On service degrade at a discount: Capacity, demand pooling, and optimal discounting

In this paper we study the capacity investment decisions and operational strategies of a firm providing two‐class services facing uncertain demands. The capacity decisions of the resources are made before demands are observed. Each service can be implemented by its corresponding resource. Should a mismatch between the capacity and the actual demand for the services arise, the low‐class resource can be used as a substitute for the high‐class service. We introduce an operational strategy called degrade‐at‐a‐discount, where a price discount is offered to motivate customers to accept a lower class service when their original choice is out of capacity. By formulating the problem as a one‐period, two‐stage stochastic problem, we analyze how to set up the optimal capacity and the optimal discount. We also conduct a comprehensive numerical study to show the benefits of the degrade‐at‐a‐discount strategy.