Dynamic capacity allocation under service-dependent demand and market exit risk

Motivated by the recent exits of automotive original equipment manufacturers (OEMs) from various markets, we study a stochastic capacity allocation problem in which the capacity allocation decisions of a dominant supplier influence both market demand and the exit risk of an OEM. For example, a shortage of critical components can jeopardize the OEM’s profitability, ultimately increasing its risk of market exit. We develop a stochastic capacity allocation model where the buyer (i.e., OEM) faces service-dependent demand and market exit risk. The customer demand is modeled as a function of the OEM’s market goodwill, which evolves based on the component supply from the supplier. We show that the supplier’s optimal capacity allocation policy follows a goodwill-dependent threshold policy characterized by two control limits, which depend on the OEM’s market goodwill, risk tolerance, and profit objectives. Our analysis yields several key insights. First, even when component supply is more critical for a fragile OEM, the supplier may sometimes allocate less capacity to the fragile OEM than to a non-fragile one. Second, when the OEM faces service-dependent demand, the supplier strategically allocates more capacity than in scenarios without service-dependent demand. Finally, we observe that as customers emphasize recent experiences, the optimal capacity allocation increases. This heightened sensitivity necessitates more careful handling by the OEM, prompting the supplier to ensure a more reliable supply of components. The insights from our study provide suppliers of critical components with valuable strategies for managing production for OEMs that are facing service-dependent demand.