How Should a Firm Manage Deteriorating Inventory? (ed.3)

Firms selling goods whose quality level deteriorates over time often face difficultdecisions when unsold inventory remains. Since the leftover product is often perceivedto be of lower quality than the new product, carrying it over offers the firm a secondselling opportunity and an ability to price discriminate. By doing so, however, the firmsubjects sales of its new product to competition from the leftover product. We presenta two period model that captures the effect of this competition on the firm’s productionand pricing decisions. We characterize the firm’s optimal strategy and find conditionsunder which the firm is better off carrying all, some, or none of its leftover inventory.We also show that, compared to a firm that acts myopically in the first period, a firmthat takes into account the effect of first period decisions on second period profits willprice its new product higher and stock more of it in the first period. Thus, the benefitof having a second selling opportunity dominates the detrimental effect of cannibalizingsales of the second period new product.