Product Price, Quality and Service Decisions under Consumer Choice Models

Abstract

In this paper, we develop an integrated framework to study a firm's joint decisions on product price, quality and service duration in a variety of monopolistic and competitive scenarios. Product price, quality, and ancillary service (such as maintenance and factory warranty) are arguably among the most important factors consumers consider when making a purchase. Meanwhile, they are also seen as effective instruments for firms to achieve market segmentation. We consider a cost structure for the firm where the service cost depends on the product quality level. In particular, if quality is associated with product reliability (resp., complexity), the service cost would decrease (resp., increase) in the quality level. We adopt the widely used multinomial logit model and the nested logit model to study consumers' choice behavior, and employ mixed integer optimization and game theory to conduct analysis. We find that with multiple substitutable products being offered, it is sufficient for a firm to provide only two maximally differentiated service durations at optimality. The quality of each product should be set at a level such that the marginal utility to consumers equals the marginal cost to the firm, independent of the decisions on other products, whereas pricing decision should take into account all products. In addition, consumer surplus increases when the firm can make more decisions. Regardless of product substitution and market competition, the optimal quality level and service duration for each product can be determined independently of other products. Moreover, service differentiation can benefit consumers and improve the firm's profitability at the same time.