Cost learning and strategic inventory: who should carry inventory in a vertical supply chain?

Problem Definition: In a decentralized supply chain, the downstream retailer (he) may strategically carry inventory to induce lower future wholesale prices, triggering the upstream manufacturer (she) to raise the early-period wholesale price to deter such behavior. In the presence of cost learning, where future production cost declines with cumulative early-period production, the manufacturer faces a key trade-off. To accelerate cost learning, should she lower the early-period wholesale price to encourage larger retailer orders and downstream inventory carryover, or should she instead overproduce in the early-period and hold inventory herself, bearing the holding cost? Methodology: We develop a game-theoretic model to capture such supply chain interactions in the presence of the manufacturer’s cost learning and the retailer’s strategic inventory. Results: We characterize the conditions for different inventory holding patterns in the supply chain, where only the manufacturer, only the retailer, both, or neither carries inventory. Countering the established notion that a manufacturer should hold inventory to enhance cost learning when her holding cost is low, our research reveals that she should abstain from holding any inventory, even at zero holding cost, when the retailer’s holding cost is sufficiently low. Further, we show that the manufacturer should completely refrain from holding inventory as an instrument to accelerate learning, irrespective of the retailer’s holding cost, when there is no uncertainty associated with cost learning or when the learning benefits are realized continuously. Managerial Implications: Our results guide manufacturers experiencing cost learning to determine their inventory decisions based on cost learning features and the retailer’s holding cost.