UC Berkeley

In this paper we characterize the impact of production technology on the optimal product line design. We analyze a problem in which a manufacturer segments the market on quality attributes and offers products that are partial substitutes. Because consumers self-select from the product line, product cannibalization is an issue. In addition, the manufacturer sets a production schedule in order to balance production setups with accumulation of inventories in the presence of economies of scale. We show that simultaneous optimization of the product line design and production schedule leads to insights that differ significantly from the common intuition and assertions in the literature, which omits either the demand side or the supply side of the equation. In particular, we demonstrate that more expensive production technology always leads to lower product prices and may at the same time lead to higher quality products. Further, a less efficient production technology does not necessarily increase total production costs or reduce consumer welfare. We also demonstrate that in the presence of production technology, the demand cannibalization problem may distort product quality upward or the number of products upward, which is contrary to the standard result.