Beating the Accuracy Trap : Overinvestment in Demand Forecasting and Supply Chain Coordination under Downstream Competition

We study supply chain contracting with investment in demand forecasting under downstream competition. Supporting some recent industry observations, we show that under common pricing schemes, such as wholesale price or two-part tariff, downstream firms overinvest in demand forecasting. Analyzing the bounds and determinants of overinvestment, we demonstrate that the wholesale price and two-part tariff schemes can result in overinvestment up to twice the optimal level. As a result, the supply chain surplus can also suffer substantially as the wholesale price and two-part tariff schemes can result in nearly a full loss of supply chain efficiency. Further the losses with the best contracting scheme in the class of quadratic contracts, which also include the wholesale price and two-part tariff contracts, can amount to as much as half the first-best supply chain surplus. Examining the factors that determine the severity of the efficiency loss, we show that an increased number of competing retailers and uncertainty in consumer demand tend to increase inefficiency, whereas increased consumer market size, consumer price sensitivity and demand forecast costs reduce the loss in supply chain surplus. Finally, we propose a “market-based” contracting scheme that fully coordinates the supply chain in quantities and demand forecast investment, and demonstrate its desirable properties for implementability. ∗Graduate School of Business, Stanford University, Stanford CA 94305-5015. e-mails: hshin@stanford.edu, tunca tunay@stanford.edu. We are thankful to Hau Lee, Haim Mendelson, Evan Porteus, Jin Whang, Bob Wilson and seminar participants at Stanford University for valuable comments.