Cost Raising Strategies in Distribution System Design Harish KRISHNAN, Murat OZDEMIR and Maurice QUEYRANNE Sauder School of Business UBC TRANSLOG - Transportation

Cost Raising Strategiesin Distribution System Design

Harish KRISHNAN, Murat OZDEMIRand Maurice QUEYRANNE

Sauder School of Business UBC

TRANSLOG - Transportation and Logistics Workshop Reñaca, Chile

December 11, 2009

M. Queyranne Cost Raising Strategies in Distribution System Design 2

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• competitors may benefit from your own improvements

or from “operational collaboration” [Krishnan & Sohoni 2009]• or they may suffer

• “Raising Rivals Costs” [Salop & Scheffman, 1987]


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


Motivation

A logistics consolidation decision considered by a major e-tailer: current system:

Manufacturer

e-tailer Competitors

Inbound logistics

Outbound logistics


Outbound logistics from DC


…with consolidation points


Separate outboundand inbound logistics


Combining outboundand inbound logistics


The business question

Should the e-tailer “internalize” its inbound logistics?


A similar case… Nov. 6, 1998: Barnes & Noble announces the $600 M

purchase of leading wholesaler, Ingram Book Group

Ingram

Barnes & Noble Other booksellers

Publishers


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


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?


Timing

Stage 0:e-tailer makes

internalization decision

Stage 1:Manufacturer

chooses contracts

Stage 2:Retailer competition


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)


Logistics costs

TCe = w

e + LCe TC

f = wf + LC

f

LCe = c

me + ceo LC

f =cmf + c

fo

Manufacturer

e-tailer f-tailer

cme

cmf

ceo c

fo

we

wf

Inbound logistics costs

Wholesale price

Outbound logistics costs Logistics costs


Demands and competition

E-tailer and f-tailer compete on prices (Bertrand competition)

Manufacturer

e-tailer f-tailer

De(pe, pf) Df(pe, pf)


Assumptions…Assume

the demand function Di(pi , pi) for retailer i is smooth, downward

sloping in own price, and strictly positive the products are gross substitutes:

the profits are strictly (quasi)concave functions of own price equilibrium demands are positive

….so (pure strategy) equilibrium exists and is unique

0),(

0),(

i

iii

i

iii

p

ppD

p

ppDand


With a non-strategic manufacturer, it is optimal for the e-tailer to internalize

if either of these equivalent conditions are satisfied:

1. “Elasticity condition”:

where e = e-tailer demand elasticity

Special case: Iso-elastic demandInternalization is profitable if revenue increases

2. “Demand condition”:

where (De(p)) = slope of demand curve with respect to own price

Special case: Linear demand

Internalization is profitable if demand increases

Conditions for profitable internalization

)p(Dp

)p(Dp0e

1e

e0e

e1e

0

1

))p((D

))p((D

))p((D

))p((D

e

e2

e

2e

0

1

0

1


Linear demandUtility function of the representative consumer:

U(qe , qf) = e qe + f qf ½ (e qe2 + qe qf + f qf

2 )

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 independentand 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 priced = / 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


With linear demands, internalization is profitable for the e-tailer if

the demand condition is satisfied:

the changes in logistics costs satisfy the threshold condition:

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)

Internalization with linear demands

)p(D )p(D ee01

12

0:

2

2

2

dbb

dbNote

TCdbb

dbTC

fe

f

ffe

fe


Assume that in each case (internalization or not): Logistics costs are given Contract costs are determined by the manufacturer

Earlier condition reads:

Even when the manufacturer optimally sets wholesale prices, internalization is profitable for the e-tailer if

Ratio still depends on logistics costs alone A retailer considering a cost-raising strategy need not worry about

the manufacturer’s response

Strategic manufacturer

)(2

)(

2

2

2

fffe

fee

ffe

fe

LCwdbb

dbLCw

TCdbb

dbTC

ffe

fe LC

dbb

dbLC

22


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


Other types of contracts (2)

A “powerful” e-tailer: E-tailer maximizes its channel’s profits

Internalization is profitable for the e-tailer if

Comparison with previous threshold:

more power makes it “easier” for the e-tailer to internalize

LCdbbb

dbbdLC f

fee

fee

)4(

)2(3

2

)2(

2

)4(

)2(23

2

dbb

db

dbbb

dbbd

fe

f

fee

fe


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


We have assumed price (Bertrand) competition

What if the retailers were quantity (Cournot) competitors? Insights are unchanged (some details differ) Internalization is profitable for the e-tailer if

Note:

Compare with the Bertrand threshold:

Computing the Cournot threshold requires only “local” information

Cournot competition

fe

e TCb

dTC

2

f

fe

ff

ee TC

dbb

dbTC

b

dTC

)2(

2

2 2

)2(

2.

2 2dbb

dbvs

b

d

fe

f

e

5.02

0 eb

d


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


Back to the motivating example…

Issue:

Can we “operationalize” these results?

Impact on welfare?

Antitrust implications?

Comments welcome!

Thank you.

Documents

Cost Raising Strategies in Distribution System Design Harish KRISHNAN, Murat OZDEMIR and Maurice QUEYRANNE Sauder School of Business UBC TRANSLOG - Transportation