The Price Theory and Empirics of Inventory Management

Abstract

We develop a directed search model where buyers purchase goods produced by sellers through intermediaries. The presence of search frictions creates demand uncertainty and makes instantaneous replenishment impossible. To avoid the risk of stockout, an intermediary holds inventory. The intermediary's trade-off between inventory cost and stockout risk depends on the size of inventory and determines its optimal retail pricing and restocking policy. In equilibrium, when the intermediary's inventory increases, he posts a lower retail price to speed up sales and depresses wholesale price to slow down purchases. In the steady state, the equilibrium generates unimodal distributions of both inventory holdings and retail prices. Using a dataset that contains detailed information on used car listings, we empirically examine dealers' inventory, new orders, sales, and retail prices. Our empirical findings are consistent with the model predictions.

Keywords: Directed Search, Inventory Management, Revenue Management, Price Dispersion, Used Car, Dealers, Intermediary

JEL Classification: D82, D83, L15, L62