Profitability of Service‐Level‐Based Price Differentiation with Inventory Rationing

Abstract

In this paper, we study the profitability of service‐level‐based price differentiation (SLBPD) in an inventory‐rationing context. SLBPD implies that a company offers several combinations of prices and guaranteed service levels, from which customers self‐select; different customers choose different offerings because they incur different shortage costs if an order is not fulfilled immediately. We develop an analytical model for SLBPD and explore if and when such a service differentiation strategy yields higher profits than a single undifferentiated offering. The results of our analyses suggest that SLBPD is profitable only if a company faces pricing restrictions, e.g., because of competitive pressure or regulatory restrictions. We develop necessary and sufficient conditions under which a specific and relevant form of SLBPD (called “service‐level‐based upselling”) is profitable, and provide an algorithm to compute the optimal parameters of such a policy. Based on this algorithm we carry out numerical analyses that allow us to characterize the profit increment of service‐level‐based upselling. We derive managerial insights into the attractiveness of SLBPD and explain how our basic analytical framework can be extended to account for more complex practical features.