Adding features to a product: A micro-economic model

Abstract

During the development stages of a new product, a firm needs to determine what product features to add, the selling price, the production capacity that must be allocated to the product, and how this product with its bundle of features will affect the firm's share value. In this paper we develop a cash flow model for a product in the design stage where desirable features may or may not be added to the basic product. Contingent claims pricing techniques are used to calculate the present value of the cash flows and to provide a framework for determining the bundle of features and the pricing and production strategies that maximize the firm's value. The results indicate that under certain conditions additional product features may be desirable even when the premium that can be added to the price due to the new features is lower than the unit cost of producing the features. The paper analyzes the impact of demand volatility, the growth rate of demand, the price sensitivity of demand, and the split of costs between variable and fixed on the decision to add features.