Dynamic Pricing and Inventory Buildup with Demand Diffusion

Introduction It is critical for a firm to manage its demand when launching a new product successfully. It is well studied that demand of a new product diffuses in the market, driven by consumers’ word-of-month (Rogers 1995, Mahajan et al. 2000). However, in most previous research on dynamic pricing, the demand diffusion dynamics has largely been omitted (Elmaghraby and Keskinocak 2003). Without consideration of demand diffusion, price skimming strategy has been suggested as an effective way to differentiate heterogeneous consumers so as to increase firms’ expected profit (Besanko and Winston 1990). Narasimhan (1989) is so far the closest paper to ours, who considered monopolistic pricing with strategic customers in diffusion models, without imposing the supply constraint. They assumed that the market size is constant and the demand diffusion occurs in a certain market, and they concluded that the price skimming and price penetration strategies could be optimal with different distributions of customers’ heterogeneity. In our paper, we consider the information dissemination process and the initial supply constraints in the form of inventory buildup cost. Moreover, our model jointly optimizes decisions of the initial inventory level and the pricing strategy. In fact, price skimming has gained such popularity that in many cases consumers have been trained to wait strategically for future price markdown. Consumers’ strategic waiting could be rather destructive, as it not only defers sellers’ sales revenue but also slows down the demand diffusion. Previous literature has studied the optimal dynamic pricing problem when facing with strategic consumers, under the assumption that the consumer arrival rate is constant (e.g., Su 2007, Aviv and Pazgal 2008). By contrast, we’re interested in how to manage strategic consumer behavior by setting effective pricing strategies in an early stage of product demand diffusion where past sales influence future demand. Specifically, the seller can penetrate the market with an initial low price to encourage strategic consumers to buy now. For example, Lay’s Stax potato chips were introduced at $0.69, and the price later rose above $1 (Kokemuller 2014). How to tradeoff the consumers’ heterogeneity versus the