On the interdependence of strategic inventories and new product generation introduction

The seminal study by Anand et al. (2008) demonstrates that retailers have an incentive to strategically stock inventories as bargaining chips against upstream manufacturers. To counteract the impact of such strategic inventories, the manufacturer may wish to adjust or introduce products of different qualities in the second period. Shall he then upgrade or downgrade the product's quality? In our model, the manufacturer produces a single product of a given quality in the first period, and the retailer may carry strategic inventories. In the second period, the manufacturer may choose to produce only the existing product, replace it with a new version, or may choose to produce both generations of products. We find that in the absence of strategic inventories, as the quality of the existing product increases, the manufacturer transitions from offering the existing product along with an upgraded generation to offering a downgraded generation next to the existing one, and ultimately offering only the existing version. However, in the presence of strategic inventories, we uncover a new domain: if the quality of the existing product is low, the manufacturer should offer only the upgraded product. In such a scenario, strategic inventories can benefit the manufacturer and retailer as it weakens the magnitude of double marginalization. The volume of strategic inventories decreases in the existing product quality until the retailer carries a sufficiently high volume such that only the upgraded product is offered by the manufacturer because of the retailer's ability to price discriminate between consumers based on their preferences for the two product generations.