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Procurement Mechanism Design in a Two-Echelon Inventory System with Price-Sensitive Demand

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  • Fuqiang Zhang

    () (Olin Business School, Washington University in St. Louis, St. Louis, Missouri 63130)

Abstract

This paper studies a buyer's procurement strategies in a two-stage supply chain with price-sensitive demand. The buyer procures a product from a supplier and then sells to the marketplace. Market demand is stochastic and depends on the buyer's selling price. The supplier's production cost is private information, and the buyer only knows the distribution of the cost. Both the buyer and the supplier can hold inventories to improve service, and a periodic-review inventory system is considered. The buyer takes two attributes into consideration when designing the procurement mechanism: quantity attribute (i.e., the total purchase quantity) and service-level attribute (i.e., the supplier's delivery performance). We first identify the optimal procurement mechanism for the buyer, which consists of a nonlinear menu of contracts for each of the two attributes. It can be shown that the optimal mechanism induces both a lower market demand and a lower service level compared to the supply chain optimum. In view of the complexity of the optimal mechanism, we proceed to search for simpler mechanisms that perform well for the buyer. We find that the above two attributes have different implications for procurement mechanism design: The value of using complex contract terms is generally negligible for the service-level attribute, whereas it can be highly valuable for the quantity attribute. In particular, we demonstrate that a fixed service-level contract, which consists of a target service level and a price-quantity menu, yields nearly optimal profit for the buyer. Additionally, the price-quantity menu is essentially a quantity discount scheme widely observed in practice.

Suggested Citation

  • Fuqiang Zhang, 2010. "Procurement Mechanism Design in a Two-Echelon Inventory System with Price-Sensitive Demand," Manufacturing & Service Operations Management, INFORMS, vol. 12(4), pages 608-626, August.
  • Handle: RePEc:inm:ormsom:v:12:y:2010:i:4:p:608-626
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    File URL: http://dx.doi.org/10.1287/msom.1090.0287
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    References listed on IDEAS

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    Cited by:

    1. Mobini, Z. & van den Heuvel, W. & Wagelmans, A.P.M., 2014. "Designing multi-period supply contracts in a two-echelon supply chain with asymmetric information," Econometric Institute Research Papers EI2014-28, Erasmus University Rotterdam, Erasmus School of Economics (ESE), Econometric Institute.
    2. Wang, Jian-Cai & Lau, Amy Hing-Ling & Lau, Hon-Shiang, 2012. "Practical and effective contracts for the dominant retailer of a newsvendor product with price-sensitive demand," International Journal of Production Economics, Elsevier, vol. 138(1), pages 46-54.
    3. Wang, Hong, 2013. "Contingent payment auction mechanism in multidimensional procurement auctions," European Journal of Operational Research, Elsevier, vol. 224(2), pages 404-413.
    4. Chiarolla, Maria B. & Ferrari, Giorgio & Stabile, Gabriele, 2015. "Optimal dynamic procurement policies for a storable commodity with Lévy prices and convex holding costs," European Journal of Operational Research, Elsevier, vol. 247(3), pages 847-858.
    5. Gao, Long, 2015. "Collaborative forecasting, inventory hedging and contract coordination in dynamic supply risk management," European Journal of Operational Research, Elsevier, vol. 245(1), pages 133-145.
    6. Chen, Kebing & Xiao, Tiaojun, 2015. "Outsourcing strategy and production disruption of supply chain with demand and capacity allocation uncertainties," International Journal of Production Economics, Elsevier, vol. 170(PA), pages 243-257.
    7. Guoming Lai & Wenqiang Xiao & Jun Yang, 2012. "Supply Chain Performance Under Market Valuation: An Operational Approach to Restore Efficiency," Management Science, INFORMS, vol. 58(10), pages 1933-1951, October.

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