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...instance, the average retail price of personal (desktop) computer drops by 50-58% within the first year of its production life cycle (Anon, 1998; Lee et al., 2000). Because of uncertain demands and a volatile environment, the retailers of such products tend to postpone their orders to avoid "buying high and selling low". As a result, retailers may stock too little of a product to satisfy the market demand, and suppliers (manufacturers) strive to provide incentives to the retailers to stock more.
In particular, price protection (P), midlife returns (M) and end-of-life returns (E) are often used by the suppliers to encourage the retailers to order more, especially in the PC industry. In other industries, instead of price protection, a commonly used policy is a rebate (R). Price protection policies grant retailers credits applied to their unsold inventories when the prices drop during the product life cycle. Midlife returns allow retailers to return units partway through their life cycles at a predetermined price. End-of-life returns allow retailers to return unsold units at the end of their life cycles. A rebate policy specifies the credit that the retailer will receive from the manufacturer for each unit sold after a retail price drop. (Note that this definition is slightly different from the one used in the literature for one-period models. Instead of a threshold on the quantity sold, we have a threshold on the selling time.) These policies, although common, are controversial and cause confusion in the industry. In fact, some combinations of these policies hurt the manufacturers (see, for example, Lee et al. (2000) and Taylor (2001)).
The purpose of this paper is to investigate the effectiveness of these policies in channel coordination. That is, we would like to know whether any combination of these policies can make a decentralized supply chain act in a manner similar to a fully integrated chain in which the manufacturer owns its retail channel. When such coordination happens, we also want to know whether there exists a win-win situation which means that the profit of each party is strictly greater than that under a no coordination policy. (See below for more precise definitions for channel coordination and win-win situations).
We employ a two-period, two-party supply chain model consisting of one manufacturer and one retailer. The beginning of the first period represents the beginning of the product life cycle, while the end of the second period marks the end of the life cycle. At the beginning of the second period, a competing new product is introduced to the market, so there is a retail price drop for the product under consideration. Unsatisfied demand is lost. There is a holding cost for each item left at the end of each period and a stockout cost for each unsatisfied demand. There is also a fixed salvage value for the product at the end of both periods. The retail prices are fixed in both periods, and the demands for the two periods are independent and exogenous. At the beginning of the first period, all exogenous parameters (retail prices, production costs, salvage values and demand distributions) are known to both parties. Also, the manufacturer specifies the wholesale price(s) and the terms of channel policies, and he/she will commit to the terms of the trade. The retailer decides its order and disposal quantities. The lead times for the retail orders are negligible.
Within this framework, we examine two closely related models but reach different sets of findings. The first model considers products with long manufacturing lead times relative to their life cycles. In this case, the retailer has only one purchase opportunity at the beginning of the first period. The second model considers products with shorter manufacturing lead times so that the retailer has two purchase opportunities (at the beginning of each period). We assume that the retail price is not less than the wholesale price.
For each model, we follow a four-step approach. In step 1, we obtain the optimal profit of the integrated (or centralized) chain in which the manufacturer owns the retailer so there is no wholesale price. Clearly, this is the maximum possible profit for the entire chain. In step 2, we analyze a decentralized chain in which the retailer is an independent entity and the only contract in place is the wholesale price the manufacturer charges. We obtain each party's optimal profit in this setting and demonstrate that their sum is smaller than the maximal channel profit obtained in step 1. We call this system the uncoordinated chain because no channel policy is used. In step 3, we derive the manufacturer and retailer profits in a decentralized chain in which the manufacturer offers a combination of the channel policies P, M, E and R. If there exist policy parameters such that the chain achieves the centralized profit, then we say that the chain is coordinated (under that policy) and the combination policy is a coordination policy. Finally, in step 4, we compare the individual party's profit in a coordinated chain (identified in step 3) with its counterpart in the uncoordinated chain (obtained in step 2). If the profit of each party is improved after coordination, we say that a win-win situation is achieved and the corresponding policy is a win-win policy.
For the single-purchase-opportunity model, our key result is that both PME (price protection plus midlife returns and end-of-life returns) and RME (rebate plus midlife returns and end-of-life returns) guarantee a win-win outcome. However, neither price protection alone nor midlife returns plus end-of-life returns alone can guarantee a win-win outcome. From the analysis, we see that, not surprisingly, price protection and rebates play a similar role in channel coordination and they are equivalent. In addition, under rebate alone or RE, PE cannot guarantee the coordination. We also identify the condition under which ME can coordinate the chain. These findings show the necessity of PME or RME.
For the two-purchase-opportunity model, in contrast to the one-purchase-opportunity model, a win-win policy may not exist. This is because the retailer may order too much in the first period if the wholesale price in the second period is not low enough. Indeed, it can be shown that there exists an upper bound on the supplier's profit for a coordinated chain and the upper bound depends only on the exogenous parameters. Thus, it is possible to find wholesale prices with which the supplier's profit in the uncoordinated chain is greater than the upper bound, making the supplier worse off after coordination. We also show that, if the retailer incurs no stockout costs due to loss of goodwill in the first period, then PME is always a win-win policy. Therefore, the stockout cost in the first period determines the existence of a win-win policy.
The above finding is based on the assumption of a linear wholesale price, that is, the wholesale price is independent of the order quantity. It is worth mentioning that the result holds when the wholesale price is nonincreasing in order quantity--the usual quantity discount scheme used in practice. In fact, any coordination policy that encourages the retailer to order more, such as returns policies and rebates, may not work either. This is in contrast to the conclusions drawn from the vast literature on single-period models. On the other hand, under a piecewise increasing wholesale price structure (the opposite of the quantity discount pricing scheme) PME is a win-win policy.
Another contribution of our research is that we develop detailed procedures to determine the win-win policy parameters under the assumption that the wholesale price can never exceed the retail price. These procedures provide intuitive guidelines for managers to see what kind of policy to use and what parameters to choose in order to achieve a win-win outcome. For instance, from the procedures we learn that the magnitude of the wholesale (or retail) price drop offers a benchmark for choosing between price protection alone and PME. The procedure for the two-purchase-opportunity model indicates when and how to limit the retailer's order quantity in period 1 in order to achieve a win-win outcome.
The analytical approach taken in our research may also benefit future research on related multi-period models. In particular, our approach is to split the two-period model into two one-period models (period-1 and period-2 models). For each one-period model, we identify the return policy parameter so that the order-up-to level coincides with the centralized solution. These parameters provide a benchmark for the original two-period model. For example, when the return price in the period-1 model is greater than the retail price in the period-2 model, the supplier needs to provide more incentives to the retailer than a return policy can offer, such as price protection.
For the same single-purchase-opportunity model as ours, Lee et al. (2000) show that a properly chosen price protection credit coordinates the channel. For the two-purchase-opportunity model, assuming the second period wholesale price equals the unit production cost, they show that channel coordination can be achieved by setting the right wholesale price and the price protection credit. However, they do not discuss the issue of win-win.
Taylor (2001) focuses on the two-purchase-opportunity model and explores the role of various combinations of price protection, midlife returns and end-of-life returns in channel coordination. He shows that, under certain conditions, the combination of all these policies, PME, guarantees both coordination and a win-win outcome. However, his research implicitly assumes that the wholesale price can be greater than the retailer price. In our study, we explicitly assume this can never happen.
Employing a one-period model, Taylor (2002) shows that the target-level rebate policy (under which the manufacturer pays the retailer a rebate for each unit sold beyond a specified target level) plus returns can both coordinate the chain and guarantee a win-win situation. Note that, under a target-level rebate policy, the volume is fixed but the time for the retailer to start to receive the rebate is random. This is different from the midlife rebate policy. Under the latter, the rebate credit is granted to the retailer for the items held in inventory past a specified time point, so the time is fixed while the volume level at which the retailer receives the rebate is random. Our paper appears to be the first to examine the midlife rebate policy.
Barnes-Schuster et al. (1998) use a two-period model with correlated demand to study the role of returns and future-purchase options in channel coordination. They show that, under linear pricing strategies, options plus returns do not always lead to coordination. We consider a different set of policies, and show that under linear pricing strategies these policies can always coordinate the chain.
For other related literature, we refer the reader to Pasternack (1985), Padmanabban and Png (1995), Kandel...
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