The Impact of Inventory Risk on Market Prices

Abstract

This paper demonstrates and explains a surprising effect: that an increase in the number of competing firms may lead to an increase in the equilibrium market price in a situation when firms compete on both price and quantity (inventory/capacity). We attribute this effect to inventory risk: the potential mismatch between the firm’s inventory and demand that occurs if the firm incorrectly judges how much additional demand it will generate if it lowers the price. As we show, such a risk increases in the number of competitors, making firms’ inventory management a lot more difficult and costly, hence triggering an increase in equilibrium prices. We use the concept of quantal response equilibrium to model competition between boundedly rational firms, illustrate the price increase, and then examine how it changes depending on the number of competitors, the degree of their rationality, and the composition of market demand and firms’ costs.