When to Mass-Customize and When to Mass-Produce Using the Real Options Approach to Evaluate Product Variety and Pricing Decisions

Abstract

Product bundling and pricing strategies can be effectively deployed to reduce the firm’s fixed complexity costs in product development, sourcing, manufacturing and distribution logistics and to raise consumer prices. In addition, the introduction of new and innovative product features may allow firms to raise both expected sales and consumer surplus, consumer satisfaction respectively, measured by the difference between the customers reservation price and the respective market price of the product. In general, when customer segments are very heterogeneous, then a mixed bundling or mass-customization strategy may dominate a free-choice or pure bundling strategy in terms of expected sales. This is due to the fact that the structure of micro-markets can be directly exploited. Contrary, the two other strategies can be viewed as mass production strategies, since they can not effectively exploit the willingness-to-pay of attractive micro-markets. Development of new and innovative product features can create a real option value for the firm, since it enables it to capture additional markets or market share. Utilizing a real options approach for (incremental) product development, we show that the firm’s downside risk can be curtailed due to the option to abandon the project. In general, the benefit of introducing new product features must be traded off against the possibility of market reactions by competitors and the development costs and improvement costs prior to market launch.

In this paper, we analyze the firm’s option to introduce a mixed product bundle for mass customization as opposed to a free-choice or pure product bundle policy for mass production. Moreover, the introduction of the new product can be abandoned contingent on both market and project information. In addition, the firm has the option to improve the project periodically, i.e., take corrective action in order to influence the project’s expected payoffs. We show that the option value of the project under consideration can be significantly increased this way and that the decision on the optimal product policy and pricing strategy should be postponed until (close to) the time of market entry.