Product Quality in a Distribution Channel With Inventory Risk

Marketing Science, Vol. 36, No. 5, September-October 2017

44 Pages Posted: 30 Apr 2015 Last revised: 25 Aug 2019

See all articles by Kinshuk Jerath

Kinshuk Jerath

Columbia University - Columbia Business School, Marketing

Sang-Hyun Kim

Yale School of Management

Robert Swinney

Duke University - Fuqua School of Business

Date Written: January 1, 2017

Abstract

In many industries, product design and manufacturing lead-times are sufficiently long that both the quality level of a product and the amount of inventory produced must be determined before a firm knows what the actual demand will be. In this paper, we conduct a theoretical analysis of such a setting. We first consider a centralized channel and characterize the optimal decisions by establishing relationships that must hold between the elasticity of cost of quality and the elasticity of revenue, and show that quality and inventory are strategic substitutes. Next, we consider a decentralized channel with a wholesale price contract, in which a manufacturer determines quality and wholesale price, while a retailer determines inventory and retail price. We find that, different from the case without endogenous inventory, product quality can be higher in a decentralized channel compared to a centralized channel, and this is because a wholesale price contract shields the manufacturer from inventory risk. For both centralized and decentralized channels, we find that as demand uncertainty increases, quality decreases while, different from the case without endogenous quality, inventory can be U-shaped. Interestingly, to mitigate the impact of demand uncertainty on profit, quality can be a more effective lever than inventory in a centralized channel; however, in a decentralized channel, quality is less responsive and inventory more responsive to demand uncertainty than in a centralized channel.

Keywords: quality; demand uncertainty; newsvendor; responsive pricing; channel coordination; marketing and operations interface

JEL Classification: M11, M21, M31

Suggested Citation

Jerath, Kinshuk and Kim, Sang-Hyun and Swinney, Robert, Product Quality in a Distribution Channel With Inventory Risk (January 1, 2017). Marketing Science, Vol. 36, No. 5, September-October 2017, Available at SSRN: https://ssrn.com/abstract=2600278 or http://dx.doi.org/10.2139/ssrn.2600278

Kinshuk Jerath (Contact Author)

Columbia University - Columbia Business School, Marketing ( email )

New York, NY 10027
United States

Sang-Hyun Kim

Yale School of Management ( email )

135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
United States

Robert Swinney

Duke University - Fuqua School of Business ( email )

Box 90120
Durham, NC 27708-0120
United States

HOME PAGE: http://www.robertswinney.com

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