Production capacity buildup and double marginalization mitigation in a dynamic supply chain

Abstract

The paper investigates the extent to which capacity investment considerations interact with the double marginalization effect in a simple supply chain governed by a wholesale price contract. To do so, a non-cooperative differential game model is formulated to study the pricing and capacity investment decisions in a supply chain, which consists of a supplier and a manufacturer. In such a game, there are different decision rules—open-loop, closed-loop, feedback—that are available to the supply chain participants, depending on the observability of the current state of the supply chain. While closed-loop and feedback equilibrium strategies involve the observability of other chain member’s production capacity, open-loop equilibrium strategies do not have such requirement. We examine how the supplier and the manufacturer determine, with the different decision rules, their production capacities and pricing policies to maximize their profits over an infinite planning horizon, and determine how the observability of other supply chain’s members’ production capacity affects the magnitude of the double marginalization effect. Our study suggests that the observability of other chain member’s current production capacity entails a lower production efficiency that results in a greater double marginalization effect. This allows us to conclude that observability of other chain member’s current production capacity is associated with a greater double marginalization effect.