The impact of demand uncertainty on product line design under endogenous substitution

Abstract

© 2015 Wiley Periodicals, Inc. The existing product line design literature devotes little attention to the effect of demand uncertainty. Due to demand uncertainty, the supply-demand mismatch is inevitable which leads to different degrees of lost sales depending on the configuration of product lines. In this article, we adopt a stylized two-segment setup with uncertain market sizes and illustrate the interplay between two effects: risk pooling that mitigates the impact of demand uncertainty and market segmentation that facilitates consumer differentiation. Compared to downward substitution, inducing bidirectional substitution through product line decisions including quality levels and prices can yield greater risk pooling effects. However, we show that the additional benefit from the risk pooling effect cannot compensate for the reduced market segmentation effect. We demonstrate that the presence of demand uncertainty can reduce the benefit of market segmentation and therefore the length of product lines in terms of the difference between products. We also propose three heuristics that separate product line and production decisions; each of these heuristics corresponds to one particular form of demand substitution. Our numerical studies indicate that the best of the three heuristics yields performance that is close to optimality.