Economic Models with

Fixed Costs
John Howell and Greg Allenby
The Ohio State University

We wish to thank Sawtooth Technologies and an anonymous client

for generously allowing us to share the data

Our Problem
Agricultural Equipment Manufacturer
Developed a new machine for detecting diseases
Two components: a test reader and disposable
test strips
Three different test strips to detect three
different diseases
Study is real client study, but attributes and
levels have been disguised

Primary Objective
Estimate the volume of both readers and test
strips sold under different pricing scenarios
CBC not sufficient as it does not directly allow
for volume estimates
Volumes should depend on both the reader
price and the test strip prices

Example Screen
Please select the option you would chose and indicate how many tests you would
purchase for system you selected.
Reader 1

Reader 2

Reader 3

Option 1 for $6,000

Option 2 for $5,000

Option 3 for $10,000

Feature Level 1

Feature Level 2

Feature Level 1

Service Level 1

Service Level 2

Service Level 4

Disease 1: $10/Test
Disease 2: $7/Test
Disease 3: $15/Test

Disease 1: $12/Test
Disease 2: $6/Test
Disease 3: $10/Test

Disease 1: $6/Test
Disease 2: $9/Test
Disease 3: $5/Test

I would not purchase

any of these readers

Disease 1 tests per year

Disease 2 tests per year
Disease 3 tests per year

Prior Work
Tom Eagle presented a number of models at
previous conference
Regression based approach
Choice Modeling approaches
Volume = Share * MEV

Joint Discrete/Continuous models

Economic Models

Whats New?
Fixed Cost: A one time cost that a consumer
must incur in order to participate in a market
Need not be monetary

Variable Cost: The cost associate with each

unit

Examples

Examples

Examples

Examples

Examples

Examples

Fixed Cost
Make purchasing small quantities too costly
leading to no purchases with small quantities
Expect to observe no data with small purchase
quantities

Intuition
A consumer will buy a product as long as the
benefit outweighs the cost
With Fixed Costs

For small quantities the price per unit is high,

but decreases as quantity increases

Demand including fixed costs w/ varying preferences

2
1
0

Product 2

All products purchased

P2 & P3 Purchased
P1 & P3 Purchased
P1 & P2 Purchased
Only 1 Product Purchased

4
Product 1

Properties of Fixed Costs

Create local monopolies through switching

costs
Cause respondents to self-screen in to high
volume purchasers and no volume
purchasers

11

Simple Economic Model

. .

12

Simple Economic Model

Product of Interest

Outside Good

. .

12

Simple Economic Model

Baseline Preference for x

. .
Expenditure

Fixed Cost for x Variable Cost for x

12

Simple Economic Model

Diminishing Marginal Benefit

. .
Fixed cost only applies if x is positive

12

Preference Parameter

    d 

13

Preference Parameter

    d 

Part-worths

13

Preference Parameter

    d 

13

One Product Example

15

Optimal Indifference Curves for various values of

14
13
12
11
10

Outside Good

9
8
7
6

x = .4

4
3
Minimum Demand non-zero demand for inside good

x = .8

Bu
dg
et
Co
nst
rai
nt

1
0

Inside Good

14

Example Screen
Please select the option you would chose and indicate how many tests you would
purchase for system you selected.
Reader 1

Reader 2

Reader 3

Option 1 for $6,000

Option 2 for $5,000

Option 3 for $10,000

Feature Level 1

Feature Level 2

Feature Level 1

Service Level 1

Service Level 2

Service Level 4

Disease 1: $10/Test
Disease 2: $7/Test
Disease 3: $15/Test

Disease 1: $12/Test
Disease 2: $6/Test
Disease 3: $10/Test

Disease 1: $6/Test
Disease 2: $9/Test
Disease 3: $5/Test

I would not purchase

any of these readers

Disease 1 tests per year

Disease 2 tests per year
Disease 3 tests per year

15

Bayesian Estimation
Bayesian modeling makes this easier
Bayesian Data Augmentation
Estimate so and E easily estimated

Gibbs Sampling with adaptive rejection sampling

to efficiently estimate

Details available in paper

Email me (howell.316@osu.edu) for a copy

16

Sample Characteristics
3 categorical attributes plus 4 continuous
prices
220 respondents from population of 3500
Only 147 were usable for estimation

12 choice tasks
Difficult task
Respondents asked to make product choice and
then provide volume estimates

17

600
400
200
0

Number of Observations

800

Raw Data

0 1600 3750 6000 8200

11000

14000

18000

21000

Total Number of Tests per Year

18

600
400
0

10

20

30

40

50

200
0

Number of Observations

800

Raw Data

60

80

100

125

143

160

190

0 1600 3750 6000 8200

11000

14000

18000

21000

Total Number of Tests per Year

18

10

20

30

40

50

Raw Data

g
e
t
o

d
n
i
p

n
a
m

60

80

100

125

143

160

190

19

Model Validation
Compared fit of two holdout tasks
3 Products + None
3 Volume estimates for chosen product

Total of 3 reader volume and 9 test volume

estimates

20

Holdout 1-Reader Volume

50

25

0
Choice 1

Predicted
*RMSE = 5.93%

Choice 2

Choice 3

Actual
21

Holdout 2 - Reader Volume

50

25

0
Choice 1

Predicted
*RMSE = 3.55%

Choice 2

Choice 3

Actual
22

Comparison to CBC
CBC does not natively handle volume
estimation
Procedure
Calculate the max test volume for each
respondent (MEV) for each test
Weight the share predictions by individuals
average volume
Volume = ShareReader*MEVDisease
23

40

60

80

100

120

140

CBC Raw Predictions

20

g
o
N

d
n
i
p

n
a
m

23

50

75

100

125

150

175

200

24

Comparison with CBC

RMSE

FCCA

CBC

Holdout 1

5.93%

10.31%

Holdout 2

3.6%

5.0%

25

Test Volume Comparison

RMSE

FCCA

CBC

Holdout 1

768.24

1375.66

Holdout 2

642.89

687.27

26

Example Simulation
Fixed costs screen out low volume
purchasers
Low volume customer may be unprofitable
Optimize allocation of sales, service, and
support resources

27

Example Simulation
Screening Respondents
Base Case

$0 Reader

Purchase Structure 1

Purchase Structure 1

$X,000 Reader

$0 Reader

Feature Level 1

Feature Level 1

Service Level 3

Service Level 3

Same Test Strip Prices

Same Test Strip Prices

28

Results
Base Case

$0 Reader

%Change

Customers

17.21

71.3

314%

Disease 1

25,115

66,765

166%

Disease 2

10,309

29,566

187%

Disease 3

1,047

4,692

348%

Revenue

49%

Revenue/
Customer

-64%

29

Summary
Pros:
Theoretically Sound
Accurate volume estimates
Automatically enforces economic constraints
Volumes sensitive to product configuration and all
prices
Allows wider range of possible simulations

Cons:
Estimation more difficult
Simulation more difficult
No packaged software yet
30

Thank You
31