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

Grado Department of Industrial and Systems Engineering, Virginia Polytechnic Institute and State University, Blacksburg, Virginia 24061-0118
Grado Department of Industrial and Systems Engineering, Virginia Polytechnic Institute and State University, Blacksburg, Virginia 24061-0118
ebru{at}vt.edu
qiwang1{at}vt.edu

We study the optimal resource investment decision faced by a two-product, price-setting firm that operates in a monopolistic setting and employs a postponed pricing scheme. The firm has the option to invest in dedicated resources as well as a more expensive, flexible resource that can satisfy both products. While the resource investment decision is made under demand uncertainty, pricing and resource allocation decisions are postponed to the time when demand curves are realized. Our analysis provides the structure of the firm's optimal resource investment strategy as a function of demand parameters and investment costs, and shows that the flexible resource investment decision follows a threshold policy. We also show that it can be optimal for the firm to invest in the flexible resource even when demand patterns are perfectly positively correlated. The reason for flexible capacity investment in this case is financial rather than risk pooling. On the other hand, we show that it can be optimal for the firm not to invest in the flexible resource even when demand patterns are perfectly negatively correlated. The flexible resource investment decision in this case depends on the profitability of the two products. Based on our analysis, we provide principles on the firm's optimal resource investment decision.

Subject classifications: facilities/equipment planning; resource flexibility; pricing; uncertainty; inventory/production; substitution and demand correlation; stochastic.
History: Received August 2002; revision received March 2003; accepted November 2003.

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