Positive vs. negative externalities in inventory management: Implications for supply chain design

In this paper we analyze the impact of supply-side externalities existing among downstream retailers on supply chain performance. Namely, multiple retail firms face stochastic demand, purchase the product from the upstream wholesaler, and make stocking decisions that affect all other retailers in the same echelon. Two sources of inefficiencies exist in such a supply chain: One is double marginalization and the other is externalities among retailers. Whereas double marginalization always leads to inventory understocking at the retail echelon, we find that the implications of externalities are more complex, because different externalities can improve or deteriorate supply chain performance, relative to the situation without externalities. We show that the effect of externalities depends critically on whether the stocking decisions of retailers exhibit positive (complementarity) or negative (substitutability) externalities, and whether retailers are managed centrally or competitively. Under complementarity, competing retailers tend to understock the product (compared with the centralized inventory management at the retail level), thus aggravating the double-marginalization effect. This is the opposite of what happens under substitutability, where competing retailers tend to overstock the product, thus compensating for the double-marginalization effect. Hence, we conclude that supply chain coordination between retailers and the wholesaler is most important when there is downstream competition that exhibits complementarity. From the wholesaler's point of view, competition among retailers is preferable over centralization of retailers when externalities are negative, and vice versa when externalities are positive. Moreover, with competition on complements, both retailers and the wholesaler have incentives to coordinate the supply chain.