Strategic Inventory, Network Externality and Copycats

Abstract

Prior studies on decentralized supply chains have identified the downstream retailer’s strategic incentive of holding inventory in successive periods to bring down the upstream supplier’s wholesale price. This creates an opportunity to mitigate double marginalization and improve the overall supply chain profitability. Our paper introduces two new features that appear naturally in a dynamic environment, network externality and copycatting, and generates novel insights on their impacts on the retailer’s strategic inventory. Namely, strategic inventory is cultivated by network externality but is discouraged by copycats. To elaborate, copycats, on the one hand, deter the retailer’s strategic inventory by exerting strong competition to the brand-name supply chain. When copycats are highly competitive, the retailer chooses not to hold any inventory even if it is costless to do so. Copycats, on the other hand, can amplify the benefit of strategic inventory, provided that it exists, in mitigating double marginalization. As a result, both the supplier and retailer can get better off from experimenting strategic inventory regardless of the retailer’s inventory cost. Network externality, on the one hand, increases the value of brand-name products and incentivizes both the supplier and retailer to introduce more purchases by lowering their prices. This allows the retailer to stock more strategic inventory at lower marginal costs. Network externality, on the other hand, causes cross-period double marginalization, which otherwise would not take place should network externality not exist. Specifically, if the retailer chooses to lower her price to induce higher sales in an early period, the supplier will exploit this opportunity by charging a higher wholesale price at a late stage. This in turn reduces the retailer’s incentive to create high sales in the first place. However, the presence of strategic inventory, as cultivated by network externality, partially alleviates the inefficiency associated with cross-period double marginalization, but to fully overturn this inefficiency, the retailer’s inventory cost must be sufficiently small to enable a considerable amount of strategic inventory affordable to the retailer. A combined analysis of strategic inventory, network externality and copycats provides additional insights. Both strategic inventory and network externality can be leveraged to alleviate the threat of copycats, with the former targeting better supply chain efficiency and the latter aiming at higher values of brand-name products. When managed jointly, they are always complementary in increasing the supplier’s payoff, but can serve as substitutes to the retailer under a large inventory cost and weak network externality.