Chapter 9 - What is double marginalization

What Negates the Bullwhip Effect

-Avoid multiple demand forecasts - Electronic Data Interchange (EDI); Point of sale (POS) data -Order smaller batches, more frequently - quick response (QR) or Continuous replenishment program (CRP) - 3rd party logistics management (consolidate less-than truckload shipments) -Every day low pricing eliminates forward buys trade deals -Allocations based on past sales records avoids shortage gaming

Bullwhip Effect - Final

Bullwhip effect describes how the variability in demand increases when orders move upstream in a supply chain -this can be avoided, and variation in demand can even be smoothed

Supply Chains

are most often fairly complex, even if they are remarkably simple, there is double marginalization, there are many possible solutions (not discussed in detail in this course)

Example of Double Marginalization

there is a supply chain consisting of a manufacturer who sells to a retailer who in turn sells to end customers. To make a profit, the manufacturer adds some margin to its cost to get the "wholesale price" at which it sells to the retailer. In turn, the retailer buys at this wholesale price and adds some margin to get the retail price at which it then sells to the end customers. Thus by the time the product gets to the end customer, two margins have been added to the cost (hence the term double marginalization).

Double Marginalization

-Thus supply chain profit is reduced by ¼ due to the "double margin of the two-firm supply chain. The supply chain needs to devise a "coordinating contract" or use some other mechanism to get back those "lost profits." - when the manufacture and retail are just one they make more profit

What causes the bullwhip effect

-demand forecast updating: each upstream firm adds some safety stock, fluctuations in forecasts get magnified -Order Batching: clumping daily demands into monthly orders, hockey-stick phennomenon -Price Fluctuation: forward buying - to the opportunity to make extra profit when a vendor offers temporary special terms, or when a cost increase is about to become effective. In these situations a merchant can take advantage of the situation by buying more than the usual amount. -Shortage Gaming: exaggeration followed by cancellation of orders (the company buys more than they need and then they cancel some of their

Bullwhip Effect

-demand variability increases in the supply chain when moving from the customer "upstream" to the raw material suppliers

Good Use of Info: Production smoothing

-many products sell more in one period than another - ice-cream sells more in summer & electronics sell more in winter (Christmas)

Due to double marginalization

-the total profit in a supply chain involving multiple firms may be reduced as compared to the profit if the supply chain were integrated (one owned by a single entity) other things being equal

Qualitative Insights

1) Double marginalization is the phenomenon where, in a supply chain, both the manufacturer and the retailer (who buys from the manufacturer and sells to the customer) add a margin. The result is that the retail price is higher than when the supply chain is integrated (i.e., the manufacturer sells directly to the customers) and therefore the sales will be lower. 2) The optimal price for the manufacturer is halfway between the cost and the maximum price it could ask such that the sales are zero. For example, if the demand function is q = 5,000 - 10p, then the maximum price to ask is $500, at which point the sales quantity will be zero. If the cost is $200, then the optimal price is $350, halfway between the cost and the maximum price. The sales would then be 1,500 and the profits 1,500 times the margin of $150, or $225,000. 3) If there is a retailer as well, then she will again price halfway between her cost (i.e., the manufacturer's price) and the maximum price. In this case, that would be $425, with corresponding sales of only 750 (i.e., cut in half!). The profit for the manufacturer would then be only 750 times the same margin of $150, or $112,500, while the retailer's margin is half the manufacturer's ($500 - $425 = $75), so realizes only $61,250 in profits. 4) As such, the manufacturer's profit is cut in half by double marginalization, and since the retailer's profits are half of the manufacturer's (due to a margin that is half the manufacturer's margin), the reduction in supply chain profits (from the integrated situation to the double marginalization situation) is 25%.

How to solve a double marginalization problem

1) Start by determining the demand function. Usually, this is given, but it could also be derived from the text. For example, if the text states "the maximum price that can be asked is $2,000 and the sales at a price of $0 are 5,000", then we can derive from this that the demand function equals: q = 5,000 - 2.5p, because then at a price of $0 the sales are 5,000, and at a price of $2,000 the sales are 0. 2) Draw the demand function in a graph. You only need to points to draw a straight line through them: i) the maximum demand (intercept on the x-axis) and ii) the maximum possible price (intercept on the y-axis). 3) Add the cost (c) to the graph by drawing a horizontal line at the cost level on the y-axis. Let's assume the costs are $1,000 in the example. 4) Determine the optimal price for the manufacturer, either by deriving this mathematically, or simply by determining the halfway point between the cost and the maximum possible price. In the example, it would be halfway between $1,000 and $2,000, so $1,500. 5) In case of a retailer, determine the options price for the retailer, preferably again simply by determining the halfway point between its cost (i.e., the manufacturer's price) and the maximum possible price. In the example, it would be $1,750. 6) Determine the demand by filling in the customer price (i.e., the manufacturer's price in case of an integrated supply chain and the retailer's price in case of the situation with double marginalization) in the demand function. In the example, the sales would be 5,000 - 2.5*1,500 = 1,250 for the integrated supply chain and 5,000 - 2.5*1,750 = 625 for the double marginalization situation. 7) Determine the profit for the manufacturer (and the retailer) by realizing that it equals the sales multiplied by the margin (i.e., price minus cost). In the example, the profit for the manufacturer would be 1,250 * ($1,500 - $1,000) = $625,000 in the integrated supply chain, while otherwise the profits would be 625 * ($1,500 - $1,000) = $312,500 and 625 * ($1,750 - $1,500) = $156,250 for the manufacturer and the retailer respectively.

1000-p

This means that when they charge a higher price the demand goes down