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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 • • M. Queyranne competitors may benefit from your own improvements or from “operational collaboration” [Krishnan & Sohoni 2009] or they may suffer • “Raising Rivals Costs” [Salop & Scheffman, 1987] Cost Raising Strategies in Distribution System Design 2 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 M. Queyranne Cost Raising Strategies in Distribution System Design 3 Motivation A logistics consolidation decision considered by a major e-tailer: current system: Manufacturer Inbound logistics e-tailer Competitors Outbound logistics M. Queyranne Cost Raising Strategies in Distribution System Design 4 Outbound logistics from DC M. Queyranne Cost Raising Strategies in Distribution System Design 5 …with consolidation points M. Queyranne Cost Raising Strategies in Distribution System Design 6 Separate outbound and inbound logistics M. Queyranne Cost Raising Strategies in Distribution System Design 7 Combining outbound and inbound logistics M. Queyranne Cost Raising Strategies in Distribution System Design 8 The business question Should the e-tailer “internalize” its inbound logistics? M. Queyranne Cost Raising Strategies in Distribution System Design 9 A similar case… Nov. 6, 1998: Barnes & Noble announces the $600 M purchase of leading wholesaler, Ingram Book Group Publishers Ingram Barnes & Noble M. Queyranne Cost Raising Strategies in Distribution System Design Other booksellers 10 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 M. Queyranne Cost Raising Strategies in Distribution System Design 11 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? M. Queyranne Cost Raising Strategies in Distribution System Design 12 Timing Stage 1: Manufacturer chooses contracts Stage 0: e-tailer makes internalization decision M. Queyranne Cost Raising Strategies in Distribution System Design Stage 2: Retailer competition 13 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) M. Queyranne Cost Raising Strategies in Distribution System Design 14 Logistics costs Manufacturer we Wholesale price wf cme Inbound logistics costs e-tailer Outbound logistics costs ceo TCe = we + LCe LCe = cme + ceo M. Queyranne Cost Raising Strategies in Distribution System Design cmf f-tailer cfo Logistics costs TCf = wf + LCf LCf =cmf + cfo 15 Demands and competition Manufacturer e-tailer De(pe, pf) f-tailer Df(pe, pf) E-tailer and f-tailer compete on prices (Bertrand competition) M. Queyranne Cost Raising Strategies in Distribution System Design 16 Assumptions… Assume the demand function Di(pi , pi) for retailer i is smooth, downward sloping in own price, and strictly positive Di ( pi , pi ) Di ( pi , pi ) the products are gross substitutes: 0 and 0 pi pi the profits are strictly (quasi)concave functions of own price equilibrium demands are positive ….so (pure strategy) equilibrium exists and is unique M. Queyranne Cost Raising Strategies in Distribution System Design 17 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 M. Queyranne Cost Raising Strategies in Distribution System Design 18 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 M. Queyranne Cost Raising Strategies in Distribution System Design 19 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) M. Queyranne Cost Raising Strategies in Distribution System Design 20 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 M. Queyranne Cost Raising Strategies in Distribution System Design 21 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 M. Queyranne Cost Raising Strategies in Distribution System Design 22 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 M. Queyranne Cost Raising Strategies in Distribution System Design 23 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 M. Queyranne Cost Raising Strategies in Distribution System Design 24 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 ) M. Queyranne Cost Raising Strategies in Distribution System Design 25 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 M. Queyranne Cost Raising Strategies in Distribution System Design 26 Back to the motivating example… Issue: Can we “operationalize” these results? Impact on welfare? Antitrust implications? M. Queyranne Cost Raising Strategies in Distribution System Design 27 Comments welcome! Thank you.