Strategic inventories under the reference price effect

Abstract

Prior research shows that strategic inventories carried by a downstream retailer initially increase and then decrease the wholesale price. Carrying these inventories mitigates double marginalization and benefits the supplier and occasionally the retailer. Our study relaxes the assumption that customer purchasing decisions depend solely on the current price by recognizing that consumers react to price changes, known as the “reference price effect”. It investigates the interplay between strategic inventories and the reference price effect, with a focus on their impact on supply chain profitability. We develop a two-period game-theoretic model in which a supplier sells a new product through a retailer, competing to establish a reference price and manage strategic inventories. We find that the retailer only holds strategic inventories when the holding cost is sufficiently low. These inventories facilitate a high reference price, following the conventional wisdom that a high selling price deters strategic inventories and establishes a beneficial high reference price. However, under a sufficiently high holding cost, strategic inventories unexpectedly suppress first-period prices. This results in a novel outcome where firms set a low reference price, causing the supplier losses while the retailer profits. This contradicts existing studies, which suggest firms prefer a high reference price and that strategic inventories favor the supplier over the retailer, highlighting the need for managers to consider consumer responses to price changes. Our results remain robust under extensions with strategic consumers, decreasing product values, discounted future profits, and longer horizons.