Product line selection and pricing under a share-of-surplus choice model

Abstract Product line selection and pricing decisions are critical to the profitability of many firms, particularly in today’s competitive business environment in which providers of goods and services are offering a broad array of products to satisfy customer needs. We address the problem of selecting a set of products to offer and their prices when customers select among the offered products according to a share-of-surplus choice model. A customer’s surplus is defined as the difference between his utility (willingness to pay) and the price of the product. Under the share-of-surplus model, the fraction of a customer segment that selects a product is defined as the ratio of the segment’s surplus from this particular product to the segment’s total surplus across all offered products with positive surplus for that segment. We develop a heuristic procedure for this non-concave, mixed-integer optimization problem. The procedure utilizes simulated annealing to handle the binary product selection variables, and a steepest-ascent-style procedure that relies on certain structural properties of the objective function to handle the non-concave, continuous portion of the problem involving the prices. We also develop a variant of our procedure to handle uncertainty in customer utilities. In computational studies, our basic procedures perform extremely well, producing solutions whose objective values are within about 5% of those obtained via enumerative methods. Our procedure to handle uncertain utilities also performs well, producing solutions with expected profit values that are roughly 10% higher than the corresponding expected profits from solutions obtained under the assumption of deterministic utilities.