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The purpose of this study is to analyze the problem of optimal product line design in marketing channels where consumers are heterogeneous in both horizontal and vertical dimensions.

This paper develops a model to evaluate when it is preferable for a firm to extend the product line in a vertical or horizontal direction. Consumers are modeled as being vertically heterogeneous with respect to their valuation of quality and horizontally heterogeneous with respect to their preference on the esthetic component of the product. These model characteristics allow us to consider a broader set of product line extension strategies. By considering both a vertically integrated channel and a decentralized channel, this study investigates how channel structure influences optimal product line design. The problem with supplemental numerical analyses is mathematically analyzed.

The analysis shows that a horizontal product line extension strategy that offers the customized product can be used as an alternative to a vertical product line extension strategy. If the fixed cost is not too high, offering the customized product with low quality may be preferred to the quality-based segmentation strategy. Furthermore, the analysis shows that the channel structure is influential as the preference for the horizontal product line extension strategy is more pronounced in the decentralized channel than in the centralized channel.

The analysis presented in this paper is limited by the consideration of full market coverage. Further research is needed to see how the results can be generalized to the case with partial market coverage.

The analysis suggests that a firm may consider product customization as part of its product line strategy. Information regarding market characteristics and channel structure is important when deciding on the optimal product line design.

The model reflects a more realistic marketing strategy and channel structure than previous studies that typically consider product line extension in only one direction and focus on the centralized distribution channel. Combining the standard product line extension and customization strategies also represents an important contribution to the literature. These extensions produce interesting new results and insights into a firm’s optimal product line design strategy.