| Summary: |
We develop a two-stage model for versioning products with respect to both
vertical and horizontal attributes. At first, a firm positions its
top-quality flagship product in a market with an imperfectly known
distribution of tastes and reservation prices. In the second stage, the firm learns these consumer characteristics and has
the option of extending its product line by versioning the flagship product
using pure horizontal differentiation, quality degrading, or both. The firms
nonconvex versioning problem is solved analytically for the two-product case.
We find that ex ante extending the product line through vertical differentiation is optimal
for low marginal cost of quality (development cost); otherwise pure
horizontal differentiation is superior. Given quasilinear consumer
preferences and a uniform distribution of consumer characteristics,
versioning with respect to both horizontal and vertical attributes is never
optimal. Under delayed differentiation the optimal policy is contingent on
the observed demand realization and may lead to horizontal cannibalization
and price dispersion for equal-quality products. The firm tends to increase
its investment in product quality unless it adopts a state-contingent policy
of horizontal versioning for high and vertical versioning for low demand
realizations. Following a state-contingent policy, the optimal upfront
development effort may be significantly lower than under full ex-ante
commitment. The option value of delayed differentiation is generally
nonmonotonic in the firms development cost. |
