Option Contracts and Capacity Management—Enabling Price Discrimination under Demand Uncertainty

Abstract

We explore using an option contract as a price discrimination tool under demand uncertainty. In our capacity game model, a monopolistic supplier has to build capacity before observing the uncertain demand. The demand is generated by two potential customers, who privately know their own types. The types could be either high or low, differing in willingness to pay for each unit of demand. To discriminate between the customer types, the supplier designs option contracts so that only the high type will buy options in advance. The high type will do so because the options can hedge their risk of demand loss when capacity is tight. The supplier profits in three ways. First, the high type customers pay higher marginal prices on average. Second, the high type customers' demand is satisfied as a first priority, guaranteeing allocation efficiency. Third, the supplier can observe the number of options being purchased and so determine customer types, improving capacity investment efficiency. We compare our results to those of classical second degree price discrimination. We show that our proposed framework guarantees the same level of supplier profit even when the supplier cannot discriminate between the customers by bundling products.