Time- and price-based product differentiation in hybrid distribution with stockout-based substitution

A delivery mix that includes delivery from stock and drop-shipping is of interest to many internet retailers. We consider a retailer serving a time- and price-sensitive market with two substitutable products that differ in the guaranteed delivery time and price, an express product (delivered from the stock) and a regular product (drop-shipped). In case of stockout, customers may switch from the express product to the regular product. We study how to differentiate the products in terms of delivery times and prices and how to determine the stock level to maximize the retailer's expected profit while satisfying service constraints. We solve different variants of the problem and derive insights into the optimal retailer's strategy. In addition, we study the impact of stockout-based substitution. This paper is the first to investigate time- and price-based differentiation along with inventory decisions for a retailer who relies on a hybrid distribution to satisfy a time- and price-sensitive demand subject to stockout-based substitution. When prices and stock are fixed, in addition to minimum and maximum time differentiations, a medium differentiation strategy may be optimal but depends on the stock level. When only prices are fixed, there exists a price differentiation limit below which a minimum time differentiation is optimal, and above which only the express product should be offered. For the general model, numerical experiments show that a higher stockout-based substitution leads to greater time differentiation (which is consistent with the results of previous models) and more stock. However, this would not impact the price differentiation.