Do Firms Invest in Forecasting Efficiently? The Effect of Competition on Demand Forecast Investments and Supply Chain Coordination

We study the effect of downstream competition on incentives for demand forecast investments in supply chains. We show that with common pricing schemes, such as wholesale price or two-part tariffs, downstream firms under Cournot competition overinvest in demand forecasting. Analyzing the determinants of overinvestment, we demonstrate that under wholesale price contracts and two-part tariffs, total demand forecast investment can be very significant, and as a result, the supply chain can suffer substantial losses. We show that an increased number of competing retailers and uncertainty in consumer demand tend to increase inefficiency, whereas increased consumer market size and demand forecast costs reduce the loss in supply chain surplus. We identify the causes of inefficiency, and to coordinate the channel with forecast investments, we explore contracts in the general class of market-based contracts used in practice. When retailers’ forecast investments are not observable, such a contract that employs an index-price can fully coordinate the supply chain. When forecast investments are observable to others however, the retailers engage in an “arms race” for forecast investment, which can result in a significant increase in overinvestment, and reduction in supply chain surplus. Further, in that case, simple market-based contracts cannot coordinate the supply chain. To solve this problem, we propose a uniform-price divisible-good auction based contracting scheme, which can achieve full coordination when forecast investments are observable. We also demonstrate the desirable properties for implementability of our proposed coordinating contracting schemes, including incentive-compatible and reliable demand forecast information revelation by the retailers, and being regret-free. ∗Northwestern University, Evanston, IL 60208-2001. e-mail: [email protected]. †Graduate School of Business, Stanford University, Stanford, CA 94305-5015. e-mail: tunca [email protected]. ‡We are thankful to Jeannette Song (the Area Editor), the Associate Editor and two anonymous referees, Albert Ha, Blake Johnson, Hau Lee, Lode Li, Haim Mendelson, Evan Porteus, Jin Whang, Bob Wilson, Jim Contardi from First Data Corporation, Mike Everson from Ford Motors, Venu Nagali from Hewlett-Packard Procurement Risk Management Group, and Dennis Rohan from Kimball Resources Inc., as well as the seminar participants at Columbia University, HKUST, Indiana University, London Business School, Northwestern University, Queen’s University, SMU, Stanford University, UC Berkeley, UC San Diego, University of Chicago, University of Notre Dame, USC, UT Austin, UT Dallas, University of Toronto, University of Wisconsin Madison, and Yale University for valuable comments and discussions.