Optimal Capacity, Product Substitution, Linear Demand Models, and Uncertainty

September, 2007
We consider a two-product monopolist that needs to make capacity, price, and production quantity decisions. While the capacity decision needs to be made ex-ante, under demand uncertainty, pricing and quantity decisions can be postponed until after uncertainty is resolved. We show that the relationship between key demand parameters (expected market size, market risk, and the degree of product substitution) and the optimal capacity decision significantly depends on (i) the form of the demand model, (ii) the form of demand uncertainty (additive versus multiplicative), and (iii) how the degree of product substitution is measured, to the extent that the insights gained under some demand functions can be misleading. In particular, we show that some of the insights developed in the current literature are incomplete in that a higher demand risk may not always benefit a firm with a flexible resource under responsive pricing, as the literature suggests. On the contrary, the firm will make higher profits and invest more under a lower, not higher, demand risk, if the uncertainty is of a multiplicative nature. Moreover, in this case, the firm’s investment region does not depend on the magnitude of uncertainty, making the “invest or not” decision immune to forecast errors. Furthermore, we show that the different linear demand models most commonly used in the literature lead to drastically different behaviors of how optimal capacity and investment region change with the degree of product substitution. Based on our analysis, we derive insights on the robustness of these principals under the different demand settings. Key words : resource flexibility, linear demand models, additive versus multiplicative uncertainty, product substitution, responsive pricing

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1. Introduction and Motivation
In today’s highly uncertain marketplace, firms are increasingly resorting to flexibility, both on supply and demand side, to effectively match their supply with demand. An example of supplyside flexibility is “resource (capacity) flexibility,” which refers to a resource with the capability to produce multiple products (this is also known as “product-mix flexibility”); an example of demand-side flexibility arises from the use of “postponed (responsive) pricing,” under which the firm postpones its pricing decision until after market uncertainty is resolved [see Chod and Rudi (2005), Chod, Pyke, and Rudi (2006), and Van Mieghem and Dada (1999) for related discussion and examples]. As a result, the operations management literature has shown a great interest in the firm’s capacity investment decision with flexible resources, and different variations of this problem have been studied, all considering (to our knowledge) linear demand models under additive uncertainty [see Bish and Wang (2004), Chod and Rudi (2005), Fine and Freund (1990), Goyal and Netessine (2005, 2007), Lus and Muriel (2006), Van Mieghem (1998), as well as Van Mieghem (2003) for an excellent review and discussion on the capacity investment decision problem]. Obviously, the findings of these mathematical models can be only as good as the underlying assumptions. In this paper, our objective is to study how the various assumptions on demand affect the model conclusions so that we can provide managerial insights on the robustness of these conclusions. In particular, our focus is on how key demand parameters, such as the expected market size and its variability, and the degree of product substitution (i.e., how closely substitutable the products are)1 , impact the optimal flexible capacity decision and expected profit for a firm producing “substitutable” (“differentiated”) products that satisfy the same consumer need, and how these findings depend on the form of demand function, the form of demand uncertainty (“additive” versus “multiplicative” shock), and how the degree of product substitution is measured. The capacity investment literature considers the linear form of demand mostly because this represents the relationship between price and demand reasonably well while preserving analytical tractability. Linear aggregate demand models can be derived by assuming that there exists a fictional representative consumer for the whole economy, who determines the demands for the different products so as to maximize her utility surplus. When the products are substitutable, depending on the functional form and parameters of the representative consumer’s utility function, the resulting parameters of the aggregate demand models, how the parameters depend on the
1

This measure is especially important for flexible resources, since most often the products produced by flexible

resources will be substitutable, see Section 2 for examples.

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degree of product substitution, and even how the degree of product substitution is measured will be different. Yet another important aspect of demand modeling is how uncertainty in demand is modeled. While most of the related operations management literature uses the “additive” form of demand uncertainty (i.e., parallel shift) in the capacity investment stage, other functional forms of uncertainty may also arise frequently in markets, another functional form commonly used in the economics literature being the “multiplicative” uncertainty [see Cowan (2004) as well as Section 2.2 for examples of additive and multiplicative uncertainty]. We show that the relationship between key demand parameters (expected market size and its variability, the degree of product substitution) and the optimal capacity, optimal expected profit, and investment region depend significantly on (i) the form of demand function, (ii) the form of demand uncertainty (additive versus multiplicative), and (iii) how the degree of product substitution is measured, to the extent that the insights gained under some demand functions can be even misleading. While there are some papers that analyze some of these relationships for specific demand models, to our knowledge there is not a comprehensive analytical study that investigates these relationships for all demand characteristics discussed above, explaining why the results are different and prescribing guidelines for academicians and practitioners on the use of these demand models, as we do here. Several principles have been adopted in the literature on the relationship between demand variability and the optimal capacity and optimal expected profit [e.g., Chod and Rudi (2005), Fine and Freund (1990), Goyal and Netessine (2005, 2007), Lus and Muriel (2006), Van Mieghem (1998)]. In particular, under “nondelayed” pricing (i.e., when the pricing decision is made prior to the resolution of uncertainty), the capacity of the flexible resource may be decreasing or increasing in demand variability, depending on price and cost parameters, and the firm’s optimal expected profit is always decreasing in demand variability [Eppen (1979)], while under responsive pricing these effects are reversed [see Chod and Rudi (2005) for the case of the bivariate Normal distribution for the two market sizes, with additive shock, and under a relaxation of the problem with negative prices allowed], that is, with responsive pricing, the firm should always acquire more flexible resource capacity and is expected to make a higher profit, as demand risk increases. Thus, a firm utilizing resource flexibility and responsive pricing benefits from an increased variability in demand, while a firm with resource flexibility only does not. On the other hand, the findings on the relationship between the degree of product substitution and the flexible resource capacity have been rather mixed in that under a commonly used linear demand model (with additive uncertainty), the optimal flexible capacity and the optimal

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expected profit are both shown to increase as products become more substitutable, while under another common linear demand model (again with additive uncertainty), they decrease [see Bish and Suwandechochai (2005) and Goyal and Netessine (2007), where the analysis in the latter is limited to the “clearance” setting (i.e., the firm is forced to use all its capacity for production, even when it is not optimal to do so) under some other assumptions (i.e., the firm has to always produce both products, and can charge negative prices)], see Section 3.3. Lus an Muriel (2006) confirm these findings, but through a purely numerical study for a special case of the problem with discretized bivariate Normal distribution for market potentials and additive uncertainty.2 An analytical study of how the various forms of linear demand functions and the different forms of uncertainty under the more general case of “holdback” (i.e., the firm is no longer forced to use all its capacity for production) affect the relationship between the optimal flexible capacity and the optimal expected profit versus the degree of product substitution is missing. In this paper, we show that some of the insights developed in the current literature are incomplete in that a higher demand risk may not always benefit a firm with a flexible resource under responsive pricing, as the literature suggests. On the contrary, the firm will make higher profits and invest more under a lower, not higher, demand risk, thus preferring a reduced demand risk, if the uncertainty is of a multiplicative nature. Moreover, in this case, the firm’s investment region (i.e., the region in which it is profitable for the firm to invest) does not depend on the magnitude of uncertainty. Furthermore, we show, analytically, that the different linear demand models most commonly used in the literature lead to drastically different behaviors of how optimal capacity and investment region change with the degree of product substitution (even when the clearance assumption is relaxed), and these behaviors also depend highly on the nature of uncertainty. Based on our analysis, we derive insights on the robustness of these findings under the different demand settings. Moreover, throughout we do not make any distributional assumptions on the demand shock, and also analyze the problem under holdback. Thus, our results are quite general in that they hold for any arbitrary continuous distribution of the demand shock and do not require the clearance assumption. Hence, a by-product of our analysis is extending some of the earlier results that rely on a specific distribution (i.e., Lus and Muriel’s numerical results for the discretized bivariate Normal distribution, Chod and Rudi’s analytical results for the bivariate Normal distribution, etc.) to any type of continuous
2

In their numerical study, Lus and Muriel (2006) consider a more general form of the problem with both flexible and

dedicated resources (see Section 2), and focus their analysis on how the optimal resource mix changes with product substitution.

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distribution, and extending those under the clearance assumption (i.e., Goyal and Netessine’s results for one of the demand functions considered here) to the holdback case. The remainder of this paper is organized as follows. Section 2 presents our models and assumptions. Then in Section 3 we characterize the firm’s optimal capacity investment under the different demand settings, and using these characterizations, we analyze the impact of market size and risk, and the degree of product substitution, on the optimal investment decision. Finally, in Section 4, we conclude with a discussion of our findings and suggest directions for future research. To facilitate the presentation, we relegate all mathematical proofs to the Appendix.

2. Notation, Models, and Assumptions
We consider a two-product monopolist that needs to make capacity, price, and production quantity decisions. While the capacity decision needs to be made ex-ante, under demand uncertainty, pricing and quantity decisions can be postponed until after uncertainty is resolved. This modeling framework represents the long lead-times for capacity acquisition and relatively shorter lead-times for price-setting and production, and is commonly used in the capacity investment literature. Our objective is to understand how (i) the form of demand function, (ii) the measure on the degree of product substitution, and (iii) the nature of uncertainty impact the firm’s optimal capacity, K ∗ , the optimal expected profit, V ∗ , and the optimal investment region, as well as the various comparative statics regarding K ∗ , V ∗ , and the investment region. In order to isolate the effect of these factors on the optimal capacity of the flexible resource (and move away from the flexible versus dedicated resource trade-off), we assume that the firm can invest in only one flexible (shared) resource [as in Chod and Rudi (2005) and Goyal and Netessine (2005, 2007)].3 Throughout, we will consider substitutable products only, as these are the ones that flexible (shared) resources typically produce. For example, Sony can quickly shift from one model of camcorder to another [Nakamoto (2003)]. “Nissan’s new Canton, Mississippi, assembly plant can send
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The trade-off between dedicated and more expensive flexible resources has been well studied in the operations

management literature, and the firm’s optimal “capacity portfolio” [i.e., capacities and mix of flexible and dedicated resources (Van Mieghem (2003)] has been analytically characterized for a price-taker firm [Van Mieghem (1998)] as well as for a price-setter monopolist [Bish and Wang (2004), Fine and Freund (1990)] that produces products that are neither substitutable nor complementary. Lus and Muriel (2006) have performed a numerical study to analyze the capacity portfolio for substitutable or complementary products. Although in reality firms might find it preferable to invest in both dedicated and flexible resources, this complicates the analytics considerably [see Bish and Wang (2004) for the characterization of the optimal capacity portfolio under responsive pricing]. Considering only one flexible resource allows us to move away from the flexible-dedicated resource trade-off, and analyze our main questions of interest in isolation.

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a minivan, pickup truck, and sport-utility vehicle down the same assembly line, one after the other, without interruption” [Welch (2003)]. Ford’s plant in Norfolk, Virginia, builds eight different truck models on two platforms [Mcmurray (2004)]. “Mazda’s plant in Hiroshima builds the RX-7 (a rearwheel-drive sports car in standard and convertible versions), the 929 (a rear-wheel-drive luxury car), the 121 (a front-wheel-drive mini car), and the 323 (a front-wheel-drive compact car) on the same assembly line” [Goyal et al. (2006)]. In the following, we first present the different forms of demand functions, the measures for the degree of product substitution, and the types of uncertainty that we consider in our study. 2.1. Forms of Linear Aggregate Demand Functions We consider various forms of linear aggregate demand functions for two substitutable products, each with symmetric own-price and cross-price effects — this is to reduce the parameters of the demand model and study the main questions of interest. The general form of the linear demand function is given by di = θ [ i − νpi + βp3−i], i = 1, 2,
i

(1) (≥ 0) is the demand curve

where pi and di respectively denote the price and demand of product i;

intercept, which represents the market size (or is a measure of market potential); θ represents the strength of the market, and hence, is product-independent; and ν (> 0) is the product’s own-price effect and β is the cross-price effect. This demand function allows us to model both multiplicative uncertainty (in terms of uncertainty in θ) and additive uncertainty (in terms of uncertainty in
i, i

= 1, 2) in the capacity decision stage. Clearly, |β | < ν, since a product’s own price should have

more effect on its demand than the price of the other product. When β > 0, the two products are “substitutes” (i.e., demand for a product rises with an increase in the price of the other product); when β < 0, the two products are “complements” (i.e., demand for a product falls with an increase in the price of the other product); and when β = 0, the two products are “independent,” with no crossprice effect on each other (i.e., the markets for the two products become isolated). Our focus will be on substitutable or independent products (β ≥ 0). As described below, different parameterization of the underlying consumer utility functions give rise to different linear demand models of this form, depending on which parameters are functions of the degree of product substitution, which we denote by γ. In this paper, we study the three most commonly used forms of linear demand functions to model substitutable products, see Table 1. Thus, in Model I, only the cross-price effect is a function of the demand substitution parameter, γ; in Model II [Singh and Vives (1984)], the intercept, own-price effect, and cross-price effect are all

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functions of γ; and in Model III [Shubik and Levitan (1980)], both own-price effect and cross-price effect are functions of γ. We shall see subsequently how these characteristics impact the results.
Table 1

Forms of Linear Demand Functions Considered
i (γ) i αi −γα3−i 1−γ 2 i

Linear demand function Model I Model II (Singh and Vives) Model III (Shubik and Levitan)

ν(γ) ν
1 1−γ 2

β(γ) Parameter restrictions4 γ
γ 1−γ 2 γ 2 i

≥ 0, i = 1, 2, γ ∈ [0, ν)

αi ≥ 0, αi − γα3−i ≥ 0, i = 1, 2, γ ∈ [0, 1)
i

1+ γ 2

≥ 0, i = 1, 2, γ ∈ [0, ∞)

These demand functions can be derived as follows. Consider an economy with two differentiated goods and a competitive numeraire sector. A common technique used in economics is to consider a fictional representative consumer who generates the aggregate demand function for the whole economy [see Mas-Colell et al. (1995), Section 4.D for conditions under which this holds]. The utility function of the representative consumer is separable and linear in the numeraire goods; thus, there are no income effects on the two goods. The representative consumer determines consumption quantities of the goods, d1 , d2 , so as to maximize her utility surplus, that is,
2 d1 ,d2 ≥0

max U (d1 , d2 ) −
i=1

pi d i ,

where U (d1 , d2 ) represents the consumer’s utility function when she consumes di, i = 1, 2, units of good i at price pi . It is typical to assume that the utility function U (.) is quadratic, strictly concave, and additively separable, such as the form below [Singh and Vives (1984)]: 1 U (d1 , d2 ) = α1 d1 + α2 d2 − (η1 d2 + 2τ d1d2 + η2 d2 ), 1 2 2 (2)

where αi , ηi > 0, i = 1, 2, η1 η2 − τ 2 > 0 (for strict concavity of U (.)), and αi η3−i − α3−i τ ≥ 0, i = 1, 2 (for nonnegativity of the demand intercepts, as shown below). Then, since the utility surplus, U (d1 , d2 ) −
2

pi di , is also strictly jointly concave in d1 , d2 , the
i=1

first-order conditions are necessary and sufficient for optimality, leading to ∂U (d1 , d2 ) − pi = 0 ⇒ pi = αi − ηidi − τ d3−i , ∂di
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i = 1, 2.

(3)

Note that for β ≥ 0, while

i

≥ 0, i = 1, 2, constraints are sufficient for the nonnegativity of both demand and

price intercepts in Demand Models I and III, the additional αi − γα3−i ≥ 0, i = 1, 2, constraints are needed for the nonnegativity of demand intercepts in Demand Model II.

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This inverse demand function implies the following direct demand function: di = αi η3−i − α3−i τ η3−i τ − pi + p3−i, δ δ δ i = 1, 2, (4)

where δ ≡ η1 η2 − τ 2 . In this demand model, goods are substitutes (complements) if τ > (<) 0, and are independent if τ = 0. Parameter τ is used as a measure of product substitution5 . As can be seen, demand intercepts, own- and cross-price effects all change with product substitution parameter, τ [see Lus and Muriel (2006) for further discussion]. As stated above, we will consider a special case of this demand model with symmetric own- and cross-price effects by letting η1 = η2 = 1; for consistency in notation, we also let τ = γ. This implies the following direct demand function (which we will refer to as the Singh and Vives Demand Model, or simply as Model II, see Table 1): Demand Model II: di = 1 αi − γα3−i γ − p + p3−i, i = 1, 2. 2 2 i 1−γ 1−γ 1 − γ2
i

Demand Model I arises as a reparameterization of Demand Model II by letting νi ≡
η3−i , δ

αi η3−i −α3−i τ , δ

and β ≡ τ , which, for our special case of η1 = η2 = 1, leads to δ Demand Model I: di =
i

− νipi + βp3−i,

i = 1, 2,

and, as mentioned above, we will consider the form in which ν1 = ν2 = ν (see Table 1). Although these two demand models are equivalent, the cross-price effect, β, is commonly used in the operations management and marketing literature to measure the degree of product substitution for Model I [e.g., Chod and Rudi (2005), Choi (1991), Garcia-Gallego and Georgantzis (2001), McGuire and Staelin (1983). See also Lus and Muriel (2006) for related discussion.]. Thus, the difference between Demand Models I and II reduces to the different measures used for the degree of product substitution in each. Different parameterizations of the representative consumer’s utility function have also been proposed in the economics literature, leading to different forms of linear aggregate demand functions. Another commonly used function can be derived from (2) by letting α1 = α2 =
2γ τ = 2(1+γ) [Shubik and Levitan (1980)], leading to a direct demand function of 6 2+γ , 1+γ

, η1 = η2 =

Demand Model III:

di =

i

2

1 γ γ − (1 + )pi + p3−i , 2 2 4

i = 1, 2.

We will refer to this demand model as the Shubik and Levitan Demand Model or Model III. The degree of product substitution is again measured by the cross-price effect, γ, as indicated by Shubik and Levitan (1980).
5

In particular, when α1 = α2 ,

τ2 β1 β2

is used as a measure for the degree of product substitution, ranging from zero

(independent products) to one (perfect substitutes), see Singh and Vives (1984).
6

In this paper, we consider a more general setting with αi = i , i = 1, 2.

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2.2. Type of Demand Uncertainty (Demand Shift): As stated above, demand is often uncertain in the capacity investment stage. We model this uncertainty either as a “multiplicative” shift or an “additive” (parallel) shift in the direct demand function, the two most common forms of shift considered in the economics and operations management literature. Both types of shifts apply to certain economic situations. Additive demand shifts may arise due, for example, to changes in high-income population, attitudes about consumption (e.g., towards gas versus electricity, petroleum versus ethanol), and an increasing popularity resulting from successful advertisements. On the other hand, multiplicative demand shifts may arise due, for example, to changes in the number of customers or disposable incomes as a result of changes in job growth, industrial production rate, etc. [Cowan (2004)]. In the subsequent analysis, we consider each form of linear demand function in Table 1 with both additive and multiplicative shocks in the capacity investment stage. Throughout, we use capital letters to denote random variables and lower-case letters to denote their realizations. In particular, to model the additive demand uncertainty, we assume that θ is known with certainty in the investment stage, and consider Di = θ[ξi (γ) − ν(γ)pi + β(γ)p3−i], i = 1, 2,

where ξi are continuous random variables, each with positive support and finite expectation, in the investment stage. Let g(·, ·) denote the joint probability density function of ξ1 and ξ2 , and assume that g( 1, 2 ) > 0 for all
1, 2

≥ 0, and g( 1, 2 ) = 0 otherwise.
i, i =

To model the multiplicative demand uncertainty, we assume that demand intercepts,

1, 2,

are known with certainty in the investment stage, but the strength of market (Θ) is not, and consider Di = Θ [
i (γ) − ν(γ)pi + β(γ)p3−i

],

i = 1, 2,

where Θ is modeled as a continuous random variable with positive support and a finite expectation in the investment stage. Let f (·) denote its probability density function and assume that f (θ) > 0 for all θ ≥ 0, and f (θ) = 0 otherwise. We note here that when considering Demand Model II under additive uncertainty, we denote the random variables in Stage 1 as A1 and A2 (and their realizations in Stage 2 as α1 and α2 ), each with a finite expectation and with a joint probability density function of h(·, ·), where h(α1 , α2 ) > 0 for all α1 , α2 ≥ 0 and h(α1 , α2 ) = 0 otherwise. In this case, the demand intercept nonnegativity constraints render the problem infeasible in {Ai − γA3−i < 0, i = 1 or 2} (see Table 1). There are

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two approaches that one can take to model this: (1) To restrict the support region of Ai , i = 1, 2, to the feasible set only, that is, {(A1 , A2 ) ∈ [0, ∞) × [0, ∞) : Ai − γA3−i ≥ 0, i = 1, 2}, or (2) to keep the support region of Ai , i = 1, 2, as [0, ∞) × [0, ∞), but treat the infeasible region as a “zero-profit” region (i.e., no contribution to the objective function comes from realizations of random variables, A1 , A2 , in the infeasible region). In the first approach, the support region of Ai , i = 1, 2, becomes a function of γ, and so do their distributions and moments (i.e., one needs to use the conditional density function, h((α1 , α2 )|Ai − γA3−i ≥ 0, i = 1, 2), for α1 , α2 ≥ 0, as well as E[Ai (γ)], i = 1, 2, in the analysis). However, then it becomes quite difficult to perform comparative statics analysis because how the conditional density function and moments change in γ depends on the underlying distribution in a complex way. On the other hand, since in the comparative analysis we only consider marginal changes to the parameters, the exact distribution functions should not change too much. Consequently, the second approach, in which the infeasible region is treated as a zero-profit region, should provide a good approximation, and is analytically tractable. Thus, in the remainder of the paper, we take the second approach [as in Goyal and Netessine (2007)], and let h(·, ·) represent the joint density function of A1 and A2 for all γ ∈ [0, 1). 2.3. The Model We formulate the firm’s capacity investment decision problem as a two-stage stochastic programming problem, as commonly done in the literature [e.g., Bish and Wang (2004), Chod and Rudi (2005), Fine and Freund (1990), Goyal and Netessine (2005, 2007), Lus and Muriel (2006)]. The firm determines the flexible resource capacity to acquire (K) ex-ante, in the first stage, and then decides on its production (q1 , q2 ) and pricing (p1 , p2 ) ex-post, in the second stage. Specifically, in the first stage, when the firm makes its capacity investment decision, market conditions are uncertain (i.e., ξi, i = 1, 2, under additive uncertainty, and Θ under multiplicative uncertainty). Then, in the second stage all uncertainty is resolved (i.e., under additive uncertainty realizations
2 1

and

of random variables ξ1 and ξ2 are observed, and under multiplicative uncertainty realization

θ of random variable Θ is observed), that is, the firm receives complete information on demand functions. We only assume ξi i = 1, 2, and Θ are arbitrary continuous random variables and do not make any distributional assumptions. On the financial side, we consider linear investment and production costs, with a unit investment cost of cK and a unit production cost of cq . In the following, E[·|Ωk] and E[·] respectively denote the conditional expectation operator given event Ωk , and the unconditional expectation operator. Let x = (x1 , x2 ) denote a two-dimensional vector, and x+ = max{x, 0}. Let V X(i) and ΠX(i) respectively denote the expected profit in Stages

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1 and 2 under demand model i, i = I, II, III, and with either multiplicative shock (X = M ) or additive shock (X = A). Let y ∗X(i) denote the value of y in an optimal solution under demand model i, i = I, II, III, and with multiplicative shock (X = M ) or additive shock (X = A) for y =
{V, K, Π, qi, di, pi , i = 1, 2}. We use the general form, di = θ[ i − νpi + βp3−i], i = 1, 2, of the direct

demand function (and drop the demand model superscript i) when the result holds for all linear demand models considered. We can formulate the decision problem under additive and multiplicative shocks as the following stochastic programming problems, where ξi, i = 1, 2, or Θ are continuous random variables in the first stage, and their realizations
Table 2
i, i =

1, 2, or θ are observed in the second stage.

Mathematical formulation of the decision problem under additive and multiplicative shocks Additive Shock Multiplicative Shock

P1 : max V A ≡ Eξ [Π∗ (K)] − cK K (5)
K

P1 : max V M ≡ EΘ [Π∗ (K)] − cK K (7)
K

subject to K ≥ 0. P2 :

(6) Π∗ (K) ≡ max subject to
i=1 2 p,q i=1 2

subject to K ≥ 0. (pi − cq )qi

(8) (9) (10) (11) (12) (13) (14)

qi ≤ K,

qi ≤ θ[ i − νpi + βp3−i], i = 1, 2 νpi − βp3−i ≤ i , qi ≥ 0, pi ≥ 0, i = 1, 2 i = 1, 2 i = 1, 2.

In the above formulation, (10) ensures that the total production quantity does not exceed the capacity acquired in the first stage; (11) implies that the production of each product does not exceed its demand, induced by the firm’s pricing decision; and (12)-(14) are the nonnegativity constraints for product demands, production quantities, and prices, respectively. Observe that (11) and (13) imply (12). Nevertheless, we include (12) here for the sake of completeness.

3. Analysis
This section is organized as follows. First, in Section 3.1, we characterize some properties of an optimal solution. Then, in Sections 3.2 and 3.3, we utilize these properties to study how the

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expected market size and its variability, and the degree of product substitution affect the optimal solution for the different demand models given in Table 1. 3.1. Characterization of an Optimal Solution We first characterize properties of an optimal solution to the capacity decision problem given in (5)–(6) (or (7)–(8)) and (9)–(14) for substitutable or independent products (i.e., β ∈ [0, ν)). Proposition 1. Consider Problem P2 with the general linear demand function in (1), and with 0 ≤ β < ν 7 . In an optimal solution to Problem P2 under both additive and multiplicative shocks, we
∗ have qi = d∗ , i = 1, 2 (i.e., Constraints (11) are tight). In addition, price nonnegativity constraints i

(i.e., Constraints (14)) are redundant. Proof: See Appendix A.

Thus, Proposition 18 states that in an optimal solution to Problem P2 with substitutable (β > 0) or independent (β = 0) products, the firm sets prices (hence demands) such that all demand is satisfied. With Proposition 1, for 0 ≤ β < ν the formulation for Problem P2 reduces to the following:
2

P2 : Π (K) = max Π(K) = max θ → −
p p i=1 2 2

(pi − cq )( i − νpi + βp3−i) K θ

(15)

subject to (ν − β)
i=1

pi ≥
i=1

i

(16)

νpi − βp3−i ≤

i,

i = 1, 2,

(17)

where pi , i = 1, 2, are the only decision variables in Problem P2 . In what follows, we find the solution to the stochastic programming problems by backwards induction. That is, we first solve the second stage problem and obtain the optimal prices for every realization of the random variable(s). Then, using this characterization, we analyze the corresponding capacity investment problem in the first stage and determine the necessary and
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It is important to reiterate the restriction that β < ν, that is, β can take on values in the -neighborhood of ν

[see Bazaraa, Sherali, and Shetty (1993) p. 561 for definition of -neighborhood], which does not include point ν. Otherwise, as observed in Choi (1991), when β = ν, the demand function reduces to di = θ[ i − ν(pi − p3−i )], i = 1, 2, that is, as long as p1 = p2 , demands become independent of prices, and infinite profits can be realized by charging infinite prices, leading to unbounded objective function values for Problem P2 (hence for Problem P1 ).
8

As a note, this result does not extend to complementary products (−ν < β < 0).

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sufficient optimality conditions for each linear demand function (Models I, II, and III) under each type of demand shock (additive and multiplicative), see Appendices B and C. The optimality conditions indicate that each linear demand function with each type of demand shock leads to a threshold type investment policy, as stated below. Proposition 2. The optimal investment policy under linear demand function i, i = I, II, III, and demand shock type X, X = A, M , is the following threshold policy: If cK < cX(i) , then K ∗X(i) > 0, otherwise, K ∗X(i) = 0, where
− cA(I ) = E→ [ ξ

νξ2 + βξ1 − cq |ξ2 ≥ ξ1 , νξ2 + βξ1 > (ν 2 − β 2 )cq ] Pr{ξ2 ≥ ξ1 , νξ2 + βξ1 > (ν 2 − β 2 )cq } ν 2 − β2 νξ1 + βξ2 − − cq |ξ1 > ξ2 , νξ1 + βξ2 > (ν 2 − β 2 )cq ] Pr{ξ1 > ξ2 , νξ1 + βξ2 > (ν 2 − β 2 )cq }, + E→ [ 2 ξ ν − β2

− cA(II ) = E→ [A2 − cq |A2 ≥ cq , A2 ≥ A1 , A1 − γA2 ≥ 0] Pr{A2 ≥ cq , A2 ≥ A1 , A1 − γA2 ≥ 0} A → [A1 − cq |A1 ≥ cq , A1 ≥ A2 , A2 − γA1 ≥ 0] Pr{A1 ≥ cq , A1 ≥ A2 , A2 − γA1 ≥ 0}, + E− A − cA(III ) = E→ [ ξ

cM (I )

(1 + γ )ξ2 + γ ξ1 γ 2 2 − cq |ξ2 ≥ ξ1 , (1 + )ξ2 + 1+γ 2 (1 + γ )ξ1 + γ ξ2 γ 2 2 − + E→ [ − cq |ξ1 > ξ2 , (1 + )ξ1 + ξ 1+γ 2 ν max{ 1 , 2 } + β min{ 1 , 2 } = − cq , ν 2 − β2 (1 + γ ) max{ 1 , 2} + γ min{ 1 , 2 } 2 2 − cq . 1+γ

γ γ γ ξ1 > (1 + γ)cq ] Pr{ξ2 ≥ ξ1 , (1 + )ξ2 + ξ1 > (1 + γ)cq } 2 2 2 γ γ γ ξ2 > (1 + γ)cq ] Pr{ξ1 > ξ2 , (1 + )ξ1 + ξ2 > (1 + γ)cq }, 2 2 2

cM (II ) = max{α1 , α2} − cq , cM (III ) =

Proof: Follows directly from Theorems 2, 4, 6, and 8 in Appendices B and C. Proposition 2 is not surprising given the linear cost structure; similar threshold-type results have been obtained in the literature [e.g., Bish and Wang (2004), Chod and Rudi (2005), Fine and Freund (1990), Goyal and Netessine (2005, 2007), Van Mieghem (1998)]. What is interesting is that, under multiplicative shock, the threshold value in every demand function is a constant, independent of the distribution function of Θ. In other words, as long as the demand shock is multiplicative, the investment threshold is the same, whether Θ is a constant or a random variable in Stage 1. Thus, in terms of the “invest, no invest” decision, the firm is immune to forecast errors as long as the uncertainty is of a multiplicative nature. The fundamental reason for this is that the demand shock affects the demand function only as a “scale” parameter. Consequently, whether or not ex-ante production is profitable depends only on the shape of the demand curve (i.e., parameters i , i = 1, 2, ν, and β, all of which are known at the outset), and not on the strength of the market (i.e., the realization of Θ).

13

All the existing literature on flexible resource investment considers additive uncertainty in demand, as a result of which the threshold functions (hence the investment regions) critically depend on the distribution and parameters of the demand shock, see Proposition 2, that is, uncertainty affects the investment region. Our study with both additive and multiplicative demand shocks shows the significant impact the nature of uncertainty has on the firm’s investment region. The resource capacity, however, does depend on the distribution and parameters of the random shock under both additive and multiplicative uncertainties (see the optimality conditions in Theorems 2, 4, 6 in Appendix B). It would be interesting to compare the threshold values under additive and multiplicative shocks. For this purpose, in the multiplicative shock case, we let
i

= E[ξi], i = 1, 2, in Models I and III,

and αi = E[Ai], i = 1, 2, in Model II. Then, when θ = E[Θ] also (this is for completeness only; θ in the additive model does not affect any threshold function), the expected market sizes are equal under both additive and multiplicative shocks. Proposition 3. If E[ξi] = i, i = 1, 2, then cA(j) ≥ cM (j), j = I, II, III. Furthermore, when ξ1 and ξ2 are perfectly positively correlated (i.e., ξ1 = aξ2 with probability one, for some a > 0) and cq = 0, we have cA(j) = cM (j). Proof. See Appendix D. Thus, when the expected market sizes under additive and multiplicative shocks are equal, a variability in the demand intercept (i.e., stochastic ξi , i = 1, 2, in the additive model) is more desirable than a variability in the market strength (i.e., stochastic Θ in the multiplicative model) for all demand models, independent of their respective magnitudes, in that it expands the investment region (by increasing the investment threshold). This is due to the risk pooling advantage under the additive model. For each demand model and under both additive and multiplicative uncertainty, the optimal production strategy in Stage 2 is to always (i.e., for every realization of the random variable(s)) allocate more of the flexible resource capacity to the product with a higher realized market potential (θ i ), i.e., if θ i ≥ θ
3−i , i = ∗ ∗ 1 or 2, then qi ≥ q3−i (see the Appendix for expressions

on the optimal stage 2 production quantities for each model under each type of uncertainty). Then, under multiplicative uncertainty (i.e., the market strength, Θ, is unknown, while both
1

and

2

are known in Stage 1), both market potentials (in fact the entire demand functions) rise or shrink together, that is, market potentials are perfectly positively correlated. On the other hand, under additive uncertainty, it is possible to have a high market potential for one product and a low market potential for the other, which provides the firm with risk pooling capability.

14

Interestingly, a perfect positive correlation between ξ1 and ξ2 (i.e., ξ1 = aξ2 = aξ) is necessary, but not sufficient, for the additive and multiplicative investment thresholds to be equal. This is due to the existence of a positive production cost (cq ), and can be explained as follows. When cq > 0, under additive shock there is a positive probability that production in the second stage will not be profitable at all (i.e., if ξ is too low, equivalently, ξ ∈ ΩA , which, for the case of perfect 5 ¯ ¯ positive correlation, reduces to ξ ≤ ξ for some threshold value ξ) even if the firm has acquired capacity in the first stage. Once the market potential is below the ξ-threshold, the optimal decision in stage 2 is always not to produce, independent of how bad the market potential is. On the other hand, under multiplicative shock, the firm knows, with certainty, in stage 1 (based on parameters
i, i

= 1, 2, ν, β, cq ), whether or not it will be profitable to produce in stage 2. Then, if it is not

profitable, the firm does not acquire any capacity, and if it is profitable, then the firm acquires capacity and always produces some in stage 2, the production quantity depending on the realization of Θ. As a result, both good and bad market conditions affect the firm under multiplicative shock (in other words, if there is investment, then production quantity is always proportional to the market conditions), whereas under additive shock, once the firm invests, if the market is good, then its production quantity will be proportional to market conditions, but if the market is bad, then it will not (because the optimal decision will simply be not to produce). This makes the firm under additive uncertainty partially immune to bad market conditions, resulting in a wider range of investment cost values under which it acquires capacity. When cq = 0, once there is investment under additive uncertainty, the optimal recourse action for the firm will be to always produce in stage 2, with the production quantity being proportional to market condition, similar to the multiplicative shock setting. As a result, under no risk pooling and zero production cost, investment thresholds under additive and multiplicative shocks become equal. In summary, Proposition 3 indicates that modeling the demand shock as additive (when, in fact, it is multiplicative) may lead to a more optimistic decision in that the firm may invest when it should not. Hence, practitioners should be very careful about how to model the demand shock. In the remainder of this section, we perform a comparative statics analysis on how the optimal capacities and thresholds in each demand model and under each type of uncertainty change with the magnitude and variability of the demand shock, and the degree of product substitution. Throughout, the symbols ↑, ↓, and — respectively correspond to the terms weakly increasing, weakly decreasing, and no change.

15

3.2. Impact of Market Size and Market Uncertainty In this section we study the effect of stochastic and convex order increase in the demand shock (i.e., ξi , i = 1, 2, in the additive model, and Θ in the multiplicative model) on the investment region, the optimal capacity, and the optimal expected profit. First we provide some definitions that we make use of subsequently. ¨ Definition 1 (Muller and Stoyan (2002) p.2). Let X and Y be two random variables. We say that X is smaller than the random variable Y with respect to usual stochastic order (written X ≤ST Y ) if ¯ ¯ FX (x) ≤ FY (x), for all real x. Theorem 1. [M¨ller and Stoyan (2002) p.5] The following statements are equivalent: u (i) X ≤ST Y ; (ii) the inequality E[f (X)] ≤ E[f (Y )] holds for all increasing functions f such that the expectations exist. Definition 2. [M¨ller and Stoyan (2002) p.16] Let X and Y be random variables with finite u means. Then we say that X is less than Y in convex order (written X ≤cx Y ), if E[f (X)] ≤ E[f (Y )] for all real convex functions f such that the expectations exist. Thus, while the concept of stochastic ordering allows us to understand the effect of a larger expected market size (i.e., X ≤ST Y implies E(X) ≤ E(Y )), the concept of convex ordering implies a higher variability in market size, keeping its expectation the same (i.e., X ≤cx Y implies V ar(X) ≤ V ar(Y ) and E(X) = E(Y )). We have the following results. Proposition 4. As the demand shock (ξ1 , ξ2 in the additive model, and Θ in the multiplicative model) increases in stochastic ordering, the threshold function, cX(i) , the optimal capacity, K ∗X(i) , and the optimal expected profit, V ∗X(i) , i = I, II, III, X = A, M , change as in Table 3.
Table 3

How the investment decision changes as the demand shock increases in stochastic order Additive Shock Multiplicative Shock (X = A) cX(i) , i = I, II, III K ∗X(i) , i = I, II, III V ∗X(i) , i = I, II, III
↑ ↑ ↑

(X = M ) —
↑ ↑

16

Proposition 4 holds for all demand models, and is not surprising. Furthermore, as discussed above, while the threshold also increases with the expected market size in the additive model, it is independent of the demand shock in the multiplicative model. Proposition 5. As the demand shock (ξ1 , ξ2 in the additive model, and Θ in the multiplicative model) increases in convex ordering (i.e., becomes more risky), the threshold function, cX(i) , the optimal capacity, K ∗X(i) , and the optimal expected profit, V ∗X(i) , i = I, II, III, X = A, M , change as in Table 4.
Table 4

How the investment decision changes as the demand shock increases in convex order (i.e., becomes more risky) Additive Shock Multiplicative Shock (X = A) cX(i) , i = I, II, III K ∗X(i) , i = I, II, III V ∗X(i) , i = I, II, III
↑ ↑ ↑

(X = M ) — ?

We are not able to show, analytically, the behavior of K ∗M (i) , i = I, II, III, when Θ increases in convex ordering. However, our numerical study considering the uniform and gamma distributions for Θ (see Tables 9 and 10 in Appendix E) suggests that for multiplicative demand shock, K ∗M (i), i = I, II, III, decreases when Θ increases in convex ordering. Thus, our results show that how risk affects a flexible firm’s optimal capacity decision, optimal expected profit, and investment region is significantly different for a firm operating under additive uncertainty than a firm operating under multiplicative uncertainty. In particular, it has been shown, when ξ1 , ξ2 follow a bivariate Normal distribution, that with responsive pricing the firm should acquire more flexible resource capacity and is expected to make a higher profit as demand risk increases [Chod and Rudi (2005)]. Proposition 5 extends this result to additive uncertainty under any continuous distribution of ξ1 , ξ2 , and more importantly, it shows that for a firm operating under multiplicative uncertainty, the result is the opposite! While a flexible firm under additive uncertainty benefits from more risk, a flexible firm under multiplicative uncertainty prefers a low risk environment. This result comes from the fact that V ∗ is a convex increasing function of (ξ1 , ξ2 ), but a concave increasing function of Θ. As a result, when the market potentials become more risky,

17

the profit increases faster than the risk, while when the market strength becomes more risky, the profit increases slower than the risk.

3.3. Impact of the degree of product substitution Obviously, properties of the underlying demand function will significantly impact the comparative statics on the investment threshold and the optimal capacity versus the degree of product substitution (γ). Therefore, in what follows, we first analyze how the total market size ( 1 + 2), own-price effect (ν), and cross-price effect (β) change with the degree of product substitution, see Table 5. Then we provide the results of our comparative static analysis.
Table 5

How demand parameters change as the product substitution parameter, γ, increases
total market size own-price effect cross-price effect total demand at fixed prices

Linear demand model Model I Model II Model III

1 (γ) + 2 (γ)

ν(γ) — ↑ ↑

β(γ) ↑ ↑ ↑

d1 (γ) + d2 (γ) ↑ ↓ —

— ↓ —

One would think that the less substitutable (more differentiated) the products are (i.e., the smaller γ is), the larger the total market size is and the less price-sensitive consumers are [Talluri and van Ryzin (2004)]. As Table 5 shows, as γ increases and products become less differentiated, cross-price effects (β) increase in all demand models, a result in line with intuition. However, the total market size ( 1 + 2 ) decreases in γ only in Model II, while being independent of γ in Models I and III. There is one advantage of Model III over Model I, however: Own-price effect increases with γ in Model III (as is the case for Model II), again a result in line with intuition, whereas it is independent of γ in Model I. Propositions 6–8 show the consequences of these properties. Proposition 6. As the degree of product substitution, γ, increases (i.e., products become more substitutable), the threshold function, cX(i) , i = I, II, III, X = A, M , changes as in Table 6. Proposition 7. As the degree of product substitution, γ, increases, the total demand satisfied by the firm, E[Σ2 Di i=1
∗X(i)

], i = I, II, III, X = A, M , changes as in Table 7.

18
Table 6

How cX(i) changes as the product substitution parameter, γ, increases Demand Model Additive Shock Multiplicative Shock (X = A) Model I Model II Model III
↑ ↓ ↓

(X = M )


Table 7

How E[Σ2 Di i=1

∗X(i)

] changes as the product substitution parameter, γ, increases

Demand Model Additive Shock Multiplicative Shock (X = A) Model I Model II Model III
↑ ↓ ↓

(X = M )
↑ ↓ ↓

Proposition 8. As the degree of product substitution, γ, increases, the optimal capacity, K ∗X(i) , i = I, II, III, X = A, M , changes as in Table 89 .
Table 8

How K ∗X(i) changes as the product substitution parameter, γ, increases Demand Model Additive Shock Multiplicative Shock (X = A) Model I Model II Model III
↑ ↓ ↓

(X = M )
↑ ↓ ↓

Thus, under additive uncertainty, both Demand Models II and III lead to a decrease in both the investment threshold, the optimal capacity, and the expected total demand satisfied, as products
9

We note here that Goyal and Netessine (2007) show that K ∗A(II) (for Demand Model II under additive shock)

is decreasing in the degree of product substitution under both monopolistic and duopolistic settings and under “clearance.” Thus, our additive shock result extends this to the case where the clearance assumption is relaxed and the monopolist operates under holdback.

19

become less differentiated (γ increases), that is, the region for which it is profitable for the firm to acquire capacity shrinks, while the capacity acquired and the total demand satisfied decrease. These results are intuitive, and are direct consequences of the fact that under these demand models, the total market demand for a fixed set of prices (d1 (γ) + d2(γ)) does not increase as products become more similar, as opposed to that in Model I (see Table 5). As a result, under additive uncertainty Model I (equivalently, its corresponding measure of product substitution) produces the opposite result (that both the investment threshold, the optimal capacity, and the total market demand satisfied increase as products become more similar), which is misleading. Moreover, when the demand shock is multiplicative, Models II and III still give results in line with intuition (i.e., both the optimal capacity and the expected total demand satisfied decrease in γ), as opposed to Model I. There is now one difference between Models II and III, however. The investment threshold in Model II becomes independent of γ, whereas it is decreasing in γ in Model III. That the threshold is independent of γ in Model II is a result of our modeling assumption for this demand model (see Section 2), which excludes any realization, α1 and α2 , respectively of random variables, A1 and A2 , such that αi − γα3−i < 0, i = 1 or 2, from consideration from the objective function (i.e., no contribution to the objective function comes from such realizations).10 Consequently, if the demand shock is of a multiplicative nature and the investment region is of concern, then only Model III provides a realistic result in that the investment region does shrink as products become less differentiable. Consequently, we conclude that if the products offered by the firm are substitutable, then demand Model I (equivalently, the corresponding measure of the degree of product substitution) should not be used under either additive or multiplicative demand shock; there are alternative linear models (Models II and III) that are analytically tractable and that offer results in line with intuition.

4. Conclusions and Future Research Directions
We consider a two-stage capacity decision problem. A monopolistic firm determines its flexible resource capacity to acquire in the first stage and decides on production quantities and prices in
10

To see this, recall that under Model II, the inverse demand function (for the special case we study, see (Eq. 3)), is

given by pi = αi − di − γd3−i , i = 1, 2. Then, for αi > cK + cq , for i = 1 or 2, with γ ∈ [0, 1), we can always find a feasible solution by letting di ∈ (0, αi − cK − cq ) and d3−i = 0, leading to pi > cK + cq and p3−i = α3−i − d3−i − γdi > α3−i − γαi. Then, either α3−i − γαi ≥ 0, which in turn implies p3−i > 0, and hence, (pi , p3−i ) is feasible, or α3−i − γαi < 0, and this region contributes as a zero-profit region to the objective function and feasibility is not a concern. In either case, a nonnegative profit solution is obtained as long as αi > cK + cq , for i = 1 or 2, or equivalently, as long as cK < max{α1 , α2 } − cq = cM (II).

20

the second stage. We compare three commonly used demand functions and two forms of demand uncertainty. Based on our study, we provide the following suggestions on modeling the uncertain demands of substitutable products. First, practitioners should be very careful about how to model the demand shock, as we find it to have a significant impact on the capacity decision. For all demand functions and demand shocks considered in our paper, the optimal investment policy is a threshold policy. This is hardly surprising given the linear cost structure. What is interesting, however, is that, the investment thresholds under additive demand uncertainty depend on the distributions of demand shocks, while under multiplicative demand uncertainty they do not. Therefore, if the firm (correctly) assumes that the demand shock is multiplicative, then in terms of the “invest or not” decision, the firm will be immune to forecast errors. However, when the expected market sizes under additive and multiplicative shocks are equal, a variability in the demand intercept (i.e., stochastic ξi , i = 1; 2, in the additive model) is always more desirable than a variability in the market strength (i.e., stochastic Θ in the multiplicative model) under all demand functions. Consequently, assuming that the demand shock is additive, when in fact it is multiplicative, may lead to the wrong decision of investing! Furthermore, while the concept of a growth in market size leads to similar conclusions under both types of demand shock, we find that a higher market risk affects the optimal capacity decision quite differently under the different shocks. In particular, when market becomes more risky, the responses of the firm are different. Under additive (multiplicative) demand shock, the firm will respond by increasing (decreasing) its capacity, and it can expect its profit to become higher (lower). These principles are important for both academicians and practitioners. Next, for firms producing substitutable products, the form of the linear demand function should be carefully selected. When we study the impact of the degree of product substitution, Demand Models II and III yield similar conclusions on the threshold function and the optimal capacity, which are in line with intuition. On the other hand, the results produced by Demand Model I are just the opposite! As stated in Section 2.1, Demand Model I (and the corresponding measure on the degree of substitution) is wildly used, however, its demand intercept
i,

i = 1, 2, own-price effect ν,

and cross-price effect β are independent of each other. Therefore, academicians and practitioners studying substitutable products should be careful describing the demands of substitutable products by Demand Model I (equivalently, using the corresponding measure or product substitution). All our analysis focuses on a monopolistic setting. Thus, the next step of this study would be to incorporate competition in our framework. Goyal and Netessine (2007) show, for one of

21

the demand functions considered here (Demand Model II under additive uncertainty), and under various assumptions (i.e., under clearance, with price nonnegativity constraints relaxed, and under the assumption that both products are always produced), that competition has a big impact on the investment region and capacity decision. To continue our analysis, it is necessary (albeit difficult) to study the effect of competition on the insights gained here, especially under multiplicative uncertainty, in this more general setting with holdback. In this paper, we consider several linear demand functions, and our results indicate that the findings depend highly on the choice of the demand model. It would be worthwhile to consider other more realistic, but more complex nonlinear demand functions (such as the isoelastic demand functions). In this work, the firm is allowed to invest in one flexible resource only. It would be a challenging research direction to study our research questions under a more general setting in which the firm can invest in both flexible and dedicated resources. Characterizing the optimal capacity portfolio for independent products is already difficult [see Bish and Wang (2004)], and to our knowledge, the only paper that combines the optimal capacity portfolio and substitution is Lus and Muriel (2006), but through a numerical study for a specific demand distribution under additive uncertainty. Finally, we assume a risk neutral firm that is an expected profit maximizer. Considering different risk behaviors would be another interesting extension to our models.

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