Examining Double Marginalization Effect for Innovative Product Supply Chain

Double marginalization effect refers to the phenomenon that when both upstream and downstream firms have monopolistic power, customers pay higher retail price and firms make less profit than when the supply chain is vertically integrated (Tirole, 1988). Although double marginalization effect has been extensively studied in the context of supply chain management for mature products, very limited attention has been given to innovative products whose demand is generated through word-of-mouth effect. The authors study the pricing decisions in a supply chain that sells innovative products. Using a modified Bass diffusion model to capture demand trajectory over time, the authors identify the optimal way for the retailer and supplier to adjust prices when profit is not discounted, and also provide numerical examples when profit is discounted. The authors show that (1) when profit is not discounted the optimal retail prices are adjusted over time, while the optimal wholesale price should be kept as a constant, and (2) double marginalization effect also exists in an innovative product supply chain, but its degree depends on a number of factors, such as the innovation and imitation coefficients. retail price and firms make smaller total profit in a decentralized supply chain (Tirole, 1988). This effect is referred to as “double marginalization” effect, and it provides an incentive for vertical integration. However, these studies have been largely focused on supply chains of “mature” products which have existed in markets long enough. Very limited attention has been given to supply chains of “innovative” products that are new to market. These products include, for example, smart phones, solar power heaters, hybrid cars, etc. Compared with mature products, innovative products have a different demand pattern. More specifically, demand for innovative products is often changing over DOI: 10.4018/joris.2012010103 38 International Journal of Operations Research and Information Systems, 3(1), 37-52, January-March 2012 Copyright © 2012, IGI Global. Copying or distributing in print or electronic forms without written permission of IGI Global is prohibited. time, and also, interrelated over time. How popular the product is today influences how popular it will be in the future, because a large portion of the future demand is created by word-of-mouth effect generated from current users (Bass, 1969). Therefore, measures that increase current demand not only have an impact on profit today but also influence profit in the future. These measures often include pricing, advertisement, etc. In this paper, we focus on pricing decisions in a supply chain that sells innovative products. We are interested in how firms optimally adjust prices to maximize profits, as well as the impact of difference supply chain structures (centralized vs. decentralized control) on the optimal pricing decisions. In order to capture the demand trajectory of innovative products, we adopt the classical Bass diffusion model (Bass, 1969) and its variant with price effect (Dolan & Jeuland, 1981). Based on these models that describe customer demand trajectories, we use optimization techniques to study the optimal pricing decisions in a supply chain. We consider two situations: a supply chain under centralized control, and one under decentralized control. In both cases, we identify the optimal demand and price trajectories. Then we compare the two cases and examine the extent of double marginalization effect. In the rest of the paper, we review relevant literature and present our model and analytical results. Then we provide some numerical examples. Some discussions and conclusions are presented last.