in the underlying model at the optimization stage. Uncertainty in the demand rate model is represented using the notion of relative entropy, and a tractable reformulation of the “robust pricing problem” is obtained using results concerning the change of probability measure for point processes. The optimal pricing policy is obtained through a version of the so-called Isaacs’ equation for stochastic differential games, and the structural properties of the optimal solution are obtained through an analysis of this equation. In particular, (i) closed-form solutions for the special case of an exponential nominal demand rate model, (ii) general conditions for the exchange of the “max” and the “min” in the differential game, and (iii) the equivalence between the robust pricing problem and that of single-product revenue management with an exponential utility function without model uncertainty, are established through the analysis of this equation.

Suggested Citation

  • Andrew E. B. Lim & J. George Shanthikumar, 2007. "Relative Entropy, Exponential Utility, and Robust Dynamic Pricing," Operations Research, INFORMS, vol. 55(2), pages 198-214, April.
  • Handle: RePEc:inm:oropre:v:55:y:2007:i:2:p:198-214
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    File URL: http://dx.doi.org/10.1287/opre.1070.0385
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    References listed on IDEAS

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    Citations

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    Cited by:

    1. Omar Besbes & Assaf Zeevi, 2012. "Blind Network Revenue Management," Operations Research, INFORMS, vol. 60(6), pages 1537-1550, December.
    2. Georgia Perakis & Guillaume Roels, 2008. "Regret in the Newsvendor Model with Partial Information," Operations Research, INFORMS, vol. 56(1), pages 188-203, February.
    3. Moshe Haviv & Ramandeep S. Randhawa, 2014. "Pricing in Queues Without Demand Information," Manufacturing & Service Operations Management, INFORMS, vol. 16(3), pages 401-411, July.
    4. Denis Sauré & Assaf Zeevi, 2013. "Optimal Dynamic Assortment Planning with Demand Learning," Manufacturing & Service Operations Management, INFORMS, vol. 15(3), pages 387-404, July.
    5. William L. Cooper & Tito Homem-de-Mello & Anton J. Kleywegt, 2015. "Learning and Pricing with Models That Do Not Explicitly Incorporate Competition," Operations Research, INFORMS, vol. 63(1), pages 86-103, February.
    6. Zeynep Turgay & Fikri Karaesmen & E. Örmeci, 2015. "A dynamic inventory rationing problem with uncertain demand and production rates," Annals of Operations Research, Springer, vol. 231(1), pages 207-228, August.
    7. Yuri Levin & Jeff McGill & Mikhail Nediak, 2008. "Risk in Revenue Management and Dynamic Pricing," Operations Research, INFORMS, vol. 56(2), pages 326-343, April.
    8. Alper Atamtürk & Muhong Zhang, 2007. "Two-Stage Robust Network Flow and Design Under Demand Uncertainty," Operations Research, INFORMS, vol. 55(4), pages 662-673, August.
    9. Paul Glasserman & Xingbo Xu, 2013. "Robust Portfolio Control with Stochastic Factor Dynamics," Operations Research, INFORMS, vol. 61(4), pages 874-893, August.
    10. Michael Jong Kim & Andrew E.B. Lim, 2016. "Robust Multiarmed Bandit Problems," Management Science, INFORMS, vol. 62(1), pages 264-285, January.
    11. Arnoud V. den Boer & Bert Zwart, 2014. "Simultaneously Learning and Optimizing Using Controlled Variance Pricing," Management Science, INFORMS, vol. 60(3), pages 770-783, March.
    12. Maxime C. Cohen & Georgia Perakis & Robert S. Pindyck, 2015. "Pricing with Limited Knowledge of Demand," NBER Working Papers 21679, National Bureau of Economic Research, Inc.
    13. Jun-Ya Gotoh & Michael Jong Kim & Andrew E. B. Lim, 2017. "Calibration of Distributionally Robust Empirical Optimization Models," Papers 1711.06565, arXiv.org.
    14. repec:eee:ejores:v:263:y:2017:i:2:p:337-348 is not listed on IDEAS
    15. Henry Lam, 2016. "Robust Sensitivity Analysis for Stochastic Systems," Mathematics of Operations Research, INFORMS, vol. 41(4), pages 1248-1275, November.
    16. Josef Broder & Paat Rusmevichientong, 2012. "Dynamic Pricing Under a General Parametric Choice Model," Operations Research, INFORMS, vol. 60(4), pages 965-980, August.
    17. repec:spr:orspec:v:40:y:2018:i:3:d:10.1007_s00291-018-0513-7 is not listed on IDEAS
    18. René Caldentey & Ying Liu & Ilan Lobel, 2017. "Intertemporal Pricing Under Minimax Regret," Operations Research, INFORMS, vol. 65(1), pages 104-129, February.
    19. Arnoud V. den Boer, 2014. "Dynamic Pricing with Multiple Products and Partially Specified Demand Distribution," Mathematics of Operations Research, INFORMS, vol. 39(3), pages 863-888, August.
    20. Youyi Feng & Baichun Xiao, 2008. "Technical Note---A Risk-Sensitive Model for Managing Perishable Products," Operations Research, INFORMS, vol. 56(5), pages 1305-1311, October.
    21. Dan A. Iancu & Nikolaos Trichakis, 2014. "Pareto Efficiency in Robust Optimization," Management Science, INFORMS, vol. 60(1), pages 130-147, January.
    22. Zizhuo Wang & Shiming Deng & Yinyu Ye, 2014. "Close the Gaps: A Learning-While-Doing Algorithm for Single-Product Revenue Management Problems," Operations Research, INFORMS, vol. 62(2), pages 318-331, April.
    23. Omar Besbes & Assaf Zeevi, 2009. "Dynamic Pricing Without Knowing the Demand Function: Risk Bounds and Near-Optimal Algorithms," Operations Research, INFORMS, vol. 57(6), pages 1407-1420, December.
    24. Michael Jong Kim, 2016. "Robust Control of Partially Observable Failing Systems," Operations Research, INFORMS, vol. 64(4), pages 999-1014, August.

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