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FundamentalsofPricingand RevenueManagement
Chapter4 Lesson3
Outline
AirlinePricingandODMarkets
PricingStrategies PriceDiscriminationvs.ProductDifferentiation
AirlineDifferentialPricing
willingnesstopay(WTP)
AirlineRevenueManagement
AirlinePricingandODMarkets PricingStrategies
AirlinePricesandODMarkets
Pricing referstotheprocessofdeterminingfarelevels,combined withvariousserviceamenitiesandrestrictions,forasetoffare productsinanorigindestinationmarket RevenueManagement isthesubsequentprocessofdetermining howmanyseatstomakeavailableateachfarelevel RegulatedPricing theCivilAeronauticsBoard(CAB)useda mileagebasedformulatoensureequalpricesforequaldistances Deregulated orLiberalizedPricing DifferentODmarketscan havepricesnotrelatedtodistancetraveled,oreventheairlines operatingcosts,asairlinesmatchlowfarecompetitorstomaintain marketpresenceandshareoftraffic
ItspossiblethatlowvolumeODmarketsaremorecostlytoserveper passengerbasiswillseehigherpricesthanhighdensityODmarkets,even ifsimilardistancesareinvolved
TheoreticalPricingStrategies
FordeterminingpricestochargeinanODmarket, airlinescanutilizeoneoffollowingeconomicprinciples:
Costbasedpricing Demandbasedpricing Servicebasedpricing
Inpractice,mostairlinepricingstrategiesreflectamixof thesetheoreticalprinciples:
PricesarealsohighlyaffectedbycompetitionineachOD Market IntheUS,severecompetitioninsomemarketshasledto pricebasedcosting,meaningairlinesmustreducecoststo beabletomatchlowfarecompetitorsandpassengers price expectations
PriceDiscriminationvs.Product Differentiation
Pricediscrimination:
Thepracticeofchargingdifferentpricesforsameproduct withsamecostsofproduction Basedsolelyondifferentconsumers willingnesstopay
Productdifferentiation:
Chargingdifferentpricesforproductswithdifferent characteristicsandcostsofproduction
Currentairlinefarestructuresreflectbothstrategies:
DifferentialPricingbasedondifferentiatedfareproducts Buthigherpricesforfareproductstargetedatbusiness travelersareclearlybasedontheirwillingnesstopay
AirlinePricingPractices
Differentialpricingpresentsatradeofftocustomers betweeninconvenienceandpricelevels:
Businesstravelersarewilling topayhigherfaresinreturn formoreconvenience,fewerrestrictionsonuseoftickets Leisuretravelerslesswilling topayhigherprices,butaccept disutilitycosts ofrestrictionsonlowfareproducts
Economicconceptofwillingnesstopay(WTP)isdefined bythetheoreticalpricedemandcurve:
Willingness doesnotmeanhappiness inpayinghigher prices DifferentialpricingattemptstomakethosewithhigherWTP purchasethelessrestrictedhigherpricedoptions
DifferentialPricingTheory(circa2000)
Marketsegmentswith differentwillingnessto pay forairtravel Differentfareproducts offeredtobusiness versusleisuretravelers Preventdiversionby settingrestrictionson lowerfareproductsand limitingseatsavailable Increasedrevenuesand higherloadfactorsthan anysinglefarestrategy
Price
Demand
AirlineDifferentialPricing
WhyDifferentialPricing?
Itallowstheairlinetoincreasetotalflightrevenueswithlittleimpact ontotaloperatingcosts: Incrementalrevenuegeneratedbydiscountfarepassengerswho otherwisewouldnotfly Incrementalrevenuefromhighfarepassengerswillingtopay more Studieshaveshownthatmosttraditional highcostairlinescould notcovertotaloperatingcostsbyofferingasinglefarelevel Consumerscanalsobenefitfromdifferentialpricing: Mostnotably,discountpassengerswhootherwisewouldnotfly Itisalsoconceivablethathighfarepassengerspaylessand/or enjoymorefrequencygiventhepresenceoflowfarepassengers Ifairlinecouldchargeadifferentpriceforeachcustomerbasedon theirWTP,itsrevenueswouldbeclosetothetheoreticalmaximum
MarketSegmentation
BusinessandLeisuretravelersarethetwo traditionalsegmentstargetedbytheairlinesin theirdifferentpricingefforts
FirstClass,BusinessClass,andEconomy Restrictionsonadvancepurchase,use,and refundability
TraditionalApproach:Restrictionson LowerFares
Progressivelymoresevererestrictionsonlowfare productsdesignedtopreventdiversion:
Lowestfareshaveadvancepurchaseandminimumstay requirements,aswellascancellationandchangefees Restrictionsincreasetheinconvenienceordisutility cost oflowfarestotravelerswithhighWTP,forcing themtopaymore StudiesshowSaturdaynightminimumstay condition tobemosteffectiveinkeepingbusinesstravelersfrom purchasinglowfares
Still,itisimpossibletoachieveperfectsegmentation:
SometravelerswithhighWTPcanmeetrestrictions Manybusinesstravelersoftenpurchaserestrictedfares
Example:RestrictionDisutilityCosts
Example:BOSSEATraditional Fares
RoundTrip Fare($) $458 $707 $760 $927 $1001 $2083 $2262 $2783 Cls N M M H H B Y F Advance Purchase 21days 21days 21days 14days 14days 3days None None Minimum Stay Sat.Night Sat.Night Sat.Night Sat.Night Sat.Night None None None Change Fee? Yes Yes Yes Yes Yes No No No Comment Tue/Wed/Sat Tue/Wed ThurMon Tue/Wed ThurMon 2xOWFare 2xOWFare FirstClass
Figure4.5
FareSimplification: LessRestrictedandLowerFares
Recenttrendtowardsimplified farescompressedfare structureswithfewerrestrictions
InitiatedbysomeLFAsandAmericaWest,followedbyAlaska Mostrecently,implementedinallUSdomesticmarketsby Delta,matchedselectivelybylegacycompetitors
Simplifiedfarestructurescharacterizedby:
NoSaturdaynightstayrestrictions,butadvancepurchaseand nonrefundable/changefees Revenuemanagementsystemsstillcontrolnumberofseats soldateachfarelevel
Higherloadfactors,but1015%lowerrevenues:
Significantlyhigherdiversionwithfewerrestrictions
Example:BOSATLSimplifiedFares DeltaAirLines,April2005
RevenueImpactofEachSimplification
ImpactsonDifferentialPricingModel
Dropinbusiness demandandwillingness topayhighestfares Greaterwillingnessto acceptrestrictionson lowerfares Reductioninlowest farestostimulatetraffic andrespondtoLCCs Resultislowertotal revenueandunitRASM despitestableload factors
Price
Demand
AirlineRevenueManagement
AirlineRevenueManagement
Twocomponentsofairlinerevenuemaximization:
DifferentialPricing: Variousfareproducts offeredatdifferentpricesfor travelinthesameODmarket YieldManagement(YM): Determinesthenumberofseatstobemadeavailableto eachfareclass onaflight,bysettingbookinglimitson lowfareseats
Typically,YMtakesasetofdifferentiated prices/productsandflightcapacityasgiven:
Withhighproportionoffixedoperatingcostsfora committedflightschedule,revenuemaximizationto maximizeprofits
WhyCallitYieldManagement?
MainobjectiveofYMistoprotectseatsforlaterbooking, highfarebusinesspassengers. YMinvolvestacticalcontrolofairlinesseatinventory:
Buttoomuchemphasisonyield(revenueperRPM)canlead tooverlyseverelimitsonlowfares,andloweroverallload factors Toomanyseatssoldatlowerfareswillincreaseloadfactors butreduceyield,adverselyaffectivetotalrevenues
Revenuemaximizationispropergoal:
Requiresproperbalanceofloadfactorandyield
ManyairlinesnowrefertoRevenueManagement(RM) insteadofYieldManagement
SeatInventoryControlApproaches
Figure4.11
ComputerizedRMSystems
Sizeandcomplexityofatypicalairlinesseatinventory controlproblemrequiresacomputerizedRMsystem ConsideraUSMajorairlinewith:
500flightlegsperday 15bookingclasses 330daysofbookingsbeforedeparture
Atanypointintime,thisairlinesseatinventoryconsists ofalmost2.5millionbookinglimits:
Thisinventoryrepresentstheairlinespotentialforprofitable operation,dependingontherevenuesobtained Fartoolargeaproblemforhumananalyststomonitoralone
Typical3rdGenerationRMSystem
Collectsandmaintainshistoricalbookingdataby flightandfareclass,foreachpastdeparturedate. Forecastsfuturebookingdemandandnoshowrates byflightdeparturedateandfareclass. Calculateslimitstomaximizetotalflightrevenues:
Overbookinglevelstominimizecostsofspoilage/denied boardings Bookingclasslimitsonlowvalueclassestoprotecthigh fareseats
InteractivedecisionsupportforRManalysts:
Canreview,acceptorrejectrecommendations
ExampleofThirdGenerationRMSystem
Figure4.12
RevenueManagementTechniques
Overbooking
Acceptreservationsinexcessofaircraftcapacityto overcomelossofrevenuesduetopassengernoshow effects
FareClassMix(FlightLegOptimization)
Determinerevenuemaximizingmixofseatsavailableto eachbooking(fare)classoneachflightdeparture
TrafficFlow(OD)Control(NetworkOptimization)
Furtherdistinguishbetweenseatsavailabletoshorthaul (oneleg)vs.longhaul(connecting)passengers,to maximizetotalnetworkrevenues
FlightOverbooking
Determinemaximumnumberofbookingstoaccept foragivenphysicalcapacity. Minimizetotalcostsofdeniedboardingsand spoilage(lostrevenue). U.S.domesticnoshowratescanreach1520percent offinalpredeparturebookings:
Onpeakholidaydays,whenhighnoshowsareleast desirable Averagenoshowrateshavedropped,to1015%with morefarepenaltiesandbettereffortsbyairlinestofirm upbookings
Effectiveoverbookingcangenerateasmuchrevenue gainasfareclassseatallocation.
OverbookingTerminology
PhysicalCapacity AuthorizedCapacity ConfirmedBookings NoShowRate DeniedBoardings Spoilage ShowupRate CAP AU BKD<=AU NSR DB SP SUR
Actual#ofseatsontheflight,usuallymaximumcapacityof theaircraft Maximum#ofbookingsthatanairlineiswillingtoaccept Total#ofpassengerreservationsthathavebeenaccepted Mean%ofpassengerswithconfirmedbookingsthatdonot showup
OverbookingModels
Overbookingmodelstrytominimize:
Totalcostsofoverbooking(deniedboardings plusspoilage) Riskofexcessive deniedboardingson individualflights,forcustomerservicereasons
Mathematicaloverbookingproblem:
FindOV>1.00suchthatAU=CAP*OV Butactualnoshowrateishighlyuncertain
Manual/JudgmentalApproach
Reliesonjudgmentofhumananalysttoset overbookinglevel:
Basedonmarketexperienceandperhapsrecent noshowhistory TendencytochooseOV=1+NSR(orlower) TendencytofocusonavoidanceofDB
ForCAP=100andmeanNSR=.20,then:
AU=100(1.20)=120
DeterministicModel
BasedonestimateofmeanNSRfromrecent history:
AssumethatBKD=AU(worstcasescenario) FindAUsuchthatAUNSR*AU=CAP Or,AU=CAP/(1NSR)
ForCAP=100andNSR=0.20,then:
AU=100/(1.20)=125
Probabilistic/RiskModel
IncorporatesuncertaintyaboutNSRforfutureflight:
StandarddeviationofNSRfromhistory,STD
FindAUthatwillkeepDB=0,assumingBKD=AU,witha 95%levelofconfidence:
Assumeaprobability(Gaussian)distributionofnoshowrates
KeepshowupslessthanorequaltoCAP,whenBKD=AU:
FindSUR*,sothatAUxSUR*=CAP, andProb[AUxSUR*>CAP]=5%
FromGaussiandistribution,SUR*willsatisfy:
Z=1.645=SUR*SUR STD whereSUR=meanshowuprate STD=standarddeviationofshowuprate
Probabilistic/RiskModel(cont.)
OptimalAUgivenCAP,SUR,STDwithobjectiveof DB=0with95%confidenceis:
AU= CAP SUR+1.645STD = CAP 1NSR+1.645STD
Inourexample,withSTD=0.05&NSR=.20:
AU=100/(10.20+1.645*0.05)=113
MoreOverbookingTerminology
Waitlistedpassengers Goshowpassengers Standbypassengers Noshows Showups PassengersBoarded VoluntaryDB WL GS SB NS SU PAX VOLDB
ProbabilisticModelExtensions
ReducelevelofconfidenceofexceedingDBlimit:
Zfactorindenominatorwilldecrease,causingincreasein AU
IncreaseDBtolerancetoaccountforvoluntaryDB:
Numeratorbecomes(CAP+VOLDB),increasesAU
IncludeforecastedemptyForCcabinseatsfor upgrading:
Numeratorbecomes(CAP+FEMPTY+CEMPTY),increasesAU EmptyF+Ccouldalsobeoverbooked
Deductgroupbookingsandoverbookremaining capacityonly:
Firmgroupsmuchmorelikelytoshowup FlightswithfirmgroupsshouldhavelowerAU
CostBasedOverbookingModel
FindAUthatminimizes:
[CostofDB+CostofSP]
ForanygivenAU:
TotalCost=$DB*E[DB]+$SP*E[SP] $DBand$SP=costperDBandSP,respectively E[DB]=expectednumberofDBs,givenAU E[SP]=expectednumberofSPseats,givenAU
MathematicalsearchoverrangeofAUvaluestofind minimumtotalcost.
Example:CostBasedOverbookingModel
CostInputstoOverbookingModel
DeniedBoardingCosts:
CashcompensationforinvoluntaryDB FreetravelvouchersforvoluntaryDB Mealandhotelcostsfordisplacedpassengers Spaceonotherairlines Costoflostpassengergoodwillcosts
Manyairlineshavedifficultyproviding accurateDBcostinputstothesemodels.
DynamicRevisionandIntervention
RMsystemsreviseforecastsandreoptimizebooking limitsatnumerouscheckpoints ofthebookingprocess:
Monitoractualbookingsvs.previouslyforecasteddemand Reforecastdemandandreoptimizeatfixedcheckpointsor whenunexpectedbookingactivityoccurs Canmeansubstantialchangesinfareclassavailabilityfrom onedaytothenext,evenforthesameflightdeparture
Substantialproportionoffaremixrevenuegaincomes fromdynamicrevisionofbookinglimits:
Humaninterventionisimportantinunusualcircumstances, suchasunexplained surgesindemandduetospecialevents
CurrentStateofRMPractice
Mostofthetop25worldairlines(intermsofrevenue) haveimplemented3rdgenerationRMsystems. Manysmallercarriersarestilltryingtomakeeffectiveuse ofleg/fareclassRM
LackofcompanywideunderstandingofRMprinciples Historicalemphasisonloadfactororyield,notrevenue Excessiveinfluenceand/orRMabusebydominantsalesand marketingdepartments Issuesofregulation,organizationandculture
Aboutadozenleadingairlinesarelookingtoward networkODcontroldevelopmentandimplementation
Thesecarrierscouldachievea25yearcompetitiveadvantage withadvancedrevenuemanagementsystems
SingleLegSeatAllocation Problem
Givenforafutureflightlegdeparture:
Totalbookingcapacityof(typically)thecoach compartment Severalfare(booking)classesthatsharethesame inventoryofseatsinthecompartment Forecastsoffuturebookingdemandbyfareclass Revenueestimatesforeachfare(booking)class
Objectiveistomaximizetotalexpected revenue:
Allocateseatstoeachfareclassbasedonvalue
CostInputs(contd)
SpoilageCosts:
Lossofrevenuefromseatthatdepartedempty
Whatisbestmeasureofthislostrevenue:
Averagerevenueperseatforleg? Highestfareclassrevenueonleg(sinceclosed flightsloselatebookingpassengers)? Lowestfareclassrevenueonleg(sinceincreased AUwouldhaveallowedanotherdiscountseat)?
Specifyingspoilagecostsisjustasdifficult.
Voluntaryvs.InvoluntaryDBs
ComprehensiveVoluntaryDBProgram:
Requirestrainingandcooperationofstationcrews Identifypotentialvolunteersatcheckin Offerasmuchsoft compensationasneededto makethepassengerhappy
USairlinesverysuccessfulinmanagingDBs:
2007involuntaryDBratewas1.12per10,000 Over90%ofDBsinU.S.arevolunteers Goodtreatmentofvolunteersgeneratesgoodwill
FlightLegRevenueOptimization
Givenforafutureflightlegdeparture:
Totalbookingcapacityof(typically)thecoach compartment Severalfare(booking)classesthatsharethesame inventoryofseatsinthecompartment Forecastsoffuturebookingdemandbyfareclass Revenueestimatesforeachfare(booking)class
Objectiveistomaximizetotalexpected revenue:
Allocateseatstoeachfareclassbasedonvalue
Partitionedvs.SerialNesting
InapartitionedCRSinventorystructure,allocationsto eachbookingclassaremadeseparatelyfromalltheother classes. EXAMPLE(assuminguncertaindemand):
Giventhefollowingallocationsforeachof3classesY=30,B =40,M=70foranaircraftcoachcabinwithbookingcapacity =140. If31Ycustomersrequestaseat,theairlinewouldrejectthe 31strequestbecauseitexceedstheallocationfortheYclass Itispossiblethatairlinewouldrejectthe31stYclass customer,eventhoughitmightnothavesoldallofthe(lower valued)BorMseatsyet!
SeriallyNestedBuckets
DeterministicSeatAllocation/Protection
Ifweassumethatdemandisdeterministic(orknownwith certainty),itwouldbesimpletodeterminethefareclass seatallocations
Startwithhighestfareclassandallocate/protectexactlythe numberofseatspredictedforthatclass,andcontinuewith thenextlowerfareclassuntilcapacityisreached.
EXAMPLE:3fareclasses(Y,B,M)
DemandforY=30,B=40,M=85 Capacity=140
EMSRbModelforSeatProtection: Assumptions
Basicmodelingassumptionsforserially nestedclasses:
demandforeachclassisseparateand independentofdemandinotherclasses. demandforeachclassisstochasticandcanbe representedbyaprobabilitydistribution lowestclassbooksfirst,initsentirety,followed bythenextlowestclass,etc. bookinglimitsareonlydeterminedonce(i.e., staticoptimizationmodel)
EMSRbModelCalculations
Becausehigherclasseshaveaccesstounused lowerclassseats,theproblemistofindseat protectionlevelsforhigherclasses,and bookinglimitsonlowerclasses Tocalculatetheoptimalprotectionlevels:
DefinePi(Si)=probabilitythatXi>Si, whereSiisthenumberofseatsmadeavailableto classi,Xiistherandomdemandforclassi
EMSRbCalculations(contd)
TheexpectedmarginalrevenueofmakingtheSth seatavailabletoclassiis:
EMSRi(Si)=Fi*Pi(Si)whereRiistheaveragerevenue(or fare)fromclassi
Theoptimalprotectionlevel,1forclass1fromclass 2satisfies:
EMSR1(1)=F1*P1(1)=R2
ExampleCalculation
Considerthefollowingflightlegexample: Class MeanFcst. Std.Dev. Fare Y 10 3 1000 B 15 5 700 M 20 7 500 Q 30 10 350 TofindtheprotectionfortheYfareclass,we wanttofindthelargestvalueofYforwhich EMSRY(Y )=FY*PY(Y )>RB
Example(contd)
EMSRY(Y )=1000*PY(Y)>700PY(Y )>0.70 wherePY (Y )=probabilitythatXY>Y.
ProbabilityCalculations
Next,weuseExcelorgototheStandardNormal CumulativeProbabilityTablefordifferent guesses forY.Forexample,
forY =7,Prob{(XY 10)/3>(10)/3}=0.8417 forY =8,Prob{(XY 10)/3>(10)/3}=0.7478 forY =9,Prob{(XY 10)/3>(10)/3}=0.639
NetworkRevenueManagement: OriginDestinationControl
Vastmajorityofworldairlinesstillpracticefare classcontrol:
Highyield(full)faretypesintopbookingclasses Loweryield(discount)faresinlowerclasses Designedtomaximizeyields,nottotalrevenues
Seatsforconnectingitinerariesmustbe availableinsameclassacrossallflightlegs:
Airlinecannotdistinguishamongitineraries Bottlenecklegscanblocklonghaulpassengers
YieldBasedFareClassStructure (Example)
ConnectingFlightNetworkExample
JFK
LH300 FRA
LH200
HKG
LH100 NCE
TheODControlMechanism
Revenuemaximizationoveranetworkof connectingflightsrequirestwostrategies:
1. Increaseavailabilitytohighrevenue,longhaul passengers,regardlessofyield; 2. Preventlonghaulpassengersfromdisplacing highyieldshorthaulpassengersonfullflights.
Revenuebenefitsof(1)outweighrisksof(2):
Probabilityofbothconnectingflightsbeing fullybookedislow,relativetootherpossible outcomes
WhatisODControl?
ThecapabilitytorespondtodifferentOD requestswithdifferentseatavailability. Canbeimplementedinavarietyofways:
Revenuevaluebuckets(greedyapproach) EMSRheuristicbidprice Displacementadjustedvirtualnesting Networkoptimal bidpricecontrol
Alloftheabovecanincreaserevenues,but eachonehasimplementationtradeoffs.
RevenueValueBucketConcept
Fixedrelationshipbetweenfaretypeand bookingclassisabandoned:
Bookingclasses(buckets)definedaccordingto revenuevalue,regardlessoffarerestrictions Eachitinerary/faretype(i.e..,ODF)assignedto arevenuevaluebucketoneachflightleg ODFseatavailabilitydependsonvaluebuckets
ValueBucketImplementation
WithinExistingBookingClasses:
Farecodesneedtoberepublishedaccordingto revenuevalue;nochangestoinventorystructure DoesnotrequireseamlessCRSlinks,butcanbe confusingtotravelagentsandconsumers
DevelopmentofVirtualInventoryClasses:
Substantialcostofnewinventorystructureand mappingfunctionstovirtualclasses CRSseamlessavailabilitylinksareessential
VirtualClassMappingbyODFRevenueValue
Figure4.17
ValueBucketODControl
AllowsODcontrolwithexistingRMsystem:
Datacollectionandstoragebyleg/valuebucket Forecastingandoptimizationbyleg/valuebucket DifferentODFrequestsgetdifferentavailability
Butalsohaslimitations:
RebucketingofODFsdisturbsdataandforecasts Legbasedoptimization,notanetworksolution Cangivetoomuchpreferencetolonghaul passengers(i.e...,greedy approach)
DisplacementCostConcept
ActualvalueofanODFtonetworkrevenue onalegislessthanorequaltoitstotalfare:
Connectingpassengerscandisplacerevenueon downline(orupline)legs
Howtodeterminenetworkvalueofeach ODFforODcontrolpurposes?
Networkoptimizationtechniquestocalculate displacementcostoneachflightleg LegbasedEMSRestimatesofdisplacement
ValueBucketswithDisplacement
Givenestimateddownlinedisplacement, ODFsaremappedbasedonnetworkvalue:
NetworkvalueonLeg1=Totalfareminussum ofownlinelegdisplacementcosts Underhighdemand,availabilityforconnecting passengersisreduced,localsgetmoreseats
Revisionofdisplacementcostsisanissue:
Frequentrevisionscapturedemandchanges,but ODFremappingcandisruptbucketforecasts
AlternativeMechanism:BidPrice
Undervaluebucketcontrol,acceptODFifitsnetwork valuefallsintoanavailablebucket:
NetworkValue>ValueofLastSeatonLeg;or FareDisplacement>ValueofLastSeat
ODBidPriceControl
Muchsimplerinventorycontrolmechanism thanvirtualbuckets: Simplyneedtostorebidpricevalueforeach leg EvaluateODFfarevs.itinerarybidpriceattime ofavailabilityrequest Mustrevisebidpricesfrequentlytoprevent toomanybookingsofODFsatcurrentbidprice Bidpricescanbecalculatedwithnetwork optimizationtoolsorlegbasedheuristics
Example:BidPriceControl
ABCD Givenlegbidprices BC:$240 CD:$160
AB:$35
AB:$35 BC:$240 AC BidPrice=$275 Y $519 M $374 B $292 Q $201 AD BidPrice=$435 Y $582 M $399 B $322 Q $249
Networkvs.HeuristicModels
Estimatesofdisplacementcostsandbid pricescanbederivedusingeitherapproach:
MostODRMsoftwarevendorsclaimnetwork optimal solutionspossiblewiththeirproduct Mostairlineslackdetaileddataandface practicalconstraintsinusingnetwork optimizationmodels Stillsubstantialdebateamongresearchersabout whichnetworkODsolutionismostoptimal
Revenuegain,notoptimality,iscriticalissue