How Should a Firm Manage Deteriorating Inventory? (ed.1)
Ferguson, Mark E.
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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 to the next period offers the firm a second selling opportunity, but at a reduced price. By doing so, however, the firm subjects sales of its new product to competition from the leftover product. We present a dynamic 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 of carrying all, some, or none of its leftover inventory to the next period. We also show that the price of the new product is independent of the quality level of the leftover product. Finally, we relax the model assumption and assume that there is demand uncertainty in both periods. We run a simulation and find that the firm finds it optimal to introduce the old units only if the level of uncertainty is low and does not exceed a certain threshold.