Cost Raising Strategies in Distribution System Design

1. Cost Raising Strategiesin Distribution System Design Harish KRISHNAN, Murat OZDEMIR and Maurice QUEYRANNE Sauder School of Business UBC TRANSLOG - Transportation and Logistics Workshop Reñaca, Chile December 11, 2009

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] Cost Raising Strategies in Distribution System Design

3. 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 Cost Raising Strategies in Distribution System Design

4. Motivation • A logistics consolidation decision considered by a major e-tailer: • current system: Manufacturer Inbound logistics e-tailer Competitors Outbound logistics Cost Raising Strategies in Distribution System Design

5. Outbound logistics from DC Cost Raising Strategies in Distribution System Design

6. …with consolidation points Cost Raising Strategies in Distribution System Design

7. Separate outboundand inbound logistics Cost Raising Strategies in Distribution System Design

8. Combining outboundand inbound logistics Cost Raising Strategies in Distribution System Design

9. The business question • Should the e-tailer “internalize” its inbound logistics? Cost Raising Strategies in Distribution System Design

10. A similar case… • Nov. 6, 1998: Barnes & Noble announces the $600 M purchase of leading wholesaler, Ingram Book Group Publishers Ingram Barnes & Noble Other booksellers Cost Raising Strategies in Distribution System Design

11. 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 Cost Raising Strategies in Distribution System Design

12. 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? Cost Raising Strategies in Distribution System Design

13. Timing Stage 1: Manufacturer chooses contracts Stage 0: e-tailer makes internalization decision Stage 2: Retailer competition Cost Raising Strategies in Distribution System Design

14. 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) Cost Raising Strategies in Distribution System Design

15. Logistics costs • TCqe = wqe + LCqe TCqf = wqf + LCqf LCqe = cqme + cqeo LCqf =cqmf + cqfo Manufacturer wqf Wholesale price wqe cqmf Inbound logistics costs cqme e-tailer f-tailer cqeo Outbound logistics costs cqfo Logistics costs Cost Raising Strategies in Distribution System Design

16. Demands and competition • E-tailer and f-tailer compete on prices (Bertrand competition) Manufacturer e-tailer f-tailer De(pe, pf) Df(pe, pf) Cost Raising Strategies in Distribution System Design

17. Assumptions… • Assume • the demand function Di(pi, pi)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 Cost Raising Strategies in Distribution System Design

18. Conditions for profitable internalization • With a non-strategic manufacturer, it is optimal for the e-tailer to internalize • if either of these equivalent conditions are satisfied: • “Elasticity condition”: • where e = e-tailer demand elasticity • Special case: Iso-elastic demandInternalization is profitable if revenue increases • “Demand condition”: • where (De(p)) = slope of demand curve with respect to own price • Special case: Linear demand Internalization is profitable if demand increases Cost Raising Strategies in Distribution System Design

19. Linear demand • Utility function of the representative consumer: • U(qe , qf) = e qe + f qf  ½ (e qe2 + qeqf + f qf2 ) • 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 independent and 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 /  sensitivityto own price • d= /  sensitivitytocompetitor’s price • =(e f  2) (2 / e f relative intensity of product differentiation) • For simplicity we assume symmetric demands: e = f and e = f Cost Raising Strategies in Distribution System Design

20. Internalization with linear demands • 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) Cost Raising Strategies in Distribution System Design

21. Strategic manufacturer • 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 Cost Raising Strategies in Distribution System Design

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 Cost Raising Strategies in Distribution System Design

23. 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 Cost Raising Strategies in Distribution System Design

24. Summary of findings • The e-tailer may follow a cost-raising strategy: • it may “internalize” inbound logistics even if this raises its own costs • This finding is robust to a strategic manufacturer optimally choosing wholesale prices • A “powerful” manufacturer may prevent cost-raising behavior by the e-tailer • A “powerful” e-tailer is more likely to pursue cost-raising behavior Cost Raising Strategies in Distribution System Design

25. Cournot competition • 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 Cost Raising Strategies in Distribution System Design

26. Conclusions • Cost-raising strategies are an important issue in the design of distribution systems • While designing its distribution systems and logistics networks, firms may benefit by following a cost-raising strategy • We derive simple and intuitive conditions for profitable internalization • We investigate the role of “power” in the supply chain Cost Raising Strategies in Distribution System Design

27. Back to the motivating example… • Issue: • Can we “operationalize” these results? • Impact on welfare?  Antitrust implications? Cost Raising Strategies in Distribution System Design

28. Comments welcome!Thank you.