The  Role of E-tailer Inventory Policy on E-tailer Pricing and Profitability
Hao Zhao & Yong Cao

One issue about online retailing that has received considerable attention from researchers and practitioners alike is online retailers’ pricing strategies. Contrary to initial predictions that the Internet would lead to the emergence of a frictionless economy, empirical research shows that online price dispersion is widespread and persistent. For a wide range of product categories, studies consistently show that pure e-tailers charge lower prices than multichannel e-tailers. However, these studies do not offer any explanations for such price differences. In this paper, we propose an explanation based on the role of an e-tailer’s inventory policy on its pricing strategy. More generally, the objective of this paper is to investigate how an e-tailer’s inventory policy may affect customers’ online purchase decisions, the e-tailer’s price levels, and its overall profitability. Furthermore, this investigation shows how such impacts will change as online retailing matures over time.

One of the key features of online retailing is e-tailers’ flexibility in managing their inventories. Generally, an e-tailer can be classified as either a zero-inventory e-tailer or a positive-inventory one. The former carries no inventory of its own and order the product from a third party only when it receives orders from the customer through its Web sites. The latter carry its own inventories from which the products are shipped to customers directly.

A primary benefit for adopting a zero-inventory policy is its overall low cost structure in both fixed costs and variable costs. Another benefit is that the zero-inventory policy reduces demand uncertainty the e-tailer bears. However, a zero-inventory policy is not without its disadvantages. First, delivery time is usually longer than that of a positive-inventory e-tailer because a third party is involved in product delivery. In contrast, a positive-inventory e-tailer can ship the product from its own warehouse immediately upon receiving the customer’s order. Second, not only will the zero-inventory policy result in a longer delivery time, it also has less 2 control of delivery time because a third party is involved in the delivery process. It is quite possible that the actual delivery time is even longer than what is promised on the Web site. Such weaknesses in delivery services can cause serious customer satisfaction problems for the e-tailer. Third, involvement of a third party under the zero-inventory policy increases the probability of wrong items being shipped or mistakenly charging customers for products not ready to be shipped. The zero-inventory policy also makes it more difficult for customers to return products because there are no warehousing facilities for the e-tailer to accommodate such returns. Hence, the e-tailer may find it necessary to adopt a more restrictive return policy.

The above three disadvantages of the zero-inventory policy have different impacts on consumers’ online purchase behavior. First, since consumers can learn about delivery times promised by the e-tailer before purchase, the stated delivery time is essentially a search attribute. Therefore, they have to make a trade-off between a short delivery time and a low product price. This trade-off is influenced by the relationship between customers’ impatience for delivery and their price sensitivity. It is possible that these two variables are independent of each other. Alternatively, the more price-sensitive customers may be more patient for delivery. The other two disadvantages of zero-inventory policy—delivery time longer than promised and shipping problems—are experience attributes because customers will learn about them only after receiving the product. Therefore, the inventory policy will affect customers’ repeat purchase behavior based on their purchase experience.

To study the inventory policy’s impact on an e-tailer’s pricing strategy dynamically, we construct a two-period model, in which both the search and experience attributes of inventory policies are considered. A central feature of this model is the relationship between customers’ price sensitivity and their impatience for delivery. This paper studies how this relationship 3 affects the e-tailer’s optimal prices and its profitability. In particular, we want to know which relationship conditions—independent, moderately related, or strongly related—would favor one inventory policy over the other. The paper also studies the impact of the growth rate of online retailing on the relative advantages of one inventory policy over the other.

Besides the intuitive finding that the positive-inventory e-tailer charges higher prices than the zero-inventory counterpart in both periods, we find that the positive-inventory e-tailer’s price premium over the zero-inventory e-tailer increases in the second period over the first period when the relationship between reservation price and impatience for delivery is either independent or strongly positive. We further find that more rapid market expansion is favorable to the zeroinventory e-tailer under the aforementioned conditions because there are more new and inexperienced customers it can target. Eventually, when the market matures, the zero-inventory e-tailer can only be able to attract price-sensitive segment that is willing to put up with poor delivery services in return for low prices. In terms of profitability, the positive-inventory e-tailer is most favored when the relationship between reservation price and impatience for delivery is independent. The second most favorable condition is when this relationship is strongly negative. The zero-inventory e-tailer is most favored when the relationship is moderate.

Some important managerial implications can be drawn from our findings. First, the attractiveness of a zero-inventory policy, especially favored by pure plays in the early stage of ecommerce, is often short lived when customers are more experienced and post-purchase service quality becomes the key determinant to retain customers. The strategic advantages of a positiveinventory policy will become more prominent as online retailing matures. Second, our findings suggest that traditional retailers should take full advantage of their existing inventory capabilities when starting their online operations.