Vertical Control of Inventory and Pricing Decisions

This paper offers a simple approach to the theory of decentralizing inventory and pricing decisions within a distribution system. We consider an upstream manufacturer selling to two outlets, which compete as differentiated duopolists and face uncertain demand. Demand spillovers between the outlets arise in the event of stock-outs. The price mechanism, in which each outlet simply pays a wholesale price and chooses price and inventory, never coordinates incentives efficiently. Contracts that can elicit first-best decisions include resale price floors or buy-back policies (retailer-held options to sell inventory back to the manufacturers) with fixed fees. The combination of a buy-back option plus a resale price ceiling elicits the first-best without the need for a fixed fee and is robust to asymmetry in information about demand at the time of contracting.