Global Facility Network Design with Transshipment and Responsive Pricing

Abstract

This paper considers the facility network design problem for a global firm that sells to two markets: the domestic market and a foreign market. Although the firm has to invest in capital-intensive production facilities and produce outputs in the face of demand and exchange rate uncertainties, it can postpone the transshipment, localization, and distribution of the output until after uncertainties are resolved. The key network design decisions faced by the firm are in which of the two markets to locate the capital-intensive production facilities and what the corresponding output levels should be. We provide the complete characterization of the optimal global facility network configuration for two types of global firms: a newsvendor with exogenously given selling prices and a firm with the flexibility of pricing responsively after uncertainties are resolved. Our study's focus is on the impact of exchange rate uncertainty and responsive pricing on facility network decisions. Compared with a newsvendor facing demand uncertainty only, the introduction of exchange rate uncertainty or the use of responsive pricing can increase the attractiveness of centralized production. A responsive-pricing firm's optimal network design differs from that of a newsvendor firm as follows. (1) The firm's network preference is less susceptible to the increase of localization costs. (2) The firm is less likely to switch from a network of regional production to a network of centralized production in response to the increasing size of one market. (3) Demand and exchange rate uncertainties can have opposite effects on its optimal centralized output when the nature of the random shocks they introduce to the firm's demand function is different: under the linear demand function, the optimal centralized output increases in the demand volatility when demand shock is additive, but it may decrease in the exchange rate volatility because the corresponding price shock is multiplicative. Interestingly, common to both types of firms, their network preferences, although sensitive to costs and mean demand and exchange rate, are robust to the demand and exchange rate volatilities, suggesting that transshipment-enabled output substitutability between the two markets diminishes the impact of increasing market volatilities on the network design decision.