Decoupling the Supply Chain with a Dynamic Discrete Choice Inventory Model

Abstract

Most supply chain works suppose retailers can credibly communicate costs with suppliers. But honest cost disclosure can be untenable because operational costs are opaque and stores have incentives to inflate marginal costs to shift the inventory burden upstream: e.g., stores can reduce their stockout rates by exaggerating the goodwill lost to unsatisfied demand. Accordingly, suppliers may not receive truthful cost estimates, preventing them from identifying globally optimal inventory policies. We develop an empirical means to resolve this supply chain cheap talk problem -- to compel the supplier and retailer to coordinate optimally, even when the latter is self-serving and dishonest. Rather than ask a retailer for its private costs, we estimate them directly with a dynamic discrete choice inventory model. We illustrate our approach with a 5,320-SKU, 1,371-day sample from a Chinese supermarket. We estimate that the distribution center stocking out of the median product costs as much to a store as .03 shipments, .51 lost sales, or 37 days of storage.