Value of down-conversion policy in a vertical differentiated co-production system

Abstract Raw material down conversion is common in practice, in which high-end raw materials may be transformed into low-end materials to make low-end products at a down-conversion cost. Motivated by this phenomenon, this paper investigates the profit-maximizing manufacturer’s joint input quantity, down-conversion policy and pricing decisions in a co-production system wherein two vertical differentiated products are simultaneous manufactured. We employ two stylized modeling approaches (i.e., deterministic yield model and random yield model) to formulate the manufacturer’s operation behavior. We find that the adoption of down-conversion policy is threshold controlled by the unit down-conversion cost in each yield scenario, and only when the unit down-conversion cost is sufficiently low will the manufacturer adopt this policy. In detail, the implementation of this policy tends to exaggerate the total demand base (demand enhancement effect) and increase the price differentiation (relieved cannibalization effect). To benefit from this policy sufficiently, the manufacturer is always aggressive to input more quantity regardless of the yield pattern (i.e., deterministic or random). Specifically, when the manufacturer adopts down-conversion policy (under the assumption that the random yield follows a uniform distribution), the optimal input quantity in the random yield scenario is higher than that in the deterministic yield scenario when the unit down-conversion cost is low and vice versa. In addition, the manufacturer has higher possibility to implement down-conversion policy in the random yield scenario.