Aligning Capacity Decisions in Supply Chains When Demand Forecasts Are Private Information: Theory and Experiment

Abstract

We study the coordination problem of a two-firm supply chain in which firms simultaneously choose a capacity before demand is realized. We focus on the role that (a lack of) common knowledge of demand forecasts has on firms' ability to align their capacity decisions. When forecasts are not common knowledge, there are at most two equilibria: A complete coordination failure or a monotone equilibrium in which firms earn strictly positive profits. The former equilibrium always exists, while the latter exists only when the marginal cost of capacity is sufficiently low. In the monotone equilibrium, capacities are misaligned with probability 1 and profits are lower than in the efficient equilibrium of the common knowledge game. We also show that firms have an incentive to share their information. In a series of experiments, we test the model's predictions. We find that: (1) most subjects use monotone strategies and those that do not earn significantly less; (2) when forecasts are not common knowledge, alignment often suffers, though profits do not; (3) information sharing improves earnings through greater accuracy and alignment; and (4) subjects learn to align their decisions, and earnings increase, over time.