Product variety and vertical differentiation in a batch production system

We develop an integrated modeling framework to study a monopolist firm's decisions of product variety and related production batch planning for vertically differentiated products along design quality attributes. Customers are heterogeneous in their marginal valuations of the product quality level and make their purchase decisions to maximize a utility function of price and quality. Our key insight is the firm's optimal number of product variants is determined by a parameter which is a function of market size and operations-related costs such as setup and inventory holding costs. The parameter can be interpreted as the relative cost of production technology. Less expensive production technology provides the firm opportunities to produce more product variants. More expensive production technology results in less product variety, lower product quality, and less total market coverage (i.e., percentage of the covered market). Our result indicates that producing product variety is always beneficial for a given production technology as long as each customer segment generates nonzero profit. In addition, the firm's access to the customers' preference information can increase profitability via higher quality levels and increased market coverage.