Volume Flexibility, Product Flexibility, or Both: The Role of Demand Correlation and Product Substitution

We analyze volume flexibility — the ability to produce above/below the installed capacity for a product — under endogenous pricing in a two-product setting. We discover that the value of volume flexibility is a function of demand correlation between products, an outcome which cannot be explained by classical risk-pooling arguments. Furthermore, while the value of product flexibility always decreases in demand correlation, we show that the value of volume flexibility can increase or decrease in demand correlation depending on whether the products are strategic complements or substitutes. We further find that volume flexibility better combats aggregate demand uncertainty for the two products, while product flexibility is better at mitigating individual demand uncertainty for each product. Our results thus underscore the necessity of analyzing volume flexibility with more than one product, and emphasize the contrast with product flexibility. Furthermore, we highlight the possible pitfalls of combining flexibilities: we show that while adding volume flexibility to product flexibility never hurts performance, adding product flexibility to volume flexibility is not always beneficial, even when such an addition is costless.