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Cost Raising Strategies in 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

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M. Queyranne Cost Raising Strategies in Distribution System Design 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]

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M. Queyranne 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

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

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

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

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M. Queyranne Cost Raising Strategies in Distribution System Design 7 Separate outbound and inbound logistics

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M. Queyranne Cost Raising Strategies in Distribution System Design 8 Combining outbound and inbound logistics

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

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M. Queyranne 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 Ingram Barnes & Noble Other booksellers Publishers

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M. Queyranne 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 Ingrams 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

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M. Queyranne 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?

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

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M. Queyranne 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 (competitors response) (3) Contracts (manufacturers 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)

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M. Queyranne Cost Raising Strategies in Distribution System Design 15 Logistics costs TC e = w e + LC e TC f = w f + LC f LC e = c me + c eo LC f =c mf + c fo Manufacturer e-tailerf-tailer c me c mf c eo c fo w e w f Inbound logistics costs Wholesale price Outbound logistics costs Logistics costs

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M. Queyranne 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 D e (p e, p f ) D f (p e, p f )

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M. Queyranne Cost Raising Strategies in Distribution System Design 17 Assumptions… Assume the demand function D i (p i, 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

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M. Queyranne Cost Raising Strategies in Distribution System Design 18 With a non-strategic manufacturer, it is optimal for the e-tailer to internalize if either of these equivalent conditions are satisfied: 1.Elasticity condition: where e = e-tailer demand elasticity Special case: Iso-elastic demand Internalization is profitable if revenue increases 2.Demand condition: where (D e (p )) = slope of demand curve with respect to own price Special case: Linear demand Internalization is profitable if demand increases Conditions for profitable internalization

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M. Queyranne Cost Raising Strategies in Distribution System Design 19 Linear demand Utility function of the representative consumer: U(q e, q f ) = e q e + f q f ½ ( e q e 2 + q e q f + f q f 2 ) whereq r = 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: D e (p e, p f ) = max {0, min {a e b e p e + d p f, ( e p e )/ e } } where a e = ( e f f ) / b e = f / sensitivity to own price d = / sensitivity to competitors price = ( e f 2 ) ( 2 / e f relative intensity of product differentiation) For simplicity we assume symmetric demands: e = f and e = f

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M. Queyranne Cost Raising Strategies in Distribution System Design 20 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-tailers logistics cost, as long as it raises the competitors cost even more (Raising Rivals Costs effect) Internalization with linear demands

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M. Queyranne Cost Raising Strategies in Distribution System Design 21 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 manufacturers response Strategic manufacturer

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M. Queyranne 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

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M. Queyranne Cost Raising Strategies in Distribution System Design 23 Other types of contracts (2) A powerful e-tailer: E-tailer maximizes its channels profits Internalization is profitable for the e-tailer if Comparison with previous threshold: more power makes it easier for the e-tailer to internalize

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M. Queyranne Cost Raising Strategies in Distribution System Design 24 Summary of findings 1.The e-tailer may follow a cost-raising strategy: it may internalize inbound logistics even if this raises its own costs 2.This finding is robust to a strategic manufacturer optimally choosing wholesale prices 3.A powerful manufacturer may prevent cost-raising behavior by the e-tailer 4.A powerful e-tailer is more likely to pursue cost-raising behavior

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M. Queyranne Cost Raising Strategies in Distribution System Design 25 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 Cournot competition

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M. Queyranne Cost Raising Strategies in Distribution System Design 26 Conclusions 1.Cost-raising strategies are an important issue in the design of distribution systems 2.While designing its distribution systems and logistics networks, firms may benefit by following a cost-raising strategy 3.We derive simple and intuitive conditions for profitable internalization 4.We investigate the role of power in the supply chain

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

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