Inventory competition and incentives to back-order

In this paper we consider the issue of inventory control in a multi-period environment with competition on product availability. Specifically, when a product is out of stock, the customer often must choose between placing a back-order or turning to a competitor selling a similar product. We consider a competition in which customers may switch between two retailers (substitute) in the case of a stock-out at the retailer of their first choice. In a multi-period setting, the following four situations may arise if the product is out of stock: (i) sales may be lost; (ii) customers may back-order the product with their first-choice retailer; (iii) customers may back-order the product with their second-choice retailer; or (iv) customers may attempt to acquire the product according to some other more complex rule. The question we address is: how do the equilibrium stocking quantities and profits of the retailers depend on the customers' back-ordering behaviors? In this work we consider the four alternative back-ordering scenarios and formulate each problem as a stochastic multi-period game. Under appropriate conditions, we show that a stationary base-stock inventory policy is a Nash equilibrium of the game that can be found by considering an appropriate static game. We derive conditions for the existence and uniqueness of such a policy and conduct a comparative statics analysis. Analytical expressions for the optimality conditions facilitate managerial insights into the effects of various back-ordering mechanisms. Furthermore, we recognize that often a retailer is willing to offer a monetary incentive to induce a customer to back-order instead of going to the competitor. Therefore, it is necessary to coordinate incentive decisions with operational decisions about inventory control. We analyze the impact of incentives to back-order the product on the optimal stocking policies under competition and determine the conditions that guarantee monotonicity of the equilibrium inventory in the amount of the incentive offered. Our analysis also suggests that, counterintuitively, companies might benefit from making their inventories “visible” to competitors' customers, since doing so reduces the level of competition, decreases optimal inventories and simultaneously increases profits for both players.