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Managing Customer Relationships Through Price and Service Quality

This paper develops a model to analyze how a company can optimize profit by managing customer relationships through price and service quality. The model describes individual customer behavior based on their level of satisfaction over interactions with the company. An aggregate Markov process then models overall customer behavior and system dynamics. The paper finds that while service quality increases customer usage rate, it does not necessarily increase total customer numbers or profit. Similarly, while price affects customer expectations, it does not directly correlate to total customers. The company must consider these complex relationships to optimize pricing and service quality for maximum profit.

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74 views

Managing Customer Relationships Through Price and Service Quality

This paper develops a model to analyze how a company can optimize profit by managing customer relationships through price and service quality. The model describes individual customer behavior based on their level of satisfaction over interactions with the company. An aggregate Markov process then models overall customer behavior and system dynamics. The paper finds that while service quality increases customer usage rate, it does not necessarily increase total customer numbers or profit. Similarly, while price affects customer expectations, it does not directly correlate to total customers. The company must consider these complex relationships to optimize pricing and service quality for maximum profit.

Uploaded by

aarivalagan
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Managing Customer Relationships

Through Price and Service Quality

By: Gabriel Bitran


Paulo Rocha e Olivera
Ariel Schilkrut

Presenter: Adrien de Chaisemartin


04/22/2004

This summary presentation is based on: Bitran, Gabriel, P. Rocha e Oliveira, and A. Schilkrut. "Managing
Customer Relationships Through Price and Service Quality." MIT Sloan School of Management, 2003.
Agenda

| Problem raised by the paper

| Model description
z Individual customer behavior
z Aggregate customer behavior

| System behavior in steady state

| Profit optimization
Agenda

| Problem raised by the paper

| Model description
z Individual customer behavior
z Aggregate customer behavior

| System behavior in steady state

| Profit optimization
Introduction

| Imagine that you are a computer hotline…


z People call you when they have questions about their computers
z They pay for this service

| You want to increase your profit, which parameters can you adjust?
z Price of the service
z Number of people who answer the questions (“service quality”)

| How do you play on these parameters?


z Decreasing price and increasing service quality can augment the number of
customer and increase my profit
| But…
z More customers can lead to more delays and thus more customers who
defect
z Lower price can lead to less profits
General context
| Subscription-based, capacity-constrained service
| Customers choose the depth of their relationship
with the company based on their level of satisfaction
| Pricing and service quality affect this level of
satisfaction
| The intuitive reasoning:
Service quality
Customer base and profit
Pricing
| But sometimes:
Service quality Customer base
Price profit

Complex relationship between pricing, service quality


and profitability
Agenda

| Problem raised by the paper

| Model description
z Individual customer behavior
z Aggregate customer behavior

| System behavior in steady state

| Profit optimization
Service quality encountered and
expected

Customers interact with the company whenever they choose to do so


w k evolves with:
w k = αk wk + (1 − αk )w k −1

x is a random variable with distribution


ik
F(x| w ) = F
k
Interactions model

ps subscription fee to have access to the service


during a period [ pT; (p+1) T]
pu usage fee. To be paid each time the service is used

(See Figure 1 on page 9 of the Bitran, et al. paper)


Rate of the interaction with the
customer
Customers use the service at the rate η : η (level of satisfaction, pu )
Utility of customer: (v(η ) − pu ) + c( w)

Customers will renew their subscription when:


∞

⎣ (
T ⎡η (υ (η ) − pu ) − η c( w )
i ) ⎤ − p > 0 with c( w
⎦ s (
i ) = c( x)dF x | w
∫ i )
0

We can then define b, the expected net utility per unit of time:

(
b η ; ps , pu , F ) ⎣ u (
i (⋅) = T ⎡η (υ (η ) − p ) − η c( w)
i) ⎤ − p
⎦ s

The customer will choose η * = arg max(b)


(
And he will defect whenever: b η * ; ps , pu , F )
i (⋅) = b* < b
min
Dynamic of customer-company
interactions

(See Figure 2 on page 10 of the Bitran, et al. paper)


Results
M onotonocity of custom er's usage rate:
η * 2 w ith p u /
η * 2 w ith c /
η * 2 w ith w /

M onotonocity of the custom er's ut ility:


b * 2 w ith p u and p s /
b * 2 w ith c /
b * 2 w ith w /

T he com pany can use w as a concrete and m anageable m easure


of custom er utility b *
Agenda

| Problem raised by the paper

| Model description
z Individual customer behavior
z Aggregate customer behavior

| System behavior in steady state

| Profit optimization
Aggregate customer behavior

Customers stay with the company if b* ≥ bmin


That corresponds to w ≤ w max with b* (w max ) = bmin

We can construct a Markov process where each state is described by the


number of previous interactions and the customer's current level of satisfaction
represented by w .
To discretize the set of level of satisfaction we use:
I= [ 0;w max ] = [ 0; u1 ] ∪ [l1; u2 ] ∪ ...[ls ; us ]

The states of theMarkov process are (i,k) where after the k th interaction, w ∈[li ;ui ]
Markov process representation

(See Figure 3 on page 14 of the Bitran, et al. paper)


State transition probability

| Recall that:

w k = αk wk + (1 − αk )w k −1

| In term of probability:

i k = y ) = Pr ⎛ w ≤ x − (1 − α k ) y ⎞ = F ⎛ x − (1 − α k ) y ⎞
i k +1 ≤ x | w
Pr( w ⎜ k ⎟ ⎜ ⎟
⎝ α k ⎠ ⎝ α k ⎠

Where F is the true distribution of the company service quality


|  is uniformly distributed in [li; ui] then:
If we assume that w
⎡ ui ⎛ u j − (1 − α k ) y ⎞ ui
⎛ l j − (1 − α k ) y ⎞ ⎤
i k +1 ≤ u | w
ik ∈ I ) = ⎢∫ F ⎜
p = Pr(l j ≤ w ⎟ dy − ∫ F ⎜ ⎟ dy ⎥
k 1
∆i
ij j i
⎢⎣ li ⎝ αk ⎠ li ⎝ αk ⎠ ⎥⎦
System behavior in steady state

| Now that we know how the customers react to the decisions of the
company, we can calculate the number of customers who pay the
subscription fee and the service demand rate from customers to the
company

λ jk = ∑
i: I i ∈I
{
pijk −1 λik −1 with I = I i ∈ I : ⎡⎣ w
i ∈ I ⎤ → ⎡ b* ( w
i⎦ ⎣
i) ≥ b ⎤
}
min ⎦
Customer response to a change in
the service quality
Let λ the total service demand rate: λ = ∑ λik
i ,k

λ 2 with W /

BUT...
There is no such rule for the total number of customers N
λ jk
( ie: N calculated with N= ∑ )
j,k η j
Numerical experiment

(See Figure 4 on page 18 of the Bitran, et al. paper)


Intuitive explanation

| As the service quality decreases, the probability that the


customer leaves the company increases. At the same time his
number of interactions decreases
| Let’s study the effects of this on the length of stay:

E (length of stay)=E (total number of interaction) x (Average interval between interaction)

Decrease with a lower service quality Increase with a lower service quality

| The length of stay can thus increase with the decrease of


service quality and thus make the number of customer increase
Customer response to a change in
the company pricing policy

pu and ps affect directly wmax which in turn affects λ .


For a higher price, customers expect a better service
Consequently: λ 2 with pu and ps /

BUT...
There is no such rule for the total number of customers N
Numerical experiment

(See Figure 5 on page 21 of the Bitran, et al. paper)


Intuitive explanation

| Based on the monotonicity of η*, the increase of pu will


produce an increase in the time between customer
interactions
| But at the same time, the increase of pu will make the
criteria for staying in the company more strict and thus the
number of interactions will decrease
| There is therefore no direct relation between the length of
stay and pu, and consequently, no direct relation between N
and pu
| On the other hand : N 2 with ps /
Agenda

| Problem raised by the paper

| Model description
z Individual customer behavior
z Aggregate customer behavior

| System behavior in steady state

| Profit optimization
Problem description

| Revenue:
R = λ pu + Nps

| Cost:
C (λ , W )

| Thus we have the following nonlinear program to solve:


max Π = λ pu + Nps − C (λ , W )
Such that: λ = g ( pu , ps ,W )
N = h( pu , ps , W )
W ≥0
Solving and interpretation

| Using the Lagrange multipliers we obtain the equations:

(See equations 12, 13, and 14 on page 14 of the Bitran, et al. paper)

| Those equations equate marginal revenue with marginal


costs
| Each of them can be decomposed into several intuitive parts
Conclusion

| This paper gives the analytical tools to understand the


complex relation between pricing policy, service quality and
customer base and behavior
| The main originality of this paper is the introduction of this
factor of relation depth: η
| Principal criticism: the paper does not take into account the
fact that there is a difference between subscribing to the
whole period and subscribing for one interaction. At the end
of each period, even if the customer had been satisfied
enough to make another interaction, he could decide that
overall the service is not good enough to pay for another
whole period

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