product L βc. In the second period, the expected profit function for the firm is
(p2L − βc) θ2 − p2L _p2L if pH > pL + θ2(1 − β),
β
(p2H _ p2H +
c) θ2 1 −β pL
π (θ , p ) = − − − if p p + θ (1 β),
β H L
2 2 2 _ p2H p2L _ p2L 2
≤ ≤ −
(p2L βc) 1 − β
_ β _
(p2H − − − if pH < pL .
c) (θ2 p2H ) β
− −
With this cost structure, the optimal product decision is to sell product H only in period 2 at the price of p∗2H = 12 (θ2 + c). Back in period 1, we have also four options : H only, H and L, L only, hold-up. The conditions for these four options are,
respectively,
Case I : Only product L has positive demand in the first period : p1H
θ1(1 − β) for product L only and p1L ≤ Ω(θ1 − c) + βc ( since θ2 ≤ θ1) ; Case II : Only product H has positive demand in the first period : p1H <
βc) + c ( since θ2 < ), p1H ≤ Φ2 (θ1 − c) + c ( since θ2 ≤ θ1) ;
Case III : Both products H and L have positive demand in the first period : 2ΩΦ (p1L − βc) + c ≤ p1H ≤ p1L + θ1(1 − β), p1L ≤ Ω(θ1 − c) + βc ( since θ2 ≤ θ1) ;
For the rest of the region, no demand for either product is generated.
Looking back at our previous analysis of the general cases, it is easy for us to get the optimal product strategy for the first period. By checking all conditions we find that selling product H only dominates all other options in this scenario. In summary, we have the following proposition.
PROPOSITION 8: If the cost of product L is proportional to that of product H with the scale of β, i.e. cL = βcH , the optimal product arrangement in both periods is given by
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H only ⇒ H only.
Proposition 8 indicates that if the firm can always increase his quality level by incur-ring a linear cost, it would always choose to manufacture and sell the product with the highest quality level. Therefore, in those scenarios where the costs of quality im-provement are increasing but not substantial ([120], [33], [100], the firm has incentive to provide products with a higher level of quality. In some cases, the reality is that, if a firm pursues a significantly high quality level, it could become exponentially more difficult to produce their products ([82]), under the constraints of, for example, pro-cess management or technology barriers. However, for a smaller segment, the cost structure can be always approximately considered linear.
3.7 Numerical Study and Managerial Insights
In this section, we perform a numerical study, which serves two objectives. First, we studied in Section 3.3.2 how the firm chooses an optimal strategy based on all system parameters. We hope to find out how specific parameters influence the firm’s decision and in turn the product variety offered to the market. Second, we want to show how the firm benefits from static or dynamic pricing policies. During our nume-rical study, we also discuss the managerial implications of our models and results. As we have shown previously, other than product costs, vertical product differentiation (characterized by β) and the consumer’s strategic level (γ) are two major contribu-ting factors in our model. In the following section, we will first examine different combinations of β and γ, with other parameters remaining fixed : θ1 = 1, cL = 0.1 and cH = 0.2. Note that from our previous analysis, the optimal selection for cases with cH ≤ cL is product H only.
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3.7.1 Consumer’s Strategic Level
Here we investigate the impact of the consumer’s strategic level (γ). Since we have to comply with 2β − α − γ > 0, we take a set of values such that 2β − α is relatively large in order to broaden the spectrum of γ. Here we set α = 0.7 and
β = 0.8. From Figure 3–6 we see that strategic customer behavior tends to reduce the total profit of the firm, and the profit loss from strategic customer behavior can be quite significant. This conclusion is consistent with the observations presented in [21] in a monopolistic setting and [85] in a dynamic fashion.
Figure 3–6 also shows that, as consumers become more strategic, more and more consumers will postpone their purchases till period 2. Hence the demands for both products are decreasing. The prices for both products drop as well as a result of consumers refraining from purchasing.
3.7.2 Level of Vertical Product Differentiation
In our model, the level of vertical product differentiation is characterized by β. Note that we have an assumption of 2β −α −γ > 0. In order to have a wide range for
β, we set α and γ at relatively small values. Specifically we have α = 0.3 and γ = 0.3. When the products become less differentiated, product L attracts more consumers. If the firm increases the price of product L, we see that it will in turn increase its profit margin. The total profit would also increase. Figure 3–7 demonstrates the benefit of increasing β with an independent cost structure.
Note that we consider the cost to be exogenous to the level of quality differen-tiation. Namely, the cost of product L does not change as its quality level does. This result may not hold if the cost is dependent on the level of quality differentiation.
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0.2
0.19
0.18
Profit 0.17
0.16
0.15
0.14
0.13 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8
0
γ
(a) Total Profit
0.35
0.3 L
H
0.25
Demand 0.2
0.15
0.1
0.05
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8
0
γ
(b) Demand in Period 1
0.7
0.65 L
H
0.6
Price 0.55
0.5
0.45
0.4
0.35 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8
0
γ
(c) Price in Period 1
FIG. 3–6: The Effect of Consumer’s Strategic Level.
TAB. 3–2: Optimal Product Variety in Different Cases of β
β cH = 0.2 cH = 0.3
0.3 H ⇒ H H ⇒ H
0.4 H ⇒ H H ⇒ HL
0.5 H ⇒ H HL ⇒ HL
0.6 H ⇒ HL HL ⇒ HL
0.7 HL ⇒ HL HL ⇒ L
0.8 HL ⇒ HL L ⇒ L
0.9 L ⇒ L L ⇒ L
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0.17
0.165
Profit 0.16
0.155
0.15
0.145 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
0.2
β
(a) Total Profit
0.5
0.44 L
H
0.37
Demand 0.3
0.23
0.16
0.09
0.02
−0.05 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
0.2
β
(b) Demand in Period 1
0.8
0.7 L
H
0.6
Price 0.5
0.4
0.3
0.2
0.1 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
0.2
β
(c) Price in Period 1
FIG. 3–7: The Effect of Vertical Product Differentiation Level.
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Table 3–2 also shows the optimal product variety decision along with different
β values. When β goes up, the firm is prone to selling product L in both periods.
3.7.3 Commitment to Static Pricing
In this section, we numerically investigate the impact of pricing commitment on the firm’s profits. In order to show the profit comparison of dynamic pricing and static pricing, we first fix all system parameters except cL. We check what pricing policy could bring the highest profit on the whole spectrum of cL. The parameters we take into account for this study are θ1 = 1, α = 0.3, β = 0.8, γ = 0.3, cH = 0.3. We also conduct an analysis of the effect of static pricing in terms of β, where we set cL = 0.1.
We mentioned earlier that our one-period model actually captures the case where the firm commit to static pricing for both products. We use the dynamic model as a benchmark case and explore what pricing fashion would be the best one in terms of generating profits. From Figure 3–8 we observe that the price commitments of product H and product L have very different impacts on the firm’s total profit. The price commitment of product H brings the firm a significant profit increase. When the cost of product L increases above a curtain threshold, the return from employing price commitment for product H increases. However the price commitment of product L is generally is harmful to the firm’s profits. As we have discussed, price commitment for a product will lead to zero demand after the first period because of the product evaluation discount factor. This could impair the demand of a product with commitment in the sense that its market life cycle is intentionally shortened. On the other hand, another product without price commitment has a higher of freedom to