Fare Deals, Fair Play, and Financial Engineering
Companies, consumers and Hong Kong’s knowledge economy can all benefit from revenue management and dynamic pricing, according to SENG department head and industry operations pioneer Prof Guillermo Gallego
Prof Guillermo Gallego, Head and Chair Professor of the Industrial Engineering and Logistics Management (IELM) Department and Crown Worldwide Professor of Engineering, is a man with an eye for a good deal – for both companies and their customers.
As one of the academic founding fathers of revenue management and dynamic pricing, we have Prof Gallego and his fellow trailblazers to thank for revolutionizing the way that many businesses sell their products. For example, lower-priced air fares sold to leisure customers that book early, with prices rising for those who book close to departure depending on availability considerations.
Gaining a competitive edge
In recognition of his significant contribution to the field, Prof Gallego, who joined HKUST in 2016 from Columbia University in New York, recently received the 2016 INFORMS Impact Prize together with other academics and business executives who led the way to the widespread adoption of the revenue management strategy. The biennial accolade is one of the leading honors awarded by the prestigious Institute for Operations Research and the Management Sciences (INFORMS), the world’s largest professional organization for operations research, management science and analytics with over 12,000 members.
A response to the era of ultra-competitiveness unleashed by deregulation and globalization in the late 1970s and 1980s, revenue management and dynamic pricing started out as a method for higher-cost established airline companies in the US to match and beat the cheaper fares of newbie budget rivals. It was subsequently utilized in other industries to maximize revenue for inventory within a limited time frame, such as car rental companies, fashion retailers, sports and theater events promoters, hotels, and e-commerce.
CEOs and academics pioneered the move, the latter including Prof Gallego. Observing the trend of falling and rising fares as a frequent flyer, Prof Gallego started to ask himself questions about when an airline should increase its prices or a retailer start to discount products. In 1994, he published a fundamental paper together with his then Columbia colleague Garrett van Ryzin titled “Optimal Dynamic Pricing of Inventories with Stochastic Demand over Finite Horizons” that became highly cited and voted one of the most influential papers published in Management Science. A year later, another article written with former student Youyi Feng garnered further attention by exploring “Optimal Starting Times for End-of-Season Sales and Optimal Stopping Times for Promotional Fares”. “The rudimentary elements of how to carry out revenue management and dynamic pricing started in industry but there wasn’t a well-developed way of thinking about the problem,” Prof Gallego explained.
He and van Ryzin went on to do extensive consulting for firms in different sectors, leading to numerous applications and more papers, broadening the practical and theoretical impact. Among Prof Gallego’s consultancies have been projects for Hewlett Packard, Lucent Technologies, several airlines and airline solution providers, and Disney World, among others. “Thousands of people are now working in the field. It is common to see a vice-president for pricing or revenue management in industry and positions in academia and research labs for people with expertise in this area,” he said.
All-round benefits
His recent research has helped to address the concern of whether the consumer gains from dynamic pricing along with the firm. “Some CEOs were initially skeptical about the benefits to the customer and worried that over the long term it might prove to be a sub-zero-sum game for the company. This motivated me to look into the question of how customers fare with these tools. Lately, we have been able to demonstrate that in nearly every case it is a win-win situation for both the firm and its consumers.”
Key elements for successful revenue management and dynamic pricing are mathematical models and the development of algorithms based on theory, demand forecasting and assessment of the competition. “Essentially, it is a balancing of demand and supply,” Prof Gallego noted. But one that shows that the intuitive response to seek full planes or theaters is not always true. “In some cases, where you are capacity constrained, your action is to maximize the amount you get per unit of capacity. However, where you have ample capacity but only limited time to sell it, then time is your precious resource and you want to maximize the amount of money per unit of time until the end of the sales horizon. You know it wouldn’t be optimal to drop the price as much as you would need to sell all the seats. What you want to do is maximize the revenue rate – the rate at which you accrue revenue.”
Given the extensive parameters to be considered, companies may need to develop their own system or one that enables them to work together with others in a sector, such as the airline industry’s practice of code-sharing flights. However, it is not only multinational and businesses with deep pockets that can take advantage of revenue management and dynamic pricing, according to Prof Gallego. Smaller companies can benefit by rapidly implementing off-the-shelf results from academic papers. Should they get stuck, they can turn to such researchers and their students for guidance, he said. “With relatively small effort and expense, companies can implement a system that improves their operations substantially.”
In addition, operations and management science researchers can find fertile ground for more studies investigating demand management, an issue Prof Gallego spoke on during his INFORMS award ceremony speech on behalf of all the awardees in November. “People have been working on the supply side – supply chain management – for a long time. Yet they always assume very simple forms of demand; that there is a price and a certain demand for that price. However, companies are not really operating that way. They have to dynamically adjust their prices depending on how items are selling. Supply chain analytics need to be informed by demand management, that is revenue management and dynamic pricing. One of the goals of my INFORMS speech was to raise awareness of the interconnections between the demand and supply sides,” he said.
Boosting Hong Kong’s knowledge economy
Prof Gallego has found it immensely satisfying that his work has had such impact on different business sectors across the world, seeing the possibility of extending revenue management concepts into healthcare and into private infrastructure in the future. Another source of joy is to serve as an institutional builder. While at Columbia, he launched one of the world’s first and most sought-after financial engineering master’s programs and built up his department from nine to over 20 faculty members.
Such insights and talents are now being put to work in his role as Head of the IELM Department, which he is seeking to steer toward research and education more related to decision-analytic tools and financial engineering to assist Hong Kong’s knowledge economy, including the banking, insurance, healthcare, and airline sectors, and the government. “All these areas need smart people who can help with better decision-making. If we can train those people, then I think we will be in good shape.”
He is also pleased with his own decision-making to move to Hong Kong and join HKUST. “I was very impressed that in 25 years HKUST had become one of the world’s leading universities. Things are dynamic and move so fast here. The potential for this University over the next 10 years is enormous and I want to be part of it.”
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