Dynamic Pricing and Inventory Management Under Inventory-Dependent Demand

Dynamic Pricing and Inventory Management Under Inventory-Dependent Demand
Author(s): Nan Yang and Renyu Zhang

Source: Operations Research , September-October 2014, Vol. 62, No. 5 (September-
October 2014), pp. 1077-1094
Published by: INFORMS
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Operations Research jH^f rms
Vol. 62, No. 5, September-October 2014, pp. 1077-1094 ■
ISSN 0030-364X (print) | ISSN 1526-5463 (online) http://dx.doi.org/10.1287/opre.2014.1306
©2014 INFORMS
Dynamic Pricing and Inventory Management

Under Inventory-Dependent Demand
Nan Yang, Renyu Zhang
Olin Business School, Washington University in St. Louis, St. Louis, Missouri 63130
{yangn@wustl.edu, renyu.zhang@wustl.edu}
We analyze a finite horizon periodic review joint pricing and inventory management model for a firm that replenishes
sells a product under the scarcity effect of inventory. The demand distribution in each period depends negatively on
sales price and customer-accessible inventory level at the beginning of the period. The firm can withhold or dispose
its on-hand inventory to deal with the scarcity effect. We show that a customer-accessible-inventory-dependent order-u
to/dispose-down-to/display-up-to list-price policy is optimal. Moreover, the optimal order-up-to/display-up-to and list-p
levels are decreasing in the customer-accessible inventory level. When the scarcity effect of inventory is sufficiently str
the firm should display no positive inventory and deliberately make every customer wait. The analysis of two impor
special cases wherein the firm cannot withhold (or dispose of) inventory delivers sharper insights showing that the inven
dependent demand drives both optimal prices and order-up-to levels down. In addition, we demonstrate that an incr
in the operational flexibility (e.g., a higher salvage value or the inventory withholding opportunity) mitigates the deman
loss caused by high excess inventory and increases the optimal order-up-to levels and sales prices. We also generalize
model by incorporating responsive inventory reallocation after demand realizes. Finally, we perform extensive nume
studies to demonstrate that both the profit loss of ignoring the scarcity effect and the value of dynamic pricing under
scarcity effect are significant.
Subject classifications: joint pricing and inventory management; inventory-dependent demand.

Area of review. Operations and Supply Chains.
History: Received January 2013; revisions received September 2013, March 2014; accepted June 2014. Published onl
in Articles in Advance August 20, 2014.
1. Introduction referred to as the scarcity effect of inventory. Three major

In the operations management literature, joint pricing and mechanisms drive this effect: (1) inventory
inventory management has received extensive attention. the 3110 Popularity of a product; (2) inven
A key assumption in existing models in this stream of lit- imPlies stockout risk of a Product'' 311(1 (3) inve
erature is that demand, though random, is independent of reveals the Pncin8 strategy the retailer wiU
inventory (e.g., Fedegruen and Heching 1999), so that sales discuss these three mechanisms in detail,
and, hence, revenue are linked to inventory only through First, it has been well established in psych
the stockout effect modity theory that supply scarcity increases the attractive
In quite a few industries (e.g., automobile, electron- ness ol a Procluct to customers (Brock 1968). This
ics, and luxury products, etc.), however, we have observed âs been tested and refined by various experime
strong empirical and anecdotal evidence that demand may respect to a wide variety of product categories (e
be correlated with the amount of inventory carried by wine, and books) by, e.g., Worchel et al. (1975), V
retailers. A high inventory level sometimes promotes sales ar>d Robben (1994) and van Herpen et al. (20
because it creates a strong visual impact (the billboard desirability of the product is enhanced by scarce in
effect) and signals abundant potential availability, both of because customers are likely to infer product qu
which can make the item more desirable and increase the popularity from its inventory level. A lower inventory
chance of customer purchase. On the other hand, it is also signals more consumption by other customers an
commonly observed in practice that an ample inventory that the product is more popular and of higher q
conveys to the customers the message that the item is of the other hand, observing a high inventory, a custome
low popularity and quality, thus inducing low demand. urally believes that there are many units on hand
The negative correlations between demand and inventory no one wants to buy the item. Some recent marketin
are well supported by psychological and economic theories Stock and Balachander 2005) and operations ma
as well as rich anecdotal observations and empirical data. (e.g., Veeraraghavan and Debo 2009) papers use
The phenomena that a low inventory level may increase oretic models to demonstrate that the scarcity str
and a high inventory level may decrease demand are often effectively signal to the customers the high qu
1077

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Yang and Zhang: Pricing and Inventory Management Under Inventory-Dependent Demand
1078 Operations Research 62(5), pp. 1077-1094, ©2014 INFORMS
product, thus creating a "hot product." Empirical results on In this paper, w

the scarcity effect of inventory on demand in the automo- management mo
bile industry can also be found in, e.g., Balachander et al. The stochas
(2009) and Cachon et al. (2013). tion of the sales price and the customer-accessible inven
Second, a low inventory level spreads a sense of urgency tory level at the beginning of each decision epoch. Unmet
among customers that soon the product will be sold out demand is fully backlogged to the next period. The wait
and potential buyers will be put on a wait list. Such back- lists observed or spread through word-of-mouth success
logging risk motivates customers to make an immediate fully signal the high quality and popularity of the prod
purchase instead of searching for better options. A high uct and attract more customers (see, e.g., Brown 2001
inventory, however, grants customers the luxury of waiting and Dye 2000). From the strategic perspective, joint pric
and searching, thus lowering the current demand. A simi- ing and inventory decisions effectively deliver information
lar mechanism also drives the search behavior that a low about the quality and popularity of the product. Specif
inventory of one product type discourages a customer from ically, pricing flexibility induces more strategic customer
searching for better types (Cachon et al. 2008). Knowingly behavior (e.g., waiting for potential price discount), which
limiting the availability of a product, the retailer can induce further strengthens the scarcity effect of inventory because
"buying frenzies" among uninformed customers and set a customers may anticipate price changes based on current
higher price (DeGraba 1995). inventory (see, e.g., Liu and van Ryzin 2008).
Third, as shown in pricing and revenue management We develop a unified joint price and in
literature (e.g., Federgruen and Heching 1999, Gallego agement model that incorporates both inven
and van Ryzin 1994), retailers increase their sales prices ing and inventory disposal to address the sc
when inventories are low. Therefore, customers infer from Under the inventory withholding policy, the f
a low inventory level that it is unreasonable to expect a only part of its inventory and withholds the
lower price and decide to purchase the item immediately house not observable by customers; this i
(see, e.g., Aviv and Pazgal 2008). On the other hand, a potential demand. Analogously, with invento
high inventory level suggests that the sales price will be the firm can dispose of unnecessary excess i
more likely to decrease; this encourages customers to wait has some salvage value. Both inventory wi
before buying. Carefully making use of this mechanism, disposal may incur a cost. We show that
the retailer can enjoy the benefits of inducing customers to accessible-inventory-dependent order-up-to/di
purchase early at high prices (Liu and van Ryzin 2008). to/display-up-to list-price policy is optimal. M
A similar idea has also been adopted in the advance sell- order-up-to/display-up-to and list-price leve
ing literature (e.g., Xie and Shugan 2001), which shows ing at the customer-accessible inventory le
that firms may limit their capacity for advance selling to scarcity effect of inventory is sufficiently stron
credibly signal their pricing strategy to customers. should display no positive inventory so that e
Along with the rich theoretical and empirical justifica- must wait before getting the product. In this case
tions of the scarcity effect of inventory, practitioners have scarcity effect creates more opportunities tha
extensively adopted this idea in their marketing strategies. firm can proactively take advantage of it and in
Dye (2000) and Brown (2001) document that the scarcity demand by making customers wait (e.g., t
strategy, in which product supply is deliberately limited, keting strategy).
has become a basic tactic for marketers to promote sales. When it is too costly to withhold or disp
An increasing number of automobile manufacturers ere- tory, the unified model is reduced to the m
ate significant levels of scarcity and make a long list of inventory withholding or the model without
hard-to-get car models over time (see Balachander et al. posai, both of which deliver sharper insight
2009). Although facing thousands of customers on the wait without inventory withholding/disposal, we sho
lists, none of the manufacturers rushed to accelerate pro- inventory-dependent demand increases th
duction (Wall Street Journal 1999). Likewise, Maynard risk and, thus, lowers optimal sales prices an
(2006) shows that BMW promotes its Mini Cooper line to levels. With higher operational flexibility
by limiting supply and letting potential owners wait for, vage value or the inventory withholding opp
on average, two and half months for the models. The lim- ever, the firm addresses the scarcity effec
ited distribution strategy has accelerated demand for the more effectively and, hence, increases its sa
Mini Cooper since its reintroduction in the U.S. market. A order-up-to/display-up-to levels. In short,
similar promotional strategy is also used in the electron- posal/withholding benefits the firm by enha
ics market, especially at the introduction stage of a new tional flexibility and agility.
product generation; fans have been excited by the long wait We also generalize the unified model by
for Sony Play Stations (Retailing Today 2000), Nintendo responsive inventory reallocation, which a
Game Boys ( Wall Street Journal 1989), and Apple iPads 2 to reallocate (with cost) its inventory betwe
(Sherman 2010). warehouse after demand is realized.. In this case, the firm

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Operations Research 62(5), pp. 1077-1094, ©2014 INFORMS 1079
can keep a low inventory and better hedge against risks of a comprehensive
demand uncertainty and the scarcity effect of inventory. tory is usually mod
We perform extensive numerical studies to demonstrate (1) potential deman
(a) the robustness of our analytical results, (b) the impact after replenishmen
of the scarcity effect on the profitability of the firm, and ing in the inventory
(c) the value of dynamic pricing under the scarcity effect inventory from the pr
of inventory. Our numerical results show that the analytical The first approach to
characterizations of the optimal policies in our model are assumes that deman
robust and hold in all of our numerical experiments. Both board effect). Ger
the profit loss of ignoring the scarcity effect and the value review inventory mo
of dynamic pricing under the scarcity effect are signifi- each period is increasing
cant, and increase the intensity of the scarcity effect and/or ishment. Dana and P
demand variability. The reasons are: (1) the scarcity effect newsvendor mode
decreases future demand and magnifies future demand vari- and positively correla
ability; and (2) dynamic pricing allows the firm to induce operations managem
higher future demand and dampen future demand variabil- that demand depe
ity. In addition, a longer planning horizon increases the ishment) inventory
impact of the scarcity effect and decreases the value of effect. We refer int
dynamic pricing. chak (2001 and 2002), Balakrishnan et al. (2004 and 2008),
We summarize the main contributions of this paper as Martfiez-de-Albéniz and Roels (2011), Baron et al.
follows: (1) To our knowledge, we are the first to study and Chen et al. (2012).
joint pricing and inventory management under the scarcity The other effect of inventory on demand, as dis
effect of inventory. We characterize the optimal policy in in §1, is the scarcity effect. That is, high leftover
a general unified model and generalize our results to the tory (i.e., inventory at the beginning of the period b
model with responsive inventory reallocation. (2) We ana- replenishment) negatively influences the potential de
lyze the impact of the scarcity effect of inventory on the In the psychological commodity theory literature,
firm's optimal price and inventory policies and study the (1968) argues that supply scarcity increases the attra
effect of operational flexibilities on the firm's optimal deci- ness of a product; this has been tested by numerous exp
sions under the scarcity effect. (3) We identify the rationale iments in, e.g., Worchel et al. (1975) and van Herpen et
behind the phenomenon that firms with intense scarcity (2009). Stock and Balachander (2005) and Veerarag
effect deliberately make their customers wait before get- an(I Debo (2009) use game theoretic models to show
ting the product. (4) We numerically study the profit loss the firm can use the scarcity strategy to signal the
of ignoring the scarcity effect and the value of dynamic quality of a product. Aviv and Pazgal (2008), among
pricing under this effect. ers' demonstrate that customers may strategically wait
The rest of the paper is organized as follows. In §2, Price discounts when observing a high inventory. Liu
we position this paper in the related literature. Section 3 van ^Υζ'η (2008) propose an effective pricing sche
presents the basic formulation, notations, and assumptions induce customers to make early purchases under a revenu
of our model. In Section 4, we propose and analyze the management framework. The idea that supply conditio
unified model. Section 5 discusses additional results and signal potential pricing strategy and product qualit
insights in two important cases, i.e., the model without aIS0 heen adopted in the advance selling literature (e.g
inventory withholding and the model without inventory dis- and Shugan 2001 and Yu et al. 2014). Balachander
posai. Section 6 generalizes the unified model to the model (2009) and Cachon et al. (2013) conduct empirical
with responsive reallocation. Section 7 reports our numeri- 'es to show that the scarcity effect of inventory on dema
cal findings. We conclude by summarizing our findings and prevails in the automobile industry,
discussing a possible extension in §8. All proofs are rel- T° our knowledge, Sapra et al. (2010) is the only pap
egated to the online appendix (available as supplemental 'n inventory management literature that incorporates
material at http://dx.doi.org/10.1287/opre.2014.1306). scarcity effect of inventory (called the "wait-list effec
that paper) and assumes that potential demand is a decreas
ing function of leftover inventory. They show the optimal
2. Literature Review
ity of understocking and propose the inventory withholding
This paper is mainly related to two lines of research in the strategy. Our paper generalizes Sapra et al. (2010)
literature, i.e., (1) inventory management with inventory- following aspects: (1) We introduce a unified mod
dependent demand, and (2) optimal joint pricing and inven- encompasses dynamic pricing, inventory withholding, an
tory policy. inventory disposal, and explicitly captures the interaction
There is a large body of literature on inventory-dependent between price, inventory and
demand. We refer interested readers to Urban (2005) for lyrically show the impact of

3.108.85.85 on Thu, 16 Nov 2023 17:51:21 +00:00
on the firm's pricing policy, whereas Sapra et al. (2010) do Petruzzi (2001) a
not allow price adjustment during the planning horizon and ied the joint pri
numerically test the improvement of inventory-withholding inventory-depende
policy under different price elasticities of demand. We also sider a single per
numerically show that the value of dynamic pricing under the available inventor
the scarcity effect of inventory is significant and increases
with the scarcity effect intensity and/or demand variability. 3 MccM
(2) Because of the endogenous pricing decision introduced
to the dynamic program, analysis of our model is more We sPecify our uni
involved and requires a different approach. (3) Two special 'n tb's secdon· Con
cases of our unified model (i.e., the model without inven- periodically maki
tory withholding and the model without inventory disposal) r-Penod Planmn
demonstrate that inventory withholding and inventory dis- ■ · ·. 1 }· The firm
posal help mitigate the overage risk of inventory-dependent tlons' one with cust
demand. (4) In addition to the understocking and inven- stimulate demand' a
tory withholding policy proposed in Sapra et al. (2010), invent0ry that is
our model suggests three other strategies to dampen the rePlenish or disPo
negative effect of inventory-dependent demand: (a) price on-hand inventory
reduction, (b) inventory disposal, and (c) responsive inven- and the warehou
tory reallocation. (5) We show that when the scarcity effect lshed inventory 18
e ■ . ■ tf- ■ ., η , ,, ,. , the firm decides how much inventory to reallocate to the
of inventory is sufficiently strong, the firm should display . J
... , , « . ., -τ, customer-accessible storage. On the other hand, if the firm
no positive inventory and let customers wait. To summa- „. , , . . „
... ,. ., ... c 1 /λ/,, r\\ disposes of its on-hand inventory, it first ships inventory, if
nze, this paper generalizes the model in Sapra et al. (2010) , , / , , J
πn* 7 *vi tria anotama»· naaanniKla ntArn/ΐΛ ta tlia iiïn**alianna
any, from the customer-acces
and strengthens its results and insights.
and then chooses the disposa
There is an extensive literature on dynamic pricing and
In each period, the sequen
inventory control under general stochastic demand. Fed- , . , , . . , . , , _
, τ τ ι.· j , lows: At the beginning of each period, the firm reviews its
ergruen and Heching (1999) study the inventory system , ., , , '. .
iotai and customer-accessible leftover inventories from last
J Into I onn oiictnmor ooooccih ο Iατίηιrar imiûntanac tram loot
in a periodic review model where the firm faces price

period, simultaneously chooses the order/disposal and real
dependent demand in each decision period and unsatisfied
location quantities and the sales price, pays the ordering
demand is fully backlogged. A list-price order-up-to policy
and reallocation costs, and receives the disposal salvages.
is shown to be optimal. This line of literature has grown
The ordering and reallocation lead times are assumed to be
rapidly since Federgruen and Heching (1999). For exam
zero so that the replenished and reallocated inventories are
ple, Chen and Simchi-Levi (2004a, b and 2006) analyze
, . . . . , . , ., _ received immediately. Inventory disposal is also executed
the loint pricing and inventory control problem with fixed . .. , , ,
,. . .. .. , .. at once. The demand is then realized and the revenue is
ordering cost and show the optimality of (5, S, ρ) policy
collected. At the end of the decision
for finite horizon, infinite horizon, and continuous review
, , „ „ , , and backlogging costs are paid, and the total and customer
models. Chen et al. (2006) and Song et al. (2009) study , · . . , ., , . .
v ' b ' J accessible inventones are earned over to the beginning of
the joint pneing and inventory control problem under lost ^ ngxt perjocj
sales. In the case of a single unreliable supplier, Li and ™. . . c . . ,
,b The state of the system is given by:
Zheng (2006) and Feng (2010) show that supply uncer
tainty drives the firm to charge higher prices under ran- 1° = the sta
dom yield and random capacity, respectively. Chen et al. replen
(2011) take into consideration costly price adjustments in T,T
joint pricing and inventory management. When the replen- "cus
ishment lead time is positive, the joint pricing and inven- I, = th
tory control problem under periodic review is extremely ment/
difficult. Pang et al. (2012) partially characterize the struc-
ture of the optimal policy. We refer interested readers to
Note that the amount of inventory
Chen and Simchi-Levi (2012) for a comprehensive survey
.... , . , , _ . the warehouse is I, — /, ^ 0. We introduce the following
on loint pricing and inventory control models. The maior . , ... r , ..
,... , , , . r , notation to denote the decisions of the firm:
difference between our paper and this stream of research
is that we take into account inventory-dependent demand p, = the sales
and show that the scarcity effect of inventory drives the xat — the cus
firm to order less, dispose more, withhold inventory, and ishment/d
charge a lower price. To our knowledge, only Dana and realized in

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χ, = the total inventory level after replenishment/disposal/ base our analysis of

reallocation but before demand is realized in period t, form:
t = T,T- 1,..., 1.
8(p„It,et) = (d(pt) + y(If))ef + eat,
We assume that the price p, is bounded from above a
by the maximum allowable price ρ and from below by where E{et} — 0 and E
the minimum allowable price p. Without loss of gener- We assume that e/s are i.i.d. random vect
ality, we also assume that the customer-accessible inven- ported on [q> à] and ^ supported on [m,
tory storage capacity of the firm is Ka (0 < Ka ^ +oo), jeast one 0£ tbe two random variables (ef and
whereas the warehouse capacity is infinite. In other words, continuous distribution (i.e., a^âorm^ m
the customer-accessible inventory level after replenish- thât Dt follows a nondegenerate continuo
ment/disposal/reallocation cannot exceed Ka in each period, supported on the interval: [(dip,) + y(If
i.e., xf < Ka for all t = T,T — 1,..., 1. Following the y(If))m + a\ for any (pt, If). Note that the ab
no-artificial wait-list notion (see Sapra et al. 2010), model is quite general and includes as s
we assume that the firm cannot decrease its customer- eraj demand models from the existing liter
accessible inventory level if a wait list already exists, i.e., plC; when em _ j with probabjiity i, the
xt ^ xa, ^ min{/(a, 0}. js reduced to the additive demand model; if ef
We introduce the following model primitives: probability 1, it is reduced to the multiplic
a = discount factor of revenues and costs in future periods, model (as a generalized version of the m
0 < a < l· Sapra et al. 2010); and if y( · ) = 0, the demand model is
c = purchasing cost per unit ordered; reduced to the standard price-dependent
s = salvage value per unit disposed; proposed in Chen and Simchi-Levi 2004a
b = backlogging cost per unit backlogged at the end of a summarizes the impact of price on
perjod. As assumed above, d( ■ ) is strictly decreasing in pr In
ha = holding cost per unit stocked and accessible to eus- some market where competition is fierce and the firm h
tomers at the end of a period; no Pricin8 Power' the Pnce is exogenously fixed at p0 a
hw = holding cost per unit stocked in the warehouse at the tke P"ce induced demand is fixed at d0 = d(p0). The te
end of a period' Τ W)> which is a decreasing function of If, captures t
'd = unit reallocation fee from the warehouse to the scarcity effect of inventory on demand. Hereafter, we ref
customer-accessible storage; t0 ?( ' ) as the scarcity functl°n, and γ'( · ) as the intensit
rw = unit reallocation fee from the customer-accessible of scarcity effect· The dependence of demand on invento
storage to the warehouse. 1S measured by γ'( · ). i.e., the smaller the γ'( · ), the mor
intensive the potential demand depends on the customer
Without loss of generality, we assume that the following accessible inventory level. When demand is independent
inequalities hold: inventory, y (If) = y0 for all customer-accessible inventory
b > (1 - a)(rd + c): the backlogging penalty is higher level Note that our demand model generalizes the model
than the saving from delaying an in SaPra et aL (2010)in the sense that our model also cap
order to the next period, so that the tures the imPact of endogenous sales price on demand,
firm will not backlog all of its Since d( ' )is strictly decreasing in p„ we assume p(df)
demand- t0 ^ts strictly decreasing inverse. For the convenience
c > s: unit procurement cost dominates of our analysis, we change the decision variable from p
the unit salvage value; t0 d,^[d,d], where d = d(p) and d = d(p). To av
p>a(c + rd) + b : positive margin for backlogged the unrealistic case where demand becomes negativ
demand assume that d + y(Ka) ^ 0 to ensure that E{Df} = d, +
γ (If) ^ 0 for any d, e [d, d] and If < Ka. We impose the
Note that although we assume that the parameters and following three assumptions throughout our analysis:
demand are stationary throughout the planning horizon, the
structural results in this paper remain valid when the param- Assumption 1. The inverse demand function p( ■ ) is t
eters and demand distributions are time-dependent. continuously differentiate and concavely decreasing in
As discussed in §1, we assume that demand in mth p(dt) <0 for dte[d,d\ In addUion, p(dt)dt i
period t, Dt, depends negatively on the prevailing price cave In
and customer-accessible inventory level at the beginning The concavity of p(df)dt in d, suggests the decrea
of this period according to a general stochastic functional ing marginal revenue with respect to demand, which
form: D, — δ (pt, If, ef), where e, is a random term with standard assumption in joint pricing and inventory manage
a known continuous distribution and a connected support. ment literature, see, e.g., Chen and Simchi-Levi (20
δ( ·, ·, ef) is a twice continuously differentiable function Li and Zheng (2006) and Pang et al. (2012). For a m
strictly decreasing in p, and decreasing in If for any e(. We comprehensive discussion on decreasing marginal re

3.108.85.85 on Thu, 16 Nov 2023 17:51:21 +00:00
assumptions, see Ziya et al. (2004). The concavity of p( ■ ) Condition (

implies that the demand is more price sensitive when sales understand. Henc
prices are higher. This is also a common assumption in the condition fo
literature; see, e.g., Federgruen and Heching (1999).
As Sapra et al. (2010), we also assume that demand Lemma 2" *fR( ' '
we have:
is concavely decreasing in the customer-accessible leftover
inventory (a) For any I" such that y"(If) = 0, γ1 (I") = 0 as well.
Therefore, there exists a threshold I* ^ Ka (/* may be
Assumption 2. The scarcity function γ (·) is concavely de- —oo) such that
creasing and twice continuously differentiable. In addition,
lim y'(If) = 0 and lim y(If) = y0. <0, if ρ > If

/?->-oo 'v ' ' if-,-oo 'K ' ' ro y (i?)
= 0, otherwise,
The concavity of γ(·) refers to the phenomenon that
a higher customer-accessible leftover inventory level has and
a greater marginal effect on potential demand. However,
when the backlogged demand is very high, its value for
<0, if p > If
stimulating high potential demand is limited because γ( · ) y" {If)
= 0, otherwise.
is bounded from above. In other words, the impact of inven
tory on demand is small under a large backorder volume
so demand does not increase to infinity. Therefore, the firm 0>) There exists an 0 < M < +oo, such that, for an
cannot induce arbitrarily high demand by creating an arbi- 7" ^ â, (γ'(/,")) < —My" (If).
trarily long wait list The underlying intuition of the bound- Lemma 2(fl) shows ^ A tion 3 is satisfied
edness of y{ ■ ) is that the high demand induced by a long ., . . ., , ,, · . , , »* , .. . .·
. ,. . 'v ' , , ... . there exists a threshold inventory level/ , such that there is
wait list is canceled out by the impatience it arouses. . ™ r .... , .
J r no scarcity eftect tor all customer-accessible inventory level
Assumption 3. Let below this threshold and the scarcity function is strictly
R(d„ If) := (p(dt) — b — a(c + r,,))(d, + y (If)). (2) decreasing and strictly concave for all custom
inventory level above this threshold. Lemma 2(b) prov
R(dt, I',' ) is jointly concave in (dt, If ) on its domain. that R{ ·, · ) is jointly concave only if, for all I
Assumption 3 is imposed mainly for technical tractabil- with \y'{If)\, \y"(If)\ is sufficiently big. In other
ity because it is required to establish the joint concavity the region where the scarcity effect exists (i
of the objective and value functions in each period (see the curvature of the function y( ■ ) should b
the discussions after Lemma 4). Note that R(d,, If) is the big. This condition is not restrictive and, for
expected difference between the revenue and the total cost be satisfied by the commonly used power
(i.e., procuring, displaying, and backlogging costs) to sat- families of scarcity functions. We note that, math
isfy the current demand in the next period when the firm Lemma 2(a) is a corollary of Lemma 2(b). N
holds a customer-accessible inventory If and charges a sales that the necessary condition characterized
price p(df). The joint concavity of R{ ■, ■ ) implies that the is also sufficient to some extent,
expected difference between the revenue and the total cost
to meet the current demand in the next period has decreas- Lemma 3. If there exists an 0 < M < +oo, s
ing marginal values with respect to both the expected price- anT 7° ^ Ta, (y (7 ))2 ^ —My (If), the fol
induced demand and customer-accessible inventory level. ments hold:
The joint concavity of R( ■, ·) is stronger than the concavity (a) Tor any inverse demand curve p( ■
of expected revenue (Assumption 1) because it also captures a threshold 8* < +oo, such that, for any
the impact of inventory-dependent demand on revenue and Ρ si4 ):= Ρ ( " ) +
procurement, reallocation, and backlogging costs. We dis
cuss this assumption in detail in the following subsection. Ts(dt, If) := (ps(d,) — b - a(c + rd))(dt + y
3.1. Discussions on Assumption 3 is jointly concave in (d„ If) for d, e [d, d] and
Assumption 3 is essential to show the analytical results in C3) Suppose that ρ (■) φ 0 for any d, € [
this paper. We first characterize the necessary and sufficient scarcity function y( ■ ), there exists a thresho
condition for Assumption 3: sfch that< for an>' ? > <?*- with %(') := τ(
, r./ , ,n\ ■ · · ι · /j τ„\ ■ TJd,, If) := (p(d.) -b — a(c + rdj)(d. + yJIf)) is jointly
Lemma 1 R(d„ I ) is jointly concave in (d„ /, ) on its concave in ^ /«) for dt e [d, d] and If φ Ka.
domain if and only if
(p"(dt)(d, + y(If))+2p'(dt))(p(dt)-b-a(c+rd))y"(If)
I) Η Lemma 3 demonstrates that, as long as the condition
characterized in Lemma 2(b) on the scarcity functions,
^ (p'(d,)y'(If))2, for all dt e [d,d] and If < Ka. (3) γ(. js satisfied, /?(·,·) is jointly concave on its domain

3.108.85.85 on Thu, 16 Nov 2023 17:51:21 +00:00
if (a) the sales price of the product, p( ■ ), is sufficiently high customer-ac

high relative to the inverse of price sensitivity, |ρ'(·)|; a high holding
or (b) the price is not linear in demand, and the scarcity Both inventory
effect driven demand, γ(·), is sufficiently high relative to enable the f
the scarcity intensity, |γ'(·)Ι· These sufficient conditions accessible inve
have a clear economic interpretation: The price elastic- and mitigate th
ity of demand (i.e., \(ddj dt)/(dp,/ pt)\) is sufficiently inventory with
high relative to the inventory elasticity of demand (defined fied model.
as \(dy/y)/(dl"/lf)\). In practice, this condition is not The unified m
restrictive. Compared with the primary demand leverage to several s
(i.e., the sales price), the customer-accessible inventory own. For examp
(through the scarcity effect) has less impact on the poten- cost hw is suffi
tial demand because not every customer cares about the to the one w
backlogging risk of a product, but everyone cares about cussed in det
its price. Therefore, Assumption 3 can be satisfied under a value s is suffici
mild condition with economic interpretation. the one without i
In the online appendix (Section EC.2), we discuss the detail in §5 2
case where the inverse demand function p(-) and the j0 formulat
scarcity function γ( · ) belong to the power and/or exponen- gram jet.
tial function families, which are the most commonly used
inverse demand functions and scarcity functions in the liter- V,(/(a,/,) = th
ature (see, e.g., Sapra et al. 2010). For this case, we charac- period
terize necessary and sufficient conditions for Assumption 3 with
in model primitives, which are easy to verify. and a total inventory level I,.
Finally, when Assumption 3 does not hold (i.e.,/?(·,·) ,. ,
. . . . , , , , / . Without loss of generality, we assume that the excess inven
ts not ointly concave), we have conducted extensive , , ,. , , .,
. , . , , . x c . tory in the last penod (penod 1 ) is discarded without any
numerical experiments to test the robustness of our analyt- / , . .
ical results. Our numerical results verify that the analyti- S3Zfê vaue' 1'e"
cal characterizations of the optimal policies in our model . The,°Pt,mal value func
are robust and hold for nonconcave /?(·,· )'s in all of our slve sc eme'
experiments. In particular, Lemma 2 implies that when the
scarcity function γ( ·) contains a linear and strictly decreas- h Ί) = r
ing piece, R( ■, · ) is not jointly concave. We present our
numerical experiments for this case in §7.1. where F (If) := {(*», d,):
xat, dt € [d, d]} denotes the set of feasible in
4. Unified Model pricing decisions, and
In this section, we propose a unified model to ana
lyze the joint pricing and inventory replenishment/disposal/ Λ (χΐ > xt > > 4° » D
reallocation problem when the firm faces random demand _ _rdj<> _cj +p(d )
that is negatively correlated with the customer-accessible
leftover inventory. We characterize the structure of the +s(xt~h)
optimal
j· . Jpricing and
1 ■ 1 ,1 Λ inventory
ι λ. / \ Λ' l M \ policy and
l \ί \ «/' give
ι l// suffi-
\ ι \Γ \ I/' ι_E{ha(xat-8(p
' I// J
cient conditions under which the firm d
pose of its on-hand inventory, (b) wi
tory, (c) reallocate its customer-acc
the warehouse, or (d) display any positive
customers. - (rd + rw)(x" - If)~ + (hw - rd)x"
This model is suitable for the case wherein the firm can
+t[(b+ard)(x*-(dt + y(0)eÎ-e?>
both withhold its on-hand inventory in its private warehouse
not observable by customers (e.g., clothing and electron- +ac(xt — (dt + y(I?))e™ — e")\
ics markets) and dispose of it (e.g., in the hi-tech indus- +flnlV (xa~(d +v(ra))em-ea χ
try, the evolution of product generation is so fast that the ' ,_1 ' ' ' ' ' ' '
retailers/manufacturers have to sell excess old versions at -(dt + y(I"))e™—eat) — rd(xat —(d, + y(I"))e™-eat)
a significantly discounted price). When potential demand , m
is negatively correlated with the customer-accessible left- ' ' '
over inventory, the firm faces greater overage risk because a -(b+ha)(x" - (d, + y(lf))e™ — e")+}

3.108.85.85 on Thu, 16 Nov 2023 17:51:21 +00:00
= (p(d,) - a(c+rd) - b)(d, + y(If)) — (c — s)(xt -1,)~ When the firm dispos
~(r +r \(r"-la\--(h 4-fl -rvVir the °Ptimal display-up-to in
' ' w optimal dispose-down-to inventory level, whereas d,(If) is
+(hw+b — (1 — a)rd)xf the optimal expected price-induced demand. The following
,, ,.. . . , _ ... lemma establishes the properties of the two optimizers:
+E{-(ha+b)(xf-(d, + y(If))ef-ef)+ F F F
Lemma 4. For each t = Τ, Τ — 1,..., 1,
+«[W*M4+y (ΌΚ-^χ, mentshoid,
-(d, + y(If))ef -eat )-rd(x^~(dt + y(/,fl))e,m-ef) (a) J,(xf ,x„d„If ,If) is join
ously dijferentiable in (xf,xt,d„If,I,) except
—c(x, — (d, + y(It))el — e,)]} of measure zero4, for any fixed (I
= R(d,,If)-e(xl-I,y-(rd + rw)(x" - If)' - φχ, + φ χ* strictly jointly concave in (xf
(b) V,(If, I,) is jointly concave and continuo
+E{G((x( — (d, + y(It ))e, — et ,xt ferentiable in (If,I,), whereas Vt (
- (d, + y(If))ef - ef)}, (5) decreasing in If and I,.
Lemma 4 proves that the objective function
period is jointly concave and almost everywhe
where G,(x,y): — ~(b+ha)x++a(V,_x(x,y) — rdx — cy), entiable and the value func
n , . , ρ. continuously differentiable. Moreover, the second half of
ν: = c — s = the unit loss of inventory . ' ,
... ,,, Lemma 4(b) implies that the normalized value function,
Vt(If,I,) — rdIf — cI„ is decreasing in both the cu
ψ : = hw + (1 — a)c=the unit cost of accessible inventory level If and the total
replenishing and holding inventory which generalizes Proposition 5.1 in
in the warehouse, We note that the joint concavity of /?(·,·) on its entire
A,· —h u (λ \ domain is necessary to prove that the objective functions
w d ·//(·>·,-,If,It) ar|d that the value functions Vt(·, ·) are
=the unit saving of reallocating jointly concave, which is essential to anal
warehouse inventory to the lish other structural results in our paper. W
customer-accessible storage. find examples in which R(·,·) fails to be joi
(e.g., γ(·) contains a linear and strictly decreasing p
We use (xat*(lf,It),x*t(If,It),d*(If,If)) to denote the and leads to nonconcave Jt(-,-,-,If,I
maximizer in (4), which stands for the optimal policy in this case, we are unable to analyticall
period t, with customer-accessible inventory level If and tural results in our paper (e.g., Theorem
total inventory level /,. To characterize the structure of In §7·'' we numerically test whether th
the optimal inventory replenishment/disposal/reallocation optimal policy characterized in our th
and pricing policies, we define the following optimizers: holds. With the help of Lemma 4, we cha
(xf(If),d,(If)) and (xf(If),x,(If),dt(If)). Let tural properties of the optimal policy in t
as follows:
(xt(If)>d,(If)):= argmax [Rld,,^)^βχ" Theorem 1. For t = T,T — 1, , 1, the following state

j:fe[min{/,o,o),A:a],a,e[d,a] ments hold'.
+ E[G,(xf-8(p(dt),If,e,),xf (a) xf(If)^x,(If). Moreover, let
-S(p(d,),If,e■,))]}, (7) qf(If,It):=xf(If,I,)-It
where /3:=fc — (1 — a)(c + rd) >0. (8) denote the optimal order/disposal quantity and we have:
Note that xf(If) is the optimal order-up-to inventory level, >0 if l,<xf(If),
= 0 ifxf(If)Î,^xt(If),
if the firm procures positive inventory and displays all of qf(If,I,)
its on-hand inventory to customers, whereas dt(If) is the < 0 otherwise,
optimal expected price-induced demand in this case. Let
i.e., it is optimal to order if and only if I, <xf(If) and to
(xa.(If),xt(If),d,(lf)) dispose if and only iff>x,(If).
(b) IfI,<xat(If),
:= argmax {R(d„ If) + (6-if/)x,
4MV) ■ xa; (If,I,) = x* (If,I,)= xf(If), df(lf,It) = d,(If),
(rd + rw)(xt I) +<l>xt (.g., it is optimal to order and d
+E {Gt(xf-8(p(dt),If,ef),xt-8(p(dt),If,e,))}}. (9) charge a list price p(d

3.108.85.85 on Thu, 16 Nov 2023 17:51:21 +00:00
(c) If I, > it, (/)'), strategies. As suggested in Theorem 1, the firm needs
to price the product in accordance with the custo
(xf(IfIt),x*(I",It),d*(IfI,)) = (x°(I"),xt(I"), d,(/?)), accessible inventory level so as to better con
effect of demand. Theorem 1 also shows that when the total
i.e., it is optimal to dispose the total inventory /eve/ down inventory is high, the firm should withhold and dispose of
to xt(I"), display xf(If), and charge a list price p(d,(It )). jts on_hand inventory, which saves holding costs and miti
(d) V f € [x, (I, )]» x, (/,,/,) =/„ i.e., it is opti- gates the risk of suppressing potential demand. On the other
mal to keep the total inventory level. hand, the opportunity to redisplay the withheld inventory in
(e) xt if ) 's continuously decreasing in It, whereas the warehouse enables the firm to satisfy potential demand
d,(It ) is continuously increasing in /,. without discouraging it. In short, combining dynamic pric
Theorem 1 generalizes Proposition 5 in Sapra et al. ing, inventory withholding, and inventory disposal policies
(2010) by characterizing the structure of the optimal pol- helps the firm better match supply and demand and greatly
icy in our unified model. We show that a customer- enhances its profitability.
accessible inventory-dependent order-up-to/dispose-down- We now analyze how the model primitives influence the
to/display-up-to list-price policy is optimal. The optimal firm's optimal operational decisions, such as inventory dis
policy is characterized by two thresholds, i.e., the order- posai, inventory withholding, and inventory display.
ing threshold xf(lf) and the disposal threshold x.(If), _ „ „ ,, . ...
, , _ ,·, j j , ·,, ■ Theorem 2. The following statements hold:
both of which depend on the customer-accessible inven- ( „ -
tr.™ 1αλ7α1 i" if ti,P mq! mvpntnn, IpvM t ic KaI™,, w ν hw &ac s, x
tory level, If If the total inventory level, /,, is below the
···,!·
ordering threshold, i.e., I. <x?(/.a), the firm should order- ... _. . . , ^
, ,. . ,, , ,, .. . .. f. . , , . ^ (b) There exists an s± <c, such that, if s^s„ x,(I,) =
up-to this threshold, display all of its on-hand inventory , r„ ^ „ , „ „ , ,
, , . ... . . ■ +00 for any I? ζΚα and t = T ,T —1,...,1.
to customers, and charge a customer-accessible inventory- . ; ,, . _ ,, .
, , . .. . /./raw rr , r ι ■ , ii (c) If mf/Âr 7 \I,)^—M, for some M<+oa, there
dependent list-price p(d,(If)). If the total inventory level . '< K« ' ', , ^ ^
• u· u .. ,· ι ν · , ~ /,a\ exists an r<+oc, such that, if ru, ^ r, x (/,)>/,, for
is higher than the disposal threshold, i.e., I.>xt(I"), tn * , ' „ ' , , ' V , . ..
(, , ,, ,. , . ... , , ,, ,. , any I?^Ka and t=T,T— Ι,.,.,Ι. On the other hand, if
the firm should dispose-down-to this threshold, display . ; ' ,/+, ' , ,
part of its on-hand inventory, xf(If), to customers, a
charge a customer-accessible inventory-dependent list-price 0
any t = Τ, Τ — 1,..., 2.
p{dt(lf)). If the total inventory level is between the above
two thresholds, i.e., /,€[x,a(/f),x,(/.")], the firm should Lel l<1, a
keep its total net inventory and display part of it to eus- Probability that th
tomers. In particular, Theorem 1(b) implies that if it is smaller than L' regardle
optimal to order, the firm should not withhold anything. /
Order-and-withhold policy is dominated by displaying the a(p—b—α(ο+Γά)+ηιβ)(1 — i)y (-D)
same amount of inventory to customers but not order- _|_ (^ o, (10)
ing the inventory that will be withheld (so no inventory
will be withheld). This is intuitive, because the marginal then ^(/;+/f)^0 for any I?^Ka, /„ and
cost of order-and-withhold is at least c+hw (procure- ]
ment cost and holding cost in the warehouse), while the
marginal benefit of inventory withholding is at most ac Theorem 2(a) shows that, when the warehou
(saving from the purchasing cost in the next period). More- cost is sufficiently high (hw~âc-s), the firm
over, part (e) of Theorem 1 demonstrates that as the play all of its on-hand inventory to customers.
excess customer-accessible inventory level increases, lower demonstrates that, when inventory disposal is
demand is induced and the firm has a greater incentive to costly (.v ^ .çj, the firm would rather not dispose a
turn it over, both of which give rise to lower optimal order- inventory, regardless of its total inventory leve
up-to levels and optimal sales prices. condition in part (a) [part (b)] holds, the unified
The firm's excess inventory generally has three impacts reduced to the model without inventory withholdin
on the performance of the system: (1) satisfying future tory disposal]. This generates additional insi
demand, (2) incurring holding costs, and (3) indue- thoroughly discussed in §5.1 [§5.2], Theorem
ing/suppressing potential demand, the first with positive that the optimal inventory reallocation balanc
marginal value and the other two with negative marginal off between saving the current reallocation co
values. Hence, after normalizing the first effect (Vt(I",It)— ulating future demand. More specifically, if the in
rdI" - clt), the value-to-go function of the firm is decreas- of scarcity effect is bounded, the firm sho
ing in its customer-accessible inventory level and total locate its inventory from the customer-accessib
inventory level. To better address the intertwined trade-off to the warehouse, as long as the reallocation
between these three effects, the firm can adopt dynamic ciently high. Otherwise (i.e., the intensity of scarcit
pricing, inventory withholding, and inventory disposal is unbounded), the firm should always withh

3.108.85.85 on Thu, 16 Nov 2023 17:51:21 +00:00
its inventory in the warehouse, if the excess customer- Because no inv

accessible inventory level is high enough. model, there is no need to record the total inventory
Theorem 2(d) shows that when the demand-stimulating level /,. Therefore, the state space dimension is reduced to
effect/scarcity effect of inventory is sufficiently strong one. Similarly, we will not incur the warehouse inventory
(characterized by (10)), the backlogging cost incurred by holding cost (hw), the redisplay cost (rd), and the withhold
the wait list is dominated by the revenue generated by the ing cost (rw) in this model. The superscript "s" refers to
scarcity effect. Therefore, the firm should not display any "single location storage."
positive inventory, and every customer is placed on a wait Without loss of generality, we assume that the excess
list before receiving the product. This analytical result justi- inventory in the last period (period 1) is discarded without
fies the marketing strategy adopted by, e.g., BMW, in which any salvage value, i.e., Vq(Iq)=0, for any Ig^Ka. The
the availability of the Mini Cooper is intentionally limited value functions satisfy the following recursive scheme:
and more customers are attracted by its wait list.
Vj(I?) = cI? + max j;(xfdnIj),
5. Additional Results in Two Special
Cases where Fs(Ij) :=[min[0,/a},ifa] χ [d,d] denotes the set of
feasible order-up-to/dispose-down-to levels and expected
In this section, we study two special cases of our unified price-induced demand, and
model that are of interest on their own, i.e., the model with
out inventory withholding and the model without inventory ■// (■*," ,dt, I")
disposal. As shown in Theorem 2, when it is too expensive =p(d,)l[8(p(dJJfeJ]+s(x?-I?)'~c(x?-I?)+

to withhold [dispose] inventory, it is optimal for the firm
not to withhold [dispose of] any inventory. These two spe- —clj —§\b(xat— 8{p(d,),Ifet))
cial cases deliver new results and sharper insights on the (^xa — 8(p(d ) I" e ))+]
impact of the inventory-dependent demand on the firm's " ' ' ' ' ' '
pricing and inventory decisions. We also characterize how +aE[Vr/_1(xa —5(/j(df),/(a,e())].
the operational flexibilities (e.g., an increase in the sal- . . .
. , . . ..., ,·,. \ u ι Following the algebraic manipulation similar to that used
vage value and the inventory withholding opportunity) help ... . .
., (. . .... ,.... . . , , , in (5), we obtain:
the firm to mitigate the additional overage risk caused by ' '
inventory-dependent demand. Jj{xfd„Ij)=Rs{dt,Ij)+^xat--If)'
5.1. Without Inventory Withholding +îG'(x^-S(p(dt),Ife,))],
In some circumstances, the firm cannot store its inven- where Rs(drIj): = (p(dt) — b — ac)(d, + y(Ij)),
tory in the warehouse. Such storage may be too costly G5(j7) " = (Z?+A )y+ + a[W (y)-cy]
or transportation too inconvenient. For instance, car deal- '
ers usually display all of their automobiles because with- βΞ'=b—{\—ot)c, (11)
holding and redisplaying the inventory is too costly and , Λ . , _ , .
. , y .ι,· l £ ι · and θ is defined in (6). Note that, under Assumption 3,
inconvenient. In this subsection, we confine our analysis , wn. . . . ,
to the model without inventoryonwithholding.
its domain.
In this model, '' ' —.
because no inventory is stored in the warehouse, the state
As a corollary to Theorem 1, the optimal policy in
space dimension is reduced to one. This reduction offers
the model without inventory withholding is an inventory
new results and sharper insights into how the inventory
dependent order-up-to/dispose-down-to list-price policy, as
dependent demand influences the firm's optimal decisions. shown below:
More specifically, we demonstrate that the scarcity effect of
inventory increases the overstocking risk and, thus, drives Theorem 3. Consider a model without inventory withhold
the firm to set a lower order-up-to level and charge a lower ing. For each t = Τ, Τ — 1,..., 1, the following statements
sales price. On the other hand, when the firm has higher hold:
disposal flexibility (i.e., a higher salvage value), it can more (a) g](xfdt,F') :=E [Gst(x" — 8(p(dt),I" ,et))] is jointly
easily mitigate such overage risk by disposing of its sur- concave and continuously dijferentiable in (xat,d,,lf ) if
plus inventory. We show that the firm with a higher salvage χ° Φ I? i for any fixed If g*(·, ·,/,") is strictly concave.
value sets higher order-up-to levels and sales prices. (b) ^/(A") 's concave in If Vj(Ij) — clj is decreasing
To formulate the planning problem as a dynamic pro- and continuously dijferentiable in If
gram, let: (c) d,s(-,-,Ij) is strictly concave for any fixed If and
there exists a unique (xst*(If),d]*{Ifj) such that
Vj(Ij) — the maximum expected discounted profits in peri
ods /,r— 1,..., 1, when starting period t with a (xst*(Ij),dst*(Ij))= argmax Jj(xfd,,I
customer-accessible inventory level If CtAW'd?)

3.108.85.85 on Thu, 16 Nov 2023 17:51:21 +00:00
(d) Let qs*(If) = xf*(If) —If denote the optimal order/ (b) Assume th
disposal quantity. There exist two threshold inventory levels lim/<.^_oc
I" and If (If < If), such that, d0=d(p0). We have Î
IL for all If ^Ka.
>0 if If < If,
=0 if IL < I"
qfiO < 1H As a generalization of Theorem 3.2 in Sapra et al. (2010)
to the model with dynamic pricing and inventory disposal,
< 0 otherwise,
Theorem 4 shows that the firm should understock and
i.e., the firm should order if its inventory level If is less underprice the product under the scarcity effect o
than the lower threshold If, dispose if it is more than tory. In Theorem 4, we need the additive demand
the higher threshold If, and not order or dispose if it is tion, i.e., e™ = 1 almost surely. The additive deman
between the two thresholds. is widely applied in the joint pricing and inventory control
(e) If If<lf or If>lf, the optimal order-up-to/ literature (see, e.g., Li and Zheng 2006, Feng 201
dispose-down-to level xf(If) is decreasing in If. If If < Pang et al. 2012), primarily because it enhances te
If <If.· the optimal inventory after replenishment/disposal cal tractability and facilitates analysis. To show Theor
is increasing in If. and other comparisons between the optimizers in different
(f) The optimal price-induced-demand dsf(If) is models (Theorems 5-7 below), we need to iter
increasing in If. lish comparisons between the derivatives of value functions.
Theorem 3 implies that, when the firm cannot withhold The additive demand form is necessa
its on-hand inventory, the optimal policy is to order when tonicity relationship between optimizers
the customer-accessible inventory level is low (below If), derivatives. All results in this paper, e
to dispose of it when it is high (above If), and to make hold for the more general demand for
no adjustments when it is between the two thresholds. The Efficiently disposing of surplus inv
optimal order-up-to/dispose-down-to and list-price levels firm from the demand-suppressing effect
are customer-accessible-inventory-dependent. As shown in the salva8e value increases, the cost o
Theorem 3, when the customer-accessible inventory level is decreases, and the firm has greater dispo
higher, order-up-to/dispose-down-to levels and sales prices characterize the impact of the salvage val
are lower because a high customer-accessible inventory pricing and inventory decisions in the
level suppresses potential demand and the firm has a strong Theorem 5. Consider a model without inv
incentive to turn it over. mg. For any t = Τ, Τ — 1,..., 1, assume that
We now analyze how the scarcity effect of inventory of additive form (i.e., ef = 1 with pro
impacts optimal pricing and inventory policies. Compared d,aVs(Ia)^d,aVs(I").
with the model in which demand is independent of inven- (fi) î 'L>IL
tory, when potential demand is negatively correlated with (c) and hence
customer-accessible leftover inventory levels, the marginal ™ Ia <IH
value of on-hand inventory decreases and the firm suffers /Λ d"(Ia)<ds*(Ia)
from the demand reduction caused by a high inventory ' 1 ^ ' '
level. As a result, the firm should order less/dispose of Theorem 5(a) shows that the m
more to mitigate the additional overstocking risk caused by hand inventory increases in the salvage v
the scarcity effect of inventory. At the same time, to bet- demonstrate that with a higher salvage v
ter catch the sales opportunity, it is optimal to underprice set higher ordering thresholds, order-up-
the product so as to attract more customers. Moreover, in a prices. Recall from Theorem 4 that the i
market where the firm has little power to set the sales price, demand strengthens overstocking risk
we show a sharper result: With a more intensive scarcity tial demand so that optimal order-up-
effect, the firm should keep a lower inventory level after levels and optimal sales prices are low
replenishment/disposal. The following theorem formalizes inventory-dependent demand than those i
these intuitions. inventory-independent demand. On the other hand, The
T,^ Λ n -, , , ·., , . . ■,,, ,, orem 5 demonstrates that increased operational flexibility
Theorem 4. Consider a model without inventory withhold- .... ,
ing. Assume that D, = 8(d,,If,et) and D, = 8(dt,If ,et) with (Le" a hl8her saIva8
inventory dependent term y (If) and y (If), respectively. We dnven ^ a hlSh custome
also assume that the demand is of additive form (i.e., ef = 1 Wlth hlSher dlsPosal βεχ
with probability 1). The following statements hold: uP"t0 ,evels and sales Pric
(a) Assume that y(If) = y0=lim^_oo y(x) for all If ζ ,,
Ka, i.e., Dt does not depend on the customer-accessible Without Inve
inventory level. We show that If ζ. If, If ^ If, xf(If) ^ The model without inv
xsf(If) and df(If)^df(If) for all If^Ka. wherein the inventory is too

3.108.85.85 on Thu, 16 Nov 2023 17:51:21 +00:00
to dispose of. For example, in the automobile industry, 6.

it is too costly to dispose of unsold cars of the last in our previous
year model. In other industries, such as chemical engi- hold and re
neering, products are often so environmentally unfriendly epoch
that they cannot be disposed of arbitrarily. The model thls assumpt
without inventory disposal has a simpler optimal policy ]ocate its on
structure (customer-accessible-inventory-dependent order- Responsiv
up-to/display-up-to list-price policy) and, like the model mize jts i
without inventory withholding, delivers sharper insights realized> so
about the impacts of inventory-dependent demand and and {he tra
inventory withholding policy. More specifically, we show potential dema
that inventory-dependent demand motivates the firm to order siye inve
less and charge a lower sales price, whereas the inventory reallocate i
withholding policy helps to mitigate the overage risk and At be
increases the optimal order-up-to levels and sales prices. inventory
As a counterpart to Theorem 4, the following theorem ^ The dem
shows that inventory-dependent demand drives down the deddes th
optimal order-up-to levels and sales prices in the model warehouse
without inventory disposal: To formulate the pi
Theorem 6. Consider a model without inventory disposal. gram, let
For any t = T,T-Ι,.,.,Ι, assume that rd = rw=0, and V;(/;,/,) = th
hw>ha, i.e., reallocation is cost free and it is mor
costly to store the inventory in the warehouse. In addi- with
tion, assume that Dt = 8(d„If ,et) and Dt = 8(d„If,et) and
with inventory dependent term y [If) and y (If), respec
tively, where y(If) = y0=limx^_ooy(x) for all If^Ka, i.e., where the s
Dt does not depend on the customer-accessible inventory reallocation
level. Further assume that the demand is of additive form the exces
(i.e., ef = l with probability 1). We have: carded without
(a) The firm in the system with demand Dt should not any (If, If
withhold any inventory. We first analyze the optimal reallocation policy in
(b) xf(If)^xst*(If) and d,(If)fdf(If) for all If ^ Ka. period t. Assume that the order-up-to/dispose-down-
set by the firm before the demand realization is x, and that
An inventory withholding policy enables the firm to better the realized demand is D The optimal display.up.t0
control demand by intentionally making part of its inventory after inventory reallocation, is giv
unavailable to its customers. Hence, an inventory withhold
ing policy can stabilize the demand process and increase the xra*{Ia χ D)— argmax (_ rd(x" — I"
optimal order-up-to levels and sales prices, as shown below: ' '' " ' min(o' '
Theorem 7. Consider a model without inventory disposal. —rw(xf — If + D,)~ — bxf~ — haxf+
For any t — T,T— Ι,.,.,Ι, assume that the demand is _u r _ Vr ( a —Dtl
of additive form (i.e., ef — 1 with probability 1 ), rd = x' x> ' a t-ι xmxt
r =0 (i.e., reallocation is cost free). If I, = If, we TT r .. ,· r ,,
,w \ , Hence, the optimal value functions satisfy the following
have xf(If )fxr(If) for If <max{/f :xf(If)>If}, and
df(If,I,)fdf(If) for If fKa.
Note that Theorem 6 needs the assumption that inven- Vf (If, I, )
tory reallocation is cost free (rd = rw=0); this assumption
p(dl)l{8(P(dl),If,el)}
is necessary to reduce the state space dimension in its =( max
proof. We also assume rd = rw=0 for Theorem 7, mainly
for expositional convenience. The results still hold under ~cixt~h
the general condition that rd,rw~^0.
To summarize, inventory withholding and max {—rd(xf
inventory
min {0, dis
If—D,} <min{iTa, xt—D,}
— If + Dt)+
posai have similar strategic implications in addressing
a+
_ r ( χα /a_i_r) hxa~ h r'
inventory-dependent demand. The firm uses these strategies 'υλλι 't uxt "αΛ,
a~t
to hedge against the overage risk caused by the scarcity a r ( a ,,11

effect of inventory and stimulate more potential demand. w^x' x< Dt)+aVt_x(xt ,xt £>

3.108.85.85 on Thu, 16 Nov 2023 17:51:21 +00:00
where Fr(I?):={(xt,dt):xt^min{If,0},dte[d,d]}. Fol- order if the total inventory level is low (/, < xT,{If)), to dis
lowing the algebraic manipulation similar to that in Equa- pose of inventory if it is high (I, >x\ (/")), and to maintain
tion (5), we have: the starting inventory level otherwise. Compared with The
orem 1, which characterizes optimal policy in the unified
V,r(I','J,) model, Theorem 8 demonstrates that it is possible that the
firm orders and withholds some inventory under the op
— rdl"+cl.+ max R(dt,I?) + rd(dt + y(I?)) mal responsive inventory reallocation policy, because,
(x„d,)ef(/?)
this case, the firm has the flexibility to reallocate inventory
— Θ(χ,-Ι,) —ψχ, after the demand uncertainty is resolved.
{As in Theorem 2,cost,

+ holding weanycan
hw, show
is high that
enough, it isif the not
optimal war to
inventory in the warehouse; if the salvage value,
-\-<fya + Gr (ya -Dt,xt-Df)} 11, (12) is l°w enough, it is optimal not to dispose of
J J and if the reallocation fee to withhold inventory, r
with Grt(x,y):—-(ha+b)x+ high enough, it is optimal not to reallocate any
accessible inventory to the warehouse.
+<x[Vt-i(x,y)-rdx-cy].
Comparing the value functions (12) and (4), it is clear

7. Numerical Studies
that by postponing the reallocation decision until after This section reports a set of numerical studies
demand realization, the firm achieves a higher expected the robustness of our analytical results when
total profit. In the following theorem, we characterize the does not hold; (b) quantify the profit loss o
optimal inventory replenishment/disposal/reallocation and scarcity effect of inventory when making the p
pricing policy in the model with responsive inventory inventory decisions; and (c) quantitatively eva
reallocation: efit of dynamic pricing in the presence of the scarcity effect.
Theorem 8. The following statements hold for t = T,T-1, 0ur numerical results demonstrate that (1) the structu
j. results developed in our theoretical model are robust and
(a) Vj (If If) is jointly concave and continuously differ- hold for a large set of nonco
entiable in (If J,), whereas the normalized value function impact of the scarcity effe
Vf (If, I,) - rdIf -cl, is decreasing in If and I,. when the scarcity intensity, dem
'(b) For any given x, and realized D„ vrt(yf\If,x„D,) := ning horizon length increase;
q.r —jay-\-φγα— is con- pricing under the scarcity effect is si
cave in yf. Therefore, the optimal customer-accessible- under higher scarcity intensit
inventory level is: shorter planning horizon.
Throughout our numerical studies, we assume that
xra*(Ia,x ,D ) firm can neither withhold nor dispose of its on-hand inven
tory for two reasons: (a) to have a clear illustration of the
= argmax {i>, (yt \It ,xt,D,)} — D,. optimal policy structure in a model where Assumption 3
does not hold; and (b) to single out and highlight the impact
(c) There exist two customer-accessible inventory-level- °f focal operational elements (i.e., the scarcity effect
dependent thresholds, xfflf) and iff (If) «(/-)<xrt(If)), of inventory and the dynamic pricing strategy). We also
such that it is optimal to order up to x\ (If) if and only assume that the demand in each period is of the additive
if lt<xrt(If), to dispose down to ff(If), if and only if form, i.e., e,m = l almost surely and D, = dt + y(If)+ef
I, > x\(If), and to keep the total inventory level otherwise. Let [ef}Tt=l follow i.i.d. normal distributions with mean 0
Moreover, there exist two customer-accessible-inventory- an(f standard deviation σ. The inverse demand function is
level-dependent sales prices, p(drt(lf)) and p(d((I")), linear with slope —1, i.e., p(dt) =p0 — dt. We set the dis
such that it is optimal to charge a sales price p(drt(If)) count factor α=0.95, the unit holding cost h= 1, and the
if It^xf (If), and to charge a sales price p(drt(If)) if I, > unit backlogging cost b= 10.
^(ZD
7.1. Optimal Policy Structure with Nonconcave
Theorem 8(a) proves the joint concavity and continu
R(·, ■) Functions
ous differentiability of the optimal value functions. Part (b)
shows that, in each period, the optimal reallocation policy In this subsection, we numerically examine whether the
is obtained by solving a one-dimensional convex optimiza- structural results in our theoretical model are robust when
tion after the demand is realized. Consistent with Theo- Assumption 3 does not hold, i.e., R(·,·) is not jointly con
rem 1, part (c) of Theorem 8 proves that it is optimal to cave. We have performed extensive numerical experiments

3.108.85.85 on Thu, 16 Nov 2023 17:51:21 +00:00
to test the robustness of our analytical

Figure results. In 2.
all our Figure 2
(Colo
numerical experiments, although Assumption 3 is violated,
12
the characterizations of the optimal policy by our theoreti - With
-
/
Wit
scarcity ef ιI
cal analysis (i.e., Theorem 1, Theorem 3, and Theorem 4) - Without
- Wit ιi scarcit
continue to hold. More specifically, our numerical results En co /i
ti
verify ω
i t
"D ιi
price policy isΌ optimal
10" and th
ing in the starting inven
price [price-induced dema
the starting inventory lev
tory system without the sc
scarcity effect sets lower o
prices. Therefore, the stru
model are robust and hold fo
in all our numerical experimen
Note that from Lemma
-5
-5 0
0 5
5 10
10 15
2(a)
20
if
contains a linear and strictly
Customer
Customer acc
acc
jointly concave. Hence, we rep
the case wherein
7.2. Impact of Scarcity Effect
To'~exP(17A )' f°r h ^0, ^ ^ In this subsection we numerically study the impact of
' 1 ~ „ V ■ scarcity effect of inventory on the firm's profitability by
y0 — 1 — τ?/,, for 0 <If^Ka, ,.f . ... ™ , ....
11 ' " quantifying the profit loss of ignoring this effect under dif
ferent levels of scarcity effect intensity, demand v
It is clear that y{ ■ ) is concavely decreasing and contin- . , , ■ , . · c-τ ι ,, ,
/v ' J & and planning horizon length. As in §7.1, we assume that
uously differentiable in If for all If^Ka, but /?(·,·) is
not jointly concave in the region {(dt,If): d, e [d, d\, If e
y0 -exp(pff), for If < 0,
[Ο,Λ^]}. We have performed extensive numerical experi
7(1?) = where η > 0.
ments that test many combinations of different values of
γ0-1-η/(°, forO <I?ÇKa,
p0, γ0, c, 17, σ, d, d, Ka, and t. In all the scenarios we
examine, the predictions of the optimal policy by our the- Note that η repr
oretical analysis (i.e., Theorem 1, Theorem 3, and Theo- the inventory system
rem 4) continue to hold without Assumption 3. Figures 1-2 the scarcity effe
illustrate the optimal order-up-to level and price-induced firm that ignores t
demand with the parameter values A) = 30, y0 = 9, c = 8, first numerically ob
η = 0.5, σ = 2, [d,d\ = [6,12], Ka = 18, and i = 20. system without the s
total profits of this policy in an inventory
scarcity effect. We also evaluate the opti
Figure
Figure 1. 1.
(Color online)
(Color Optimal
online) ordering-up-to
Optimal level.
ordering-up-to level. firm under the scarc
18 —i 1 1 1 1—
and V, we take If = 0 as the reference cust
inventory level. The metric of interest is
/
17 - 17 h '
/ V*—V
^-scarcity unc'er
Ύ* different values of 17, σ and t.
/
0
! 16 £ 16 I ' /
/
o Ο
Our numerical experiments are conducted under the follow
6. 15 |_ ^
9-15]- - 'I
'
I
ing values of parameters: p(i = 21, γ0=4, c = 4, 77 = 0.35,
/
o
ο 14 -
/ 0.4,0.45,0.5,0.55, σ=1,2,3, [d,d\ = [6,12], Ka = 18, and
"co
"cô
/
i = 5,10.
E
Ε V
Ν '
o.
ο. 13 -
/ Figures 3-4 summarize the results of our numerical study
Ο O ^ I
/
on the impact of the scarcity effect on the firm's prof
12
\ / itability. Our results show that, when the scarcity effect
-- With
Withscarcity
scarcity effect
effect
-- Without
Without scarcity effecteffect
scarcity is ignored, all numerical experiments exhibit a significant
11 profit loss, which is at least 16.41% and can be as high
-10 -5 0 5 10 15
~10 -5 0 5 10 15 20 as 64.52%. Moreover, the impact of the scarcity effect is
Customer
Customer accessible inventory accessible inventor
level increasing in the scarcity intensity, demand var

3.108.85.85 on Thu, 16 Nov 2023 17:51:21 +00:00
Figure
Figure 3. (Color online) Value
3. (Color of Ascarcit
online) : t = 5. of Ascaraty: t = 5. et al.
Value
ing the scarcity effect is decreasin
In their experiments, the poten
decreasing in the leftover inventor
variability increases the expecte
thus, the firm's profitability under
7.3. Value of Dynamic Pricing

In this subsection, we numerically explore the value of
dynamic pricing under the scarcity effect of inventory with
different levels of scarcity effect intensity, demand vari
ability, and planning horizon length. As in §§7.1-7.2, we
assume that
To - exp( 17/,°), for /," < 0,

0.30 0.35 0.40 0.45 0.50 0.55 0.60
0.60
y(in= where η > 0.
t) value
γο-Ι-η/f, for 0</"ζKa,
We evaluate the profit of a firm that adopts the optimal

planning horizon length. The scarcity effect has two effects static pricing strategy, V. To compute V, we first e
on the firm s profitability: (a) it decreases future demand, the total profit of an inventory system for any fixe
and (b) it increases demand variability because the vari- in each t, and then maximize over p, to select th
ability of potential demand is intensified by that of the static price. Consistent with V*, V is evaluated at
past demand via the scarcity effect. Hence, the first [sec- ence customer-accessible inventory level I"= 0. T
ond] effect lowers firm profits with higher scarcity intensity of interest is
[demand variability]. The comparison between Figures 3-4
implies that the impact of the scarcity effect accumulates . V* — V ,
. „ , .. . . Anri,^—, under different values of η, σ and t.
over time, so that the profit loss of ignoring the scarcity pncmg ^ >
effect is higher under a longer planning horizon. In short,
the scarcity effect of inventory matters significantly to the °ur numerical experiments are c
firm's profitability when the scarcity effect intensity and 'n8 values of parameters: p0
demand variability are high, and the planning horizon is 0.4,0.45,0.5,0.55, σ= 1,2,3, \d
long. Our numerical finding confirms the result in Sapra f = 5,10.
et al. (2010) that the profit loss is increasing in the scarcity Figures 5-6 summarize the result
effect intensity. On the other hand, our numerical finding on ê value °f dynamic pric
on the impact of demand variability contrasts that in Sapra t'lc value °' dynamic pricin
ence of the scarcity effect. Federgruen and Hech
Figure 4. (Color online) Value of Ascarcity: i=10. Figure 5. (Color online) Va

0.7, r , , , ,
0.30 0.35 0.40 0.45 0.50 0.55 0.60 0.30 0.35 0.40 0.45 0.50 0.55 0.60
tj value

3.108.85.85 on Thu, 16 Nov 2023 17:51:21 +00:00
Figure
Figure 6. 6.
(Color online)
(Color Value Value
online) of λ ici
of: tApricing:
= 10. t= 10. 8.1. Sum
To our knowledge, this paper is the
ture to study the joint pricing and in
model under the scarcity effect of in
modeled as a decreasing stochastic f
customer-accessible inventory level. W
model in which the firm has several o
hedge against the risk of the stochastic
demand: (a) dynamic pricing, through
dynamically adjust its sales price; (b) i
ing, through which the firm can with
tory from customers; and (c) inventor
which the firm can dispose of part of
We show that a customer-accessible in
0.30 0.35 0.40 0.45 0.50 0.55 0.60
0.60 order-up-to/dispose-down-to/display-u
i7 value is optimal. The order-up-to/display-up
els are decreasing in the customer-a
document that the profit improvement of dynamic prie- level bec
ing in a 5-period model is between 0.46%-2.24%, when inventory. W
the coefficient of variation for demand varies between 0.7 ciently strong
and 1.4. The numerical experiments of Figure 5 report a scarcity eff
much higher profit improvement (between 0.91%—9.78%) ing every
of dynamic pricing in a 5-period model with the coeffi- strong scarc
cient of variation of demand between 0.11 and 0.33. Thus, wajt |jst
the scarcity effect of inventory gives rise to significantly When th
higher value of dynamic pricing. Dynamic pricing value ficiently hig
is driven by the following three effects: (a) it achieves inventory, a
a better match between supply and demand; (b) it helps without inv
induce higher future demand; and (c) it dampens future out invento
demand variability. While effect (a) also improves the per- results and sh
formance of an inventory system without the scarcity effect, withholdi
effects (b) and (c) have their impact only on a firm with order-up-t
the scarcity effect. Therefore, the value of dynamic pricing inventory t
is significantly increased by the scarcity effect. Moreover, Higher opera
with higher scarcity effect intensity [demand variability], inventory wi
effects (b) and (c) enhance the firm's profitability more sig- hedge again
nificantly. The comparison between Figures 5 and 6 implies firm tQ set
that the value of dynamic pricing
Ul lLCo.
decreases over time. This c
is consistent with the findings in Federgruen and Heching In additl()rli responsive
(1999) that the optimal dynamic pricing policy converges effectiye way U) address
to the optimal static pricing policy, as the planning horizon Reallocation flexibility aft
length goes to infinity. In short, the value of dynamic prie- firm U) ^ hedge aga
ing under the scarcity effect of inventory is most significant balance ^ trade_off betw
when the intensity of scarcity effect and demand variability · , · . .· ι A A T *u· u *u a
. . inducing potential demand. In this case, because the hrm
is high, and the planning horizon length is moderate. « ♦ ·«. u a · *- α α λ · ι
r . can reallocate its on-hand inventory alter demand is real
To summarize, we note that all the numerical results and · A ·. , ι . , , vuu , , , .u
. . , . , . . , , , , , „ . . t îzed, it may be optimal to order and withhold when the
insights in this section are robust and hold for (a) the gen- ,· A A A . „
; . , r ^ . , ν t ν t „ realized demand is small,
eral demand form, Equation ( 1 ), and (b) a large variety of r ^ · ι . A- «. A . ^
. iip. /■ / n\ ι · We perform extensive numerical studies to demonstrate
different inverse demand functions (i.e., p{·)) and scarcity / wu , . ~ w ι i* /u\
. .. , . . v n J (a) the robustness of our analytical results, (b) the impact
functions (i.e., γ(·)) that give rise to concave or noncon- r ^ ~ r ~ , M Λ
n,\r. the scarcity effect on the profit of the hrm, and (c) the
cave/?(·,·) functions. , ΓΛ ■ · · , , r ·
v 7 value of dynamic pricing under the scarcity effect of inven
tory. Our numerical results show that the
8. Concluding Remarks terizations of the optimal policies in our
We conclude
We concludethis
thispaper
paper with
with a summary of the main results and hold for n
a sur
and managerial
and managerialinsights
insights derived
derived f from our model and some iments. The im
thoughts on a possible direction for future research. profit is two-f

3.108.85.85 on Thu, 16 Nov 2023 17:51:21 +00:00
Acknowledgments
(b) it increases demand variability. Hence, the profit loss of
ignoring the scarcity effect is higher under higher
The authors thank scarcity
the area editor, Chung Piaw Teo, the anony
intensity (via effect (a)), higher demand variability
mous associate editor, and (via
referees for constructive comments,
effect (b)), and longer planning horizonwhich
(vialedboth
to significant improvements in the content and orga
effects).
nization
The value of dynamic pricing under the of this paper.
scarcity effect The authors
is also gratefully acknowledge
three-fold: (a) it better matches supply the
andthought-provoking
demand; (b) suggestions
it from seminar participants at
Washington University in St. Louis.
helps induce higher future demand; and (c) it dampens
future demand variability. Effects (b) and (c) lead to higher
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Nan Yang is an assistant professor of operations and manu
Urban Τ (2005) Inventory models with inventory-level-dependent demand:
facturing management at the Olin Business School, Washington
A comprehensive review and unifying theory. Eur. J. Oper. Res.
University in St. Louis. Her research interests include inventory
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management and supply risk management.
Van Herpen E, Pieters R, Zeelenberg M (2009) When demand accelerates
demand: Trailing the bandwagon. J. Consumer Psych. 19(3):302—312. Renyu Zhang is a doctoral candidate in operations and man
Veeraraghavan S, Debo LG (2009) Joining longer queues: Information ufacturing management at the Olin Business School, Washington
externalities in queue choice. Manufacturing Service Oper. Manage University in St. Louis. His research interests include inventory
ment ll(4):543-562. management and supply chain management.

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Dynamic Pricing and Inventory Management Under Inventory-Dependent Demand

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Dynamic Pricing and Inventory Management Under Inventory-Dependent Demand

Author(s): Nan Yang and Renyu Zhang

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