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Resource Flexibility with Responsive Pricing

Carroll School of Management, Boston College, Chestnut Hill, Massachusetts 02467
William E. Simon Graduate School of Business Administration, University of Rochester, Rochester, New York 14627
chodj{at}bc.edu
rudi{at}simon.rochester.edu

This article studies two types of flexibility used by firms to better respond to uncertain market conditions: resource flexibility and responsive pricing. We consider a situation in which a single flexible resource can be used to satisfy two distinct demand classes. While the resource capacity must be decided based on uncertain demand functions, the resource allocation as well as the pricing decision are made based on the realized demand functions.

We characterize the effects of two key drivers of flexibility: demand variability and demand correlation, assuming normally distributed demand curve intercepts. Demand variability creates opportunity costs and, with fixed prices, decreases the firm’s profit. We show that with the additional flexibility gained from responsive pricing, the firm can maximize the benefits of favorable demand conditions and mitigate the effects of poor demand conditions, ultimately profiting from variability. Positive demand correlation, on the other hand, remains undesirable under responsive pricing. The optimal capacity of the flexible resource is always increasing in both demand variability and demand correlation. This contrasts with the scenarios based on fixed prices, highlighting the crucial difference that responsive pricing makes in the management of flexible resources. We further quantify the value of flexibility for the firm and its customers by considering, as a benchmark, a firm relying on two dedicated resources. The value of flexibility is most significant if the demand levels are highly variable and negatively correlated. In such cases, the firm benefits from demand variability due to responsive pricing, while facing limited demand risk due to resource flexibility. Finally, we endogenize the input price of the flexible resource by considering the pricing decision of the resource supplier.

Subject classifications: inventory/production:uncertainty; pricing; flexible capacity.
History: Received September 2002; revision received March 2003; accepted April 2004.

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