The Impact of Inventory Risk on Market Prices Under Competition

Abstract

Firms often must procure inventory/capacity before knowing what the demand will be, so there is a potential for a mismatch between inventory and demand, the “inventory risk.” We show that because of inventory risk, an increase in the number of competitors can lead to an increasing trend in market prices. Furthermore, we show that, ceteris paribus, because of how inventory risk impacts competitive behavior, firms may prefer to incur inventory risk rather than to avoid it. We establish these findings using three rather different yet complementary methodologies: (i) using data from a classroom experiment, (ii) using a quantal response equilibrium simulation to capture realistic irrationalities in managerial decisions, and (iii) using a fully-rational Nash equilibrium model. That three very different methods lead to identical qualitative findings reinforces the main message of our paper: inventory risk reverses the standard intuition for how an increase in the number of competitors impacts prices.

Keywords: competition; inventory risk; pricing