Strategic Communication for Capacity Alignment with Pricing in a Supply Chain

We study a supply chain comprised of a retailer who sources a product from a manufacturer. The retailer has superior information about the market demand, and the manufacturer must build the capacity and set the wholesale price prior to observing demand realization. We explore the level of information the retailer can share with the manufacturer by means of cheap talk. We first analyze a case in which the demand distribution is discrete and show that under mild conditions, the supply chain participants can exchange information truthfully. This result stands in sharp contrast with the existing literature which shows that in a static model without behavioral concerns, such as trust, the retailer tends to manipulate the demand forecasting information; hence, information cannot be shared truthfully under a wholesale price contract. The underlying reason for this result is the fact that the manufacturer undertakes multiple actions based on the information received from the retailer; for example, she makes the operational decision of setting the capacity level as well as the marketing decision of setting the wholesale price. When sharing information, the retailer must consider the trade-off between his incentive to inflate the shared information in order to encourage the manufacturer to increase the capacity level, and to deflate the forecast information, which results in a reduced wholesale price. We demonstrate that these countervailing incentives can balance each other and lead to a truthful information exchange. We also show that information sharing can hurt the supply chain. For more general continuous demand distributions, we first find that full information sharing is not possible. We then demonstrate that by sharing sub-interval information, the supply chain partners can still reach some level of partial information exchange. Finally, we illustrate via a numerical study that as the manufacturer’s capacity build-up cost increases, her profit can increase as well, since it encourages the retailer to share more information with the manufacturer. ∗Marshall School of Business, University of Southern California, Los Angeles, CA 90089. e-mail: [email protected] †Kellogg School of Management, Northwestern University, Evanston, IL 60208. e-mail: [email protected] ‡Kellogg School of Management, Northwestern University, Evanston, IL 60208. e-mail: [email protected] §We are thankful to Gad Allon and Özalp Özer for valuable comments and discussions.