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OPTIMAL MARKDOWN PRICING STRATEGY WITH DEMAND LEARNING

Published online by Cambridge University Press:  25 November 2011

H. Dharma Kwon ,
Steven A. Lippman  and
Christopher S. Tang
H. Dharma Kwon
Affiliation:
Department of Business Administration, University of Illinois at Urbana-Champaign, Champaign, IL 61820. E-mail: dhkwon@illinois.edu
Steven A. Lippman
Affiliation:
UCLA Anderson School, UCLA Los Angeles, CA 90095. E-mail: slippman@anderson.ucla.edu; ctang@anderson.ucla.edu
Christopher S. Tang
Affiliation:
UCLA Anderson School, UCLA Los Angeles, CA 90095. E-mail: slippman@anderson.ucla.edu; ctang@anderson.ucla.edu
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Abstract

When launching a new product, a firm has to set an initial price with incomplete information about demand. However, after observing the demand over a period of time, the firm might decide to mark down the price, especially when the Bayesian updated belief about demand is lower than originally anticipated. We consider the case in which the manufacturer makes three decisions: initial price, when to mark down the price, and the markdown price. Modeling the cumulative demand as a Brownian motion with an unknown drift, we compute the posterior probability distribution of the unknown drift. We then show that it is optimal to mark down the price when the posterior probability is below a computable threshold. This threshold policy enables us to determine the optimal (a) regular price, (b) markdown price, and (c) markdown time. Additionally, we examine the impact of demand volatility and evaluate the value of learning.

Type
Research Article
Information
Probability in the Engineering and Informational Sciences , Volume 26 , Issue 1 , January 2012 , pp. 77 - 104
Copyright
Copyright © Cambridge University Press 2011

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