Download Cost-Raising Strategies in Distribution System Design

Cost Raising Strategies
in Distribution System Design
Harish KRISHNAN, Murat OZDEMIR
and Maurice QUEYRANNE
Sauder School of Business
UBC
TRANSLOG - Transportation and Logistics Workshop
Reñaca, Chile
December 11, 2009
Introduction
Traditional logistics studies emphasize cost minimization,
often ignoring effects
• on demand (price-sensitive customers)
 we teach that emphasis should be on profit maximization
• on competition
• competitors may react by adjusting their prices or offerings
 need to consider the resulting equilibrium
• competitors’ (logistics) costs may also be affected by your decisions
•
•
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competitors may benefit from your own improvements
or from “operational collaboration” [Krishnan & Sohoni 2009]
or they may suffer
• “Raising Rivals Costs” [Salop & Scheffman, 1987]
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Outline
 Motivation: a logistics internalization decision
 The business question, and research questions
 A similar case
 Model and Analyses: Internalization conditions
 Non-Strategic Manufacturer
 Strategic Manufacturer
 Other contract types – Power in the supply chain
 Bertrand vs. Cournot Competition
 Summary and conclusion
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Motivation
A logistics consolidation decision considered by a major e-tailer:
 current system:
Manufacturer
Inbound logistics
e-tailer
Competitors
Outbound logistics
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Outbound logistics from DC
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…with consolidation points
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Separate outbound
and inbound logistics
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Combining outbound
and inbound logistics
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The business question
 Should the e-tailer “internalize” its inbound logistics?
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A similar case…
 Nov. 6, 1998: Barnes & Noble announces the $600 M
purchase of leading wholesaler, Ingram Book Group
Publishers
Ingram
Barnes & Noble
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Other booksellers
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Barnes & Noble – Ingram
 Nov. 6, 1998: Barnes & Noble announces the $600 M purchase of leading
wholesaler, Ingram Book Group
 deal would give B&N access to Ingram’s 11 distribution centers, to
 cut distribution costs
 reduce delivery times to on-line customers
 “…would be devastating” “The Godzilla of publishing is wedding the King
Kong of distribution” (Paul Aiken, executive director, Authors Guild)
 Information concerns: access to competitors sales data
 RRC concerns:
 pricing
 availability of popular books
 ability to provide just-in-time delivery
 June 1, 1999: Federal Trade Comm. staff recommends blocking the deal
 even though FTC rarely challenges “vertical mergers”
 June 3, 1999: B&N announces it abandons its Ingram acquisition plans
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The questions…
 Business question:
 should the e-tailer “internalize” its inbound logistics?
 Research question:
 Under what conditions is it profitable for the e-tailer to “internalize”
its inbound logistics?
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Timing
Stage 1:
Manufacturer
chooses contracts
Stage 0:
e-tailer makes
internalization decision
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Stage 2:
Retailer competition
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Research question…
 Research question:
 Under what conditions is it profitable for the e-tailer to “internalize” its
inbound logistics?
 We need to consider the impact on:
(1) Costs
(2) Competitive equilibrium (competitor’s response)
(3) Contracts (manufacturer’s response)
 Let  = 0 denote “no internalization”
 = 1 denote “internalization”
(1) Logistics costs
 For tractability, we assume logistics costs linear in quantities
(we ignore economies of scale to concentrate on strategic interactions)
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Logistics costs
Manufacturer
we
Wholesale price
wf
cme
Inbound logistics costs
e-tailer
Outbound logistics costs ceo
TCe = we + LCe
LCe = cme + ceo
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cmf
f-tailer
cfo
Logistics costs
TCf = wf + LCf
LCf =cmf + cfo
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Demands and competition
Manufacturer
e-tailer
De(pe, pf)
f-tailer
Df(pe, pf)
 E-tailer and f-tailer compete on prices (Bertrand competition)
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Assumptions…
Assume


the demand function Di(pi , pi) for retailer i is smooth, downward
sloping in own price, and strictly positive
Di ( pi , pi )
Di ( pi , pi )
the products are gross substitutes:
 0 and
0
pi
pi
 the profits are strictly (quasi)concave functions of own price
 equilibrium demands are positive
….so (pure strategy) equilibrium exists and is unique
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Conditions for profitable
internalization
With a non-strategic manufacturer, it is optimal for the e-tailer to internalize
if either of these equivalent conditions are satisfied:
1
1
1
p
D
(
p
)

e
1. “Elasticity condition”: e e

p e0 De (p 0 ) e0
where e = e-tailer demand elasticity
 Special case: Iso-elastic demand
Internalization is profitable if revenue increases
1 2
1
(D
(
p
))
(D
(
p
))
e
e
2. “Demand condition”:

(De (p 0 )) 2 (De (p 0 ))
where (De(p)) = slope of demand curve with respect to own price

Special case: Linear demand
Internalization is profitable if demand increases
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Linear demand
Utility function of the representative consumer:
U(qe , qf) = e qe + f qf  ½ (e qe2 +  qe qf + f qf2 )
where qr = quantity purchased from retailer r{e, f}
r = relative market size for channel r
 reflects the degree of product differentiation:
 > 0 if their goods are substitutes
< 0 if they are complements
= 0 if they are independent
and all parameters such that U is increasing and concave (Vives 1999)
Resulting demand function for e:
De (pe , pf) = max {0, min {ae  be pe + d pf , (e  pe )/ e } }
where ae = (e f  f ) / 
be =  f / 
sensitivity to own price
d =/
sensitivity to competitor’s price
 = (e f  2) (2 / e f relative intensity of product differentiation)
For simplicity we assume symmetric demands: e = f and e = f
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Internalization with
linear demands
With linear demands, internalization is profitable for the e-tailer if
 the demand condition is satisfied:
De (p1 )  De (p 0 )
 the changes in logistics costs satisfy the threshold condition:
TCe 
bf d
2beb f  d
Note : 0 
2
TC f
bf d
2beb f  d
2
1
 Main message:
Internalization may be profitable even if it raises the e-tailer’s logistics
cost, as long as it raises the competitor’s cost even more
(Raising Rivals Costs effect)
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Strategic manufacturer
Assume that in each case (internalization or not):
 Logistics costs are given
 Contract costs are determined by the manufacturer
bf d
Earlier condition reads:
TCe 
TC f
2
2beb f  d
(we  LCe ) 
bf d
2beb f  d
2
(w f  LC f )
 Even when the manufacturer optimally sets wholesale prices,
internalization is profitable for the e-tailer if
LCe 
bf d
2beb f  d
2
LC f
 Ratio still depends on logistics costs alone
 A retailer considering a cost-raising strategy need not worry about
the manufacturer’s response
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Other types of contracts
A “powerful” manufacturer:
 Contract consists of a fixed fee, plus wholesale price
 Manufacturer
 sets wholesale price to marginal cost
 extracts all profit from retailers using fixed fee
 maximizes total channel profits
 A cost-raising strategy is never profitable for the e-tailer
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Other types of contracts (2)
A “powerful” e-tailer:
 E-tailer maximizes its channel’s profits
 Internalization is profitable for the e-tailer if
d (2beb f  d 2 )
LCe 
LC f
3
be (4beb f  d )
 Comparison with previous threshold:
d (2beb f  d 2 )
be (4beb f  d )
3

2b f d
(2beb f  d 2 )
 more power makes it “easier” for the e-tailer to internalize
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Summary of findings
1. The e-tailer may follow a cost-raising strategy:

it may “internalize” inbound logistics even if this raises its
own costs
2. This finding is robust to a strategic manufacturer optimally
choosing wholesale prices
3. A “powerful” manufacturer may prevent cost-raising
behavior by the e-tailer
4. A “powerful” e-tailer is more likely to pursue cost-raising
behavior
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Cournot competition
We have assumed price (Bertrand) competition
What if the retailers were quantity (Cournot) competitors?
 Insights are unchanged (some details differ)
d
 Internalization is profitable for the e-tailer if TCe 
TC f
2be
d
 0.5
 Note: 0 
2be
 Compare with the Bertrand threshold:
d
TCe 
TC f
2be

2b f d

TC f
 (2b b  d 2 )
e f





 Computing the Cournot threshold requires only “local” information
2b f d
d
vs.
2be
(2beb f  d 2 )
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Conclusions
1. Cost-raising strategies are an important issue in the design
of distribution systems
2. While designing its distribution systems and logistics
networks, firms may benefit by following a cost-raising
strategy
3. We derive simple and intuitive conditions for profitable
internalization
4. We investigate the role of “power” in the supply chain
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Back to the motivating example…
Issue:
 Can we “operationalize” these results?
 Impact on welfare?
 Antitrust implications?
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Comments welcome!
Thank you.