Argument: “Every time we’ve tried lowering prices a little, our profits have declined because the increased revenue doesn’t offset our increased costs. We’re best off staying with our current price points.”
Pitfall: If the price declines are large enough , the increased volume may justify a shift to a new technology that leads to MUCH higher profits (e.g. Wal-Mart).
Why cost-benefit analysis can be misleading:
Argument: If marginal benefits do not exceed marginal cost, the project is not worthwhile
Pitfall: Making larger changes (e.g.volume in our example) or making several changes simultaneously may lead to an improvement even if marginal changes do not.
The solution returned by the optimizer may depend on the starting point: In general, optimizers are not guaranteed to give global optimal solutions to nonlinear programs. You may have to experiment with different starting points.
This behavior is due to the inherent limitations of marginal analysis, which has broader implications for decision making.
Also, nonlinear programs are less efficient numerically; they can take much more compute time to solve than linear programs.
AMR shares initially plunged on first announcement of “Ultimate Super Saver” fares Jan. 1985
Analysts thought it was the start of a price war
“ AMR cannot operate profitably at these fares.”
But RM systems proved very effective
AA revenues rose
Competitors suffered: e.g. PeopleExpress
1984 $60M profit (all-time high)
1985 $160M loss
Sold to Continental
“ We were a vibrant, profitable company from 1981 to 1985, and then we tipped right over into losing $50 million a month. We were still the same company. What changed was American’s ability to do widespread Yield Management in every one of our markets. … That was the end of our run because they were able to under-price us at will and surreptitiously.” “ Obviously PeopleExpress failed . . .We did a lot of things right. But we didn’t get our hands around Yield Management and automation issues. [If I were to do it again . . . ] the number one priority on my list every day would be to see that my people got the best information technology tools. In my view, that’s what drives airline revenues today more than any other factor–more than service, more than planes, more than routes .” Donald Burr CEO PeopleExpress