Optimal Investment Strategies for Flexible Resources, Considering Pricing and Correlated Demands

Abstract

We study the resource investment decision faced by a firm that offers two demandclasses (i.e., products, services), while incorporating the firm's pricing decision into the investment decision. For this purpose, we consider a monopolistic situation and model the demand curve of each demand-class as a downward sloping linear function of its own price.The firm can invest in dedicated resources, which can only satisfy a specific demand-class, and/or in a more expensive, flexible resource, which can satisfy both demand-classes.We consider a two-stage stochastic decision model: In the first stage, the firm determines the dedicated and flexible resource capacities to invest in under demand uncertainty.In the second stage, demand curves are realized and the firm optimizes its revenue through pricing and resource allocation decisions, constrained by its capacity investment decision in the first stage.Our analysis provides the structure of the firm's optimal resource investment strategy as a function of price elasticities and investment costs, and shows how the value of resource flexibility depends on these parameters and demand correlations. Based on our analysis, we provide principles on the firm's optimal resource investment strategy under uncertainty.We show that it can be optimal for the firm to invest in the flexible resource when demand patterns are perfectly positively correlated, while it is not always optimal to invest in the flexible resource when demand patterns are perfectly negatively correlated.

Process flexibility: design, evaluation, and applications

“…We do not, however, touch on the related issue of how the capacities in the system could be configured. For this, we refer the readers to the works in Van Mieghem (1998), Bish and Wang (2004) and Bish et al (2005). For earlier surveys on related work on manufacturing flexibility, see Sethi and Sethi (1990) and Shi and Daniels (2003).…”

Commissioned Paper: Capacity Management, Investment, and Hedging: Review and Recent Developments

“…Indeed, a multiresource framework can be used to select the technology (defined by resources with optimal positive capacity levels), along with its capacity plan. For example, capacity papers that study investment in flexible technology include Fine and Freund (1990), He and Pindyck (1992), Jordan and Graves (1995), Van Mieghem (1998a), Netessine et al (2002), and Bish and Wang (2002). Capacity papers that study timing of new technology adoption include Li and Tirupati (1994) and Rajagopalan et al (1998).…”

“…(There is, however, no general theory yet on the impact of covariances on the optimal capacity portfolio K.) By allowing for alternate or "nonbasic" activities that can redeploy inputs and resources to best respond to resolved uncertain events, newsvendor network analysis can be used for network design. For example, newsvendor networks that study the choice between investing in product-flexible or dedicated capacity include Netessine et al (2002), Van Mieghem (1998a, and Bish and Wang (2002), who add ex-post pricing to the capacity decisions. Kulkarni et al (2002) study the choice between product-or process-focused plant network configuration.…”

Product Line and Channel Structure Design with Responsive Pricing

“…Petruzzi and Dada (1999), and Dana and Petruzzi (2001) all consider the quantity-and-price problem in a single-product newsvendor setting. Bish and Wang (2004) consider a two-product newsvendor model, but they do not consider the problem in a competitive situation.…”