The Strategic Use of Inventories in Procurement Contracts

K. Anand, R. Anupindi and Y. Bassok

*** Abstract ****

The literature on contract theory has mostly focused on models -- static or dynamic- without inventories. On the other hand, inventory theory has been developed primarily within a single decision-maker optimization framework. This paper bridges these two streams of research by studying the role of inventories in a dynamic procurement contract between a supplier and a buyer. In the model, the buyer may carry inventory across periods. Under zero fixed costs, zero lead times, no uncertainty, and stationary demand, all the classical reasons for inventories are eliminated. Yet (as we prove), the buyer's optimal strategy in equilibrium is to carry inventories, and the supplier is unable to prevent this. These inventories arise out of purely {\em strategic} considerations not identified before in the literature, and have a significant impact on the equilibrium solution, as well as supplier, buyer and channel profits. We find that strategic inventories are eliminated if the supplier can preempt the buyer's gaming behavior by committing early to wholesale prices. We compare the performance of such commitment contracts with (uncommitted) dynamic contracts. We extend the case of linear wholesale prices to two-part tariff procurement contracts, and demonstrate that strategic inventories continue to play a pivotal role. When the buyer can carry inventories strategically, two-part tariffs do not lead to optimal channel performance, nor can the supplier extract away all of the channel profits. Our results imply that firms can and must carry inventories strategically, and that the ability to carry inventories is an important factor in optimal contract design. Finally, we show that the ability to carry inventories significantly affects the equilibrium outcome, regardless of whether inventories are actually carried by the buyer in equilibrium even under arbitrary contract spaces facing general demand functions for longer horizons.