Supply chain contracting with product substitution and partial vertical integration

Abstract

Retailers stock products from competing manufacturers and a stockout of one product may cause a proportion of unsatisfied demand to be transferred to another good. Depending on the market power of the retailer, consumer demand may be at constant prices or represented by downward sloping demand curves. Retail inventory may be managed by the retailer (RMI) or by the vendor (VMI). These possibilities are considered for various supply chain configurations including independent suppliers and a vertically integrated ‘store brand’. The results are compared with theoretical and empirical findings from the literature. We find that the choice of supply chain structure and the type of integration selected by the retailer have a significant impact on the overall performance of the supply chain. Retailers prefer VMI and suppliers would prefer RMI as it maximises their own profit. In this context, it is important to recognise the significant agency costs associated with these supply chains.