Electronic Markets and Supply Chain Coordination

1. Electronic Markets and Supply Chain Coordination Xiaotong Li September, 2002 This project was supported by a research grant from CMER University of Alabama in Huntsville This work benefits from my conversation with John Conlon and Vincent Wang

2. Background • As one of the leading multidisciplinary business research topics, supply chain coordination literature is growing exponentially. • Internet technologies and electronic markets generates many opportunities in supply chain management by providing extensive connectivity. • With highly efficient and economic communication channels, collaboration among supply chain partners is greatly facilitated through chain-wide coordination, information sharing and incentive-aligned contracting.

3. Literature • The standard supply chain coordination model is the so-called “Newsvendor Model” in which a single supplier and a single retailer try to coordinate through order and production quantity. • There are many interesting contracting mechanisms including wholesale price contract (Bresnahan and Reiss (1985), buy-back contract (Anupindi and Bassok 1999), revenue sharing contract (Cachon and Lariviere 2000), quantity-flexibility contract (Tsay and Lovejoy 1999) and sale rebate contract (Taylor 2000).

4. Literature • The first extension allows the retailer to change retail price (Petruzzi and Dada 1999). The second extension gives the retailer the option to make some non-pricing efforts to spur demand (Netessine and Rudi 2001). The third extension allows multiple retailers (Wang and Gerchak 2001). Other extensions include two inventory replenishment model, multiple echelon model, internal market transfer and demand forecast sharing under information asymmetry. • Among these extensions, demand forecast sharing under information asymmetry (Cachon and Lariviere 2001) looks particularly interesting. It recognizes the wide spread information asymmetry existed in most supply chains.

5. Basic Framework of Supply Chain Coordination • Each partner in a decentralized supply chain is in general myopic, supply chain coordination problems are often examined in the game-theoretic framework. • A supply chain is said to be coordinated if all channel participants’ independently made myopic strategies can achieve chain-wide global optimum.

6. Why Coordination • Numerous studies have shown that decentralized supply chains could become inefficient and even in some cases chaotic without proper coordination. • For example, the well known “Bullwhip effect” illustrates how small disturbance of downstream orders can distort upstream partners’ perception of market dynamics (Lee, Padmanabhan and Whang 1997).

7. Why Coordination • Some supply chain participants may seek informational rent and credible information sharing becomes a challenge. Some recent studies along this line include information sharing (Lee and Whang 1998), IT-enabled new contracting mechanisms (Jin and Wu 2001) and the Internet facilitated new distribution channels (Netessine and Rudi 2001), and e-business supply chain integration (Lee and Whang 2001).

8. The 1st Model( Preliminary with unclear Tractability) • The first model examines a newsvender model in a continuous time environment. • Both coordinating parties’ expectations are modeled by a martingale process. • A generalized option embedded contract (like the contract used in Cachon and Lariviere 2001) is used to coordinate the chain. So I am able to model the scenario as real options (Li and Johnson 2002, Dixit and Pindyck 1994).

9. The 1st Model • Under risk neutrality, the option value can be endogeously determined and the option excise timing is also relevant here (compared to the two period model where options can only be excised at the beginning of the 2nd period). • Thanks to real time data sharing via high-speed network, the two parties can design a contingent contract on a real time basis.

10. The 1st Model • Our model will focus on the continuous time contingent contracts that coordinate the chain. • Information asymmetry may significantly complicate the coordination problem. It requires coordination on two dimensions: options pricing and excise timing.Bayesian game is considered with incomplete information. • In a more general setting, we also need to consider the feedback of elastic demand on option values like Burnetas and Ritchken (2002).

11. The 2nd Model(also preliminary) • The second model is motivated by my recent studies of “informational externalities” and “network externalities”. • Similar to Katz and Shapiro (1986), we consider a two period model with un-internalized externalities. • In order to take advantage of network effects in the second period, a supply chain player may alter its pricing strategy to preemptively gain market share in the first period.

12. The 2nd Model • But his chain partner may not have the incentive to help him without appropriate long-term contract (or just because of the information asymmetry). • I thus focus on subgame perfect equilibrium. • The problem becomes even more complex when a competing supply chain is also considered in the model. Competing chains are commonly seen in system market (Church and Gandal 2000, Farrell, Monroe and Saloner 1998).

13. The 2nd Model • If two chains are competing (we consider a duopoly) in a market subject to network externalities, both chain’s pricing strategies can affect chain coordination dynamics. • In the case that multiple equilibria exist, equilibrium selection may depend on the assumptions of consumers’ expectation dynamics (e.g. rational expectations v.s. naïve expectations).

14. The 2nd Model • With incomplete information and information asymmetry, the model will also address issues like signaling (also discussed in Cachon and Lariviere 2001), cheap talk (Crawford and Sobel 1982, Farrell 1994, Battaglini 2002) and strategic learning (Ellison and Fudenberg 1995). • If consumers form herd because of informational externality, the supply chain partners face a similar coordination problem as the network externality scenario: preemptive pricing strategy may be used.

15. Some Potential Issues • An intriguing question merits exploration is whether electronic markets and the Internet in general can facilitate supply chain coordination and internalization of externalities. • Cheap talk v.s. formal coordination • Costs of Supply Chain Contracting. Implications from Grossman-Hart-Moore Incomplete contracts.