Decoupling the Supply Chain with a Dynamic Discrete Choice Inventory Model

Most supply chain works suppose retailers can credibly communicate costs to suppliers. But honest cost disclosure can be untenable because stores can shift the inventory burden upstream by inflating marginal costs (e.g., they can reduce stockout rates by exaggerating the goodwill lost to unsatisfied demand). So suppliers may not receive true cost estimates, preventing them from instituting optimal inventory policies. We develop an empirical means to resolve this supply chain “cheap talk” problem—to compel the supplier and retailer to coordinate optimally, even when the latter is dishonest. Rather than ask a retailer for its private costs, we estimate them directly with a dynamic discrete choice inventory model. We illustrate this approach with a 5,320-SKU, 1,371-day sample from a Chinese supermarket. We conclude the distribution center stocking out of the median product costs the store the equivalent of .03 shipments, .51 lost sales, or 37 days of storage.