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A Mechanism Design Approach to Vendor Managed Inventory

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Abstract: This paper studies an inventory management problem faced by an upstream supplier who is in a collaborative agreement, such as vendor managed inventory (VMI), with a retailer. A VMI partnership provides the supplier an opportunity to manage inventory for the supply chain, in exchange for point-of-sales (POS) and inventory level information from the retailer. However, retailers typically posses superior local market information and, as has been the case in recent years, are able to capture and analyze customer purchasing behavior beyond the traditional POS data. Such analyses provide the retailer, access to market signals that are otherwise, hard to capture using POS information. We demonstrate and quantify the implication of the fi nancial obligations of each party in VMI that renders communication of such important market signals as non-credible. To help institute a sound VMI collaboration, we propose a learn-and-screen dynamic inventory mechanism for the supplier to effectively manage inventory and information in the supply chain. The proposed mechanism combines the ability of the supplier to learn about market conditions from POS data (over multiple selling periods) and to dynamically determine when to screen the retailer and acquire his private demand information. Inventory decisions in the proposed mechanism serve a strategic purpose in addition to their classic role of satisfying customer demand. We show that our proposed dynamic mechanism signi cantly improves the supplier s expected pro t and increases the efficiency of the overall supply chain operations under a VMI agreement. In addition, we determine the market conditions in which a strategic approach to VMI results in signi cant pro t improvements for both rms, in particular, when the retailer has high market power (i.e., when the supplier highly depends on the retailer) and when the supplier has relatively less knowledge about the end customer market compared to the retailer.

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