Managing Supply Risk for Vertically Differentiated Co-Products

The manufacturing complexity of many high-tech products results in a substantial variation in the quality of the units produced. Post manufacturing, the units are classified into vertically differentiated products. These products are typically obtained in uncontrollable fractions, leading to mismatches between their demand and supply. We focus on product stock-outs due to the supply-demand mismatches. Existing literature suggests that when faced with product stock-outs, firms should satisfy all unmet demand of a low-end product by downgrading excess units of a high-end product (downward substitution). However, this policy may be sub-optimal if it is likely that low-end customers will substitute with a higher quality product and pay the higher price (upward substitution). In this paper, we investigate whether and how much downward substitution firms should perform. We also investigate whether and how much low-end inventory firms should withhold to strategically divert some low-end demand to the high-end product. We first establish the existence of regions of co-production technology and willingness of customers to substitute upwards where firms adopt different substitution/withholding strategies. Then, we develop a managerial framework to determine the optimal selling strategy during the life cycle of technology products as profit margins shrink, manufacturing technology improves, and more capacity becomes available. Consistent trends exist for exogenous and endogenous prices.