Managing supply risk for high-tech products under stockout-based substitution1

Abstract

The aim of this paper is to investigate pricing and production decisions of a monopoly firm that operates a co-product technology with two grades. A novel mathematical model that embeds a utility-maximizing customer choice model is developed to solve this problem. The closed-form expressions for the optimal solutions are derived and the results suggest that the distribution of customer valuations, yield rate and demand uncertainties have a vital influence on the firm’s optimal prices and profits. We then extend our study by allowing stockout-based substitution where a customer may be willing to purchase a substitute if his most preferred product is not available but the substitute provides him with non-negative utility. The results indicate that disregarding stockout-based substitution (i) results in severe supply-demand mismatches for the product line in two directions; (ii) leads to higher or lower profit margins for both products; (iii) may not cause profit loss when the prices of both products are exogenous; however, this result does not hold when the prices are endogenous.