Product line optimization in the presence of preferences for compromise alternatives

Abstract

Recent advances in customer choice analysis demonstrated the strong impact of compromise alternatives on the behaviour of decision-makers in a wide range of decision situations. Compromise alternatives are characterized by an intermediate performance on some of the relevant attributes. For instance, price compromises are well known in the sense that customers tend to buy neither the cheapest, nor the most expensive alternative, but the mid-priced one. However, thus far, the literature on product line optimization has not considered such context effects.In this paper, we propose a model-based approach for optimal product line selection which incorporates customers’ preferences for compromise alternatives. We consider customer choice in a realistic, sophisticated fashion by applying an established utility model that integrates compromise variables into a multinomial logit model. We formulate the resulting optimization problem as a mixed-integer linear program. The challenging feature for modelling – making the formulation substantially more complicated than existing ones without compromises – are the endogenous effects of selected products on other alternatives’ utilities that need to be adequately captured via compromise variables. Based on data we collected by a stated choice experiment in a retail setting, we perform a computational study and demonstrate the superiority of our product line selection approach compared to a reference model that does not take compromises into account. Even under uncertainty of the estimated utility parameters, profit gains of, on average, 23% can be achieved in our experimental setting.