Dynamic Pricing and Replenishment with Customer Upgrades

We study a joint implementation of price†and availability†based product substitution to better match demand and constrained supply across vertically differentiated products. Our study is motivated by firms that utilize dynamic pricing as well as customer upgrades, as ex ante and ex post mechanisms, respectively, to mitigate inventory mismatches. To gain insight into how offering product upgrades impacts optimal price selection, we formulate a multiple period, nested two†stage model where the firm first sets prices and replenishment levels for each product while the demand is still uncertain, and after observing the demand, decides how many (if any) of the customers to upgrade to a higher quality product. We characterize the structure of the optimal upgrade, pricing and replenishment policies and find that firms having greater flexibility to offer product upgrades can restrain their reliance on dynamic pricing, enabling them to better protect the price differentiation between the products. We also show how the quality differential between the products or changes in the replenishment cost structures influence the optimal policy. Using insights gained from the optimal policy structure, we construct a heuristic policy and find that it performs well across various parameter values. Finally, we consider an extension in which the firm dynamically sets upgrade fees in each period. Our results overall help further our understanding of the intricate relationship among a firm's decisions on pricing, replenishment, and product upgrades in an effort to better match demand and constrained supply.