When to Allocate Capacity for Upward Line Extensions Under Competition and Consumer Taste Uncertainty?

Li, Xishu and Zuidwijk, Rob and de Koster, MBM and Sethi, Suresh (2021) When to Allocate Capacity for Upward Line Extensions Under Competition and Consumer Taste Uncertainty? Working Paper. SSRN Working Paper.

Abstract

An upward line extension is a new improved product within an existing product category for the high end of the market. Many firms pursue line-extension strategies, but such strategies carry risks due to uncertain consumer taste, the internal competition between products, and the external competition between firms. Bad timing is often mentioned as one of the main reasons for new product failures. Using game-theoretic models, we study when a firm should allocate production capacity for an upward line extension under competition and consumer taste uncertainty. The firm can either act early, at which point consumer taste is still uncertain, to benefit from a first-mover advantage or wait until consumer taste is realized. We develop two indexes to evaluate consumer taste risk and to evaluate the firm's competitive advantage, respectively. Consumer taste risk can be measured by the correlation between the average consumer taste and the density of consumer taste with a strong correlation meaning a large risk exposure, indicating a more likely hit-or-miss result for the new product. The firm's competitive advantage is based on both firms' expected marginal revenues of capacity allocation, considering the internal competition (represented by the firm's profitability for the line extension) and the external competition (represented by the firm's cost advantage over its competitor). We show how a competitive advantage will be amplified in the presence of consumer taste uncertainty, and characterize the firm's decision policy by deriving a threshold for the risk index against the competitive advantage index. When the threshold is exceeded, it implies that the firm's competitive advantage is not large enough and so it should postpone allocating capacity. Otherwise, it should act early. We apply our results to two industry examples and provide practical guidelines.