How do firms address the problems of spoilage and spill?

Question

What will be an ideal response?

Answer 1

Answer: In most instances of differential pricing, demand from the segment paying the lower price arises earlier in time than demand from the segment paying the higher price. The basic trade-off to be considered by the supplier with production capacity is between committing to an order from a lower price buyer and waiting for a high-price buyer to arrive later on. The two risks in such a situation are spoilage and spill. Spoilage occurs when the capacity reserved for higher price buyers is wasted because demand from the higher price segment does not materialize. Spill occurs if higher price buyers have to be turned away because the capacity has already been committed to lower price buyers.

The supplier should decide on the capacity to commit for the higher price buyers so as to minimize the expected cost of spoilage and spill. A current order from a lower price buyer should be compared with the expected revenue from waiting for a higher price buyer. The order from the lower price buyer should be accepted if the expected revenue from the higher price buyer is lower than the current revenue from the lower price buyer.