Dynamic pricing under inventory considerations and price protection

Abstract

In high-tech industry, customers’ tendency to purchase the newest versions of products forces manufacturers to reduce the prices of older models. This puts the retailers in a vulnerable position as their own sales prices also decrease for these products. For this purpose, manufacturers and retailers compromise over different price commitment terms in their contracts. One such term is price protection. In general, a price protection term obliges a manufacturer refund a retailer a portion of the difference between the new and old wholesale prices for the inventory that the retailer have in stock and that are ordered within a time window. Sometimes, refunds may also be applied on products sold based on their sales price. We study a price protection contract over a finite horizon under stochastic demand. We have a single manufacturer and a single retailer, each endowed with a fixed amount of inventory at the beginning of the horizon. The manufacturer determines the retail price and neither manufacturing nor replenishment is allowed. The objective of the manufacturer is to set the retail price in each period given how much inventory is left at the manufacturer and the retailer. We analyze the structure of the model and provide some analytical results on the effect of different factors on optimal prices and optimal expected profits. Then, we present the results of a numerical study in which we further investigate the effect of different factors to obtain managerial insights.