Role of resource flexibility and responsive pricing in mitigating the uncertainties in production systems

Abstract

© 2020 Elsevier B.V. Two effective strategies that mitigate a firm's demand risk are resource flexibility investment and responsive pricing. In addition to demand uncertainties firms also face capacity uncertainties and capacity disruptions and the effectiveness of these strategies under these risks are less clear. We investigate the value of resource flexibility and responsive pricing under different risk settings for a firm that produces two substitutable products each with its own dedicated resource that can be optionally reconfigured to produce the other product. Reconfiguration or cross-production incurs efficiency loss which can be mitigated by choosing the degree of flexibility of these resources, at a cost, in the planning stage along with capacity levels. In the production stage, after capacities and market potentials are realized, the firm allocates resources and sets prices. We find that under only demand uncertainties the value of flexibility is very low and only a moderate degree of flexibility is sufficient under high demand risk. Responsive pricing is the dominant strategy as the firm avoids investment in costly flexibility. When facing both demand and capacity uncertainties the firm invests in higher levels of flexibility but the value of flexibility is lower than the value of responsive pricing. However, under demand and capacity disruptions flexibility arises as the dominant strategy due to the resource risk pooling effect and the value of flexibility eclipses the value of pricing as the firm invests in full flexibility. For a firm with responsive pricing investment in flexibility is economically justified under high capacity uncertainties and capacity disruptions.