Product differentiation and operations strategy in a capacitated environment

We study a firm selling two products/services, which are differentiated solely in their prices and delivery times, to two different customer segments in a capacitated environment. From a demand perspective, when both products are available to all customers, they act as substitutes, affecting each other’s demand. Customized products for each segment, on the other hand, result in independent demand for each product. From a supply perspective, the firm may either share the same capacity or may dedicate a different capacity for each segment. Our objective is to understand the interaction between product substitution and the firm’s operations strategy (dedicated versus shared capacity), and how this interaction shapes the optimal product differentiation strategy. We show that in a highly capacitated system, if the firm decides to move from a dedicated to a shared capacity setting, it will need to offer more differentiated products, whether the products are substitutable or not. In contrast, when independent products become substitutable, it results in a more homogeneous pricing scheme. Moreover, the optimal response to an increase in capacity cost also depends on the firm’s operations strategy. In a dedicated capacity scenario, the optimal response is always to offer more homogeneous prices and delivery times. In a shared capacity setting, it is always optimal to quote more homogeneous delivery times, but to increase or decrease the price differentiation depending on whether the status-quo capacity cost is high or low, respectively.