Product Quality in a Distribution Channel with Inventory Risk

Abstract

In many industries, product design and manufacturing lead-times are sufficiently long that both the quality level of a product and the amount of inventory produced must be determined well before a firm knows what the actual demand will be. On the other hand, price is typically adjusted dynamically in response to observed demand. In this paper, we conduct a generalized theoretical analysis of such a setting. We first consider a centralized channel and characterize the optimal decisions by establishing relationships that must hold between the elasticity of cost of quality and the elasticity of revenue, show that quality and inventory are substitutes, and more- over show that quality rather than inventory can be a primary lever to mitigate the impact of demand uncertainty. Next, we consider a decentralized channel, in which a manufacturer deter- mines quality and contractual terms, while a retailer determines inventory and retail price. We find that the channel is not coordinated under the optimal wholesale price contract and, counter to standard intuition, product quality can be higher compared to a centralized channel because a simple wholesale price contract shields the manufacturer from inventory risk. We then examine two more sophisticated contracts: quantity discounts and buyback contracts. For the former, we derive the optimal quantity discount schedule, show that it can coordinate the channel even in the presence of joint decisions on quality, inventory and responsive pricing, and determine how it varies as the product and market characteristics change. For the latter, we show that buyback contracts can coordinate the channel only if the manufacturer can specify retail price ceilings that depend on the realized demand outcome, which is an unrealistic contracting instrument. We thus conclude that the contracts that are more likely to be implemented in practice in settings similar to our own are wholesale price contracts (because of their simplicity) and quantity discount con- tracts (because they offer a robust and implementable mechanism to coordinate the channel, with moderate complexity); this is consistent with observations from industry.