(Georgia Institute of Technology, 2005-12-15)
Ferguson, Mark E.; Koenigsberg, Oded
Firms selling goods whose quality level deteriorates over time often face difficult
decisions when unsold inventory remains. Since the leftover product is often perceived
to be of lower quality than the new product, carrying it over offers the firm a second
selling opportunity and an ability to price discriminate. By doing so, however, the firm
subjects sales of its new product to competition from the leftover product. We present
a two period model that captures the effect of this competition on the firm’s production
and pricing decisions. We characterize the firm’s optimal strategy and find conditions
under which the firm is better off carrying all, some, or none of its leftover inventory.
We also show that, compared to a firm that acts myopically in the first period, a firm
that takes into account the effect of first period decisions on second period profits will
price its new product higher and stock more of it in the first period. Thus, the benefit
of having a second selling opportunity dominates the detrimental effect of cannibalizing
sales of the second period new product.