Product Quality Choice and Inventory Risk with Strategic Consumers

Firms developing new products must often make a trade-o¤ between production costs and product quality: higher quality products are more valued by consumers, but also more costly to manufacture. We analyze this trade-o¤ in the context of demand uncertainty and strategic consumer behavior. Before the release of a product to a heterogeneous market of unknown size, a …rm must choose product quality, inventory, and price. Consumers, on the other hand, choose whether to buy the product early (at a high price) or strategically delay their purchase in hopes of a price reduction caused by supply-demand mismatch and the …rm’s e¤orts to segment the market. We …nd that such forward-looking (or strategic) consumer behavior leads the …rm to invest in a higher quality product, but with less inventory, than would be optimal with non-strategic consumers. Prices may be higher or lower with strategic consumers than with non-strategic consumers. Interestingly, these results contrast with models that separate the product design decision (quality) from the operational decision (inventory under demand uncertainty), which typically …nd that strategic consumer behavior leads to lower quality and prices. Lastly, in a decentralized supply chain in which a manufacturer determines quality and a retailer determines price and inventory, we show that the equilibrium response to strategic consumer behavior can be precisely the opposite of a centralized supply chain: that is, the decentralized system may invest in lower quality and more inventory when consumers are strategic than when they are non-strategic, illustrating a new source of ine¢ ciency that arises due to the interaction of consumer behavior and an uncoordinated supply chain. We conclude that the interplay between uncertain demand, product quality choice, and strategic consumer behavior can have a signi…cant impact on …rm decisions, implying that the joint consideration of product design and tactical operational decisions is crucial, particularly when selling to a strategic consumer population.