Production in Advance Versus Production To Order: Attila Tasn Adi
Production in Advance Versus Production To Order: Attila Tasn Adi
Production in Advance Versus Production To Order: Attila Tasn Adi
order
Attila Tasnadi 1
Department of Mathematics, Budapest University of Economic Sciences and
Public Administration, F
ov
am ter 8, H-1093 Budapest, Hungary
Abstract
We use a theoretical framework to compare production-in-advance type and production-to-order type environments. Carrying out our analysis in the framework of a
symmetric capacity-constrained Bertrand-Edgeworth duopoly game, we prove that
the equilibrium profits are the same in case of production in advance and production
to order. In addition, advance production results in higher prices than production
to order if both games have an equilibrium in nondegenerated mixed strategies.
JEL classification: D43; L13
Keywords: Price-quantity games; Bertrand-Edgeworth competition.
Introduction
29 January 2011
supply. In addition he discussed, but did not solve, the price-quantity game
with both firms simultaneously choosing prices and quantities. Shubik (p. 430)
conjectured that the value of the price-quantity game lies below that of the
price game because of the risk of being left with inventory in the price-quantity
game.
From now on, following Maskins (1986) terminology, we will refer to the
Shubik-type price game as a production-to-order game and to the Shubik-type
price-quantity game as a production-in-advance game. Production in advance
requires that production takes place before sales are realized. Markets of perishable goods are usually mentioned as examples of advance production in a
market. In contrast, in case of production to order, sales are determined before
production takes place. This mechanism is, for instance, typical in the market
for ships or planes. Phillips et al. (2001) emphasized that there are also goods
that can be traded both in a production-in-advance and in a production-toorder environment. To see this, we have to think about production-in-advance
markets as a kind of spot market while production-to-order markets are a
kind of forward market. Thus, for example, coal and electricity are sold in
both types of environments. A comparison of these two different types of environments has been carried out in an experimental context by Mestelman
et al. (1987) and Phillips et al. (2001). Assuming strictly increasing marginal
cost functions, Mestelman et al. reports that in posted offer markets the firms
profits are lower in case of advance production, which is consistent with Shubiks conjecture. In an experimental auction market Phillips et al. found that
prices and profits are higher while quantities and consumer surplus are lower
in case of advance production.
We will compare production in advance with production to order in a theoretical framework. In order to keep our analysis tractable we will carry out the
comparison in the framework of a homogeneous goods Bertrand-Edgeworth
duopoly with capacity constraints. In the Bertrand-Edgeworth game quantities and prices are both decision variables. It is well known that in general
this game does not have an equilibrium in pure strategies. The mixed-strategy
equilibrium was computed, under different conditions imposed on the demand
function and the capacity limits, by Beckmann (1965), Davidson and Deneckere (1986) as well as Allen and Hellwig (1993) for proportional rationing,
and by Levitan and Shubik (1972), Kreps and Scheinkman (1983), Osborne
and Pitchik (1986) and Vives (1986) for efficient rationing. Maskin demonstrated the existence of mixed-strategy equilibrium under very weak assumptions.
The above-mentioned works have determined mixed-strategy equilibrium corresponding to the case of production to order; that is, the production decisions
of the firms follow the choices of their prices. Assuming unlimited capacities,
Levitan and Shubik (1978) computed the mixed-strategy equilibrium for the
2
case of production in advance (i.e., firms choose prices and production quantities simultaneously). However, if the firms are capacity constrained, then only
the existence of a mixed-strategy equilibrium is known (see Maskin, Theorem
1). We are not aware of further theoretical results in the literature concerning
the mixed-strategy equilibrium for the case of production in advance.
In this paper we consider the symmetric case in which both firms have equal
capacities and the same constant unit costs up to their capacity constraints.
We suppose that the unit costs are positive. This implies that in the two different cases, production to order and production in advance, the equilibrium
in mixed strategies may differ. In particular, it seems possible that higher
prices firms will not always produce up to their capacity constraints because
they cannot sell their entire production with positive probability in a mixedstrategy equilibrium. We will establish that in a symmetric equilibrium the
firms profits are equal in both versions of the price-setting game (Theorem 1).
This means that Shubiks conjecture does not hold true for the case of identical and constant unit costs up to the same capacity constraint. In addition,
if both games equilibrium are in nondegenerated symmetric mixed strategies, then the equilibrium price distribution of the production-in-advance case
stochastically dominates (in the sense of first-order stochastic dominance) the
equilibrium price distribution of the production-to-order case (Theorem 1).
The rest of this paper is organized as follows. Section 2 presents the framework
of our analysis. Sections 3, 4 and 5 contain the comparison of the productionin-advance game with the production-to-order game for the case of small capacities, large capacities and intermediate capacities respectively. Finally, in
Section 6 we make some concluding remarks.
The model
Assumption 2 The two firms, labelled 1 and 2, have identical positive unit
costs c (0, b) up to the same positive capacity constraint k. Each of them
sets its price (p1 , p2 [0, b]) and quantity (q1 , q2 [0, k]).
The quantity decisions q1 and q2 shall be interpreted differently in case of
production in advance and in case of production to order. In the first case qi
stands for the actual production of firm i, while in the second case qi denotes
the maximum amount firm i is willing to supply. Throughout the paper i and
j will be used to refer to the two firms; in particular, i, j {1, 2} and i 6= j.
In order to enable the demand faced by the firms to be determined, we have to
specify a rationing rule. We assume efficient rationing by the low-price firm,
which occurs in a market if the consumers can costlessly resell the good to each
other or if the consumers have heterogeneous unit demands and the consumers
having higher reservation prices are served first (for more details we refer to
Davidson and Deneckere, 1986 and Tirole, 1988).
Assumption 3 The demand faced by firm i is given by
D (pi ) ,
qi
i (p1 , q1 , p2 , q2 ) = q +q
D (pi ) ,
i
j
(D (pi ) qj )+ ,
if pi < pj
if pi = pj
if pi > pj .
It is worth noting that for the results obtained in this paper many other splitting
rules can be allowed. The essential property of the rule employed here is that firm
is demand is strictly increasing in firm is own quantity.
D 1 (2k) ,
p =
if D (0) > 2k
if D (0) 2k.
0,
The function
r (p) = (p c) (D (p) k)
equals a firms residual profit whenever its opponent sells k and D (p) k.
Let p = arg maxp[c,pm ] r (p). Clearly, p and p are well defined whenever
Assumptions 1 and 2 are satisfied.
In the Introduction we mentioned that the production-to-order game has already been solved in the literature. Kreps and Scheinkman established the
uniqueness of equilibrium profits. From Osborne and Pitchik we even know
that the production-to-order game has a unique solution. We shall denote the
equilibrium profit of the production-to-order game by . The following result
is due to Levitan and Shubik (1972), Osborne and Pitchik (1986) and Vives
(1986):
Proposition 1 Under Assumptions 1, 2 and 3, the production-to-order game
has a unique symmetric equilibrium. In particular, the following three cases
emerge:
(1) If p p, then we have an equilibrium in pure strategies with both firms
setting prices equal to the market clearing price (i.e., pi = p ).
(2) If p > max {p , c}, then there is only an equilibrium in nondegenerated
mixed strategies with distribution function
F (p) =
(p c) k
(p c) (2k D (p))
5
(1)
First, we start with the case of small capacities, which is the only case with
an equilibrium in pure strategies.
Proposition 2 Let Assumptions 1, 2 and 3 be fulfilled. Then if the production-in-advance version of the Bertrand-Edgeworth duopoly game has a Nash
equilibrium in pure strategies, it is given by pi = p and qi = k (i {1, 2}).
Furthermore, a Nash equilibrium in pure strategies exists if and only if p p.
p p
By comparing Proposition 1 with Proposition 2, we can observe that the respective equilibrium prices and profits of the production-in-advance game and
of the production-to-order game coincide whenever a pure-strategy equilibrium does exist in the production-in-advance game. In addition, Proposition 2
points out a difference between the production-in-advance and the productionto-order versions of the Bertrand-Edgeworth game since in the latter version
an equilibrium in pure strategies also exists when capacities are sufficiently
large. Assuming proportional rationing, Boyer and Moreaux (1987, Proposition 1) obtained a result in the same direction as Proposition 2 in that they
showed the nonexistence of equilibrium in pure strategies for a price-setting
production-in-advance game in case of unlimited capacities.
2 (1 , (p2 , q2 )) 2
(2)
2 (1 , (p2 , q2 )) = 2
(3)
1 + 2 is upper semi-continuous in case of advance production and Property ( ) can be established similarly to the case of production to order (see
Dasgupta and Maskin, 1986b).
Before we can proceed, we need some further notations. Let be a symmetric mixed-strategy equilibrium of the production-in-advance game. We shall
denote the equilibrium profit of the production-in-advance game by e . We
define the support of a symmetric equilibrium strategy in the following way:
supp() = {(p, q) S | 1 ((p, q), ) = e } .
For any price p [c, pm ] we denote by s (p) [0, k] the set of those quantities q [0, k] for which (p, q) supp (). The correspondence s may be
called the supply correspondence. Let p stand for the projection of probability measure to the set of prices; that is, p (B) = (B [0, k]) for any
Borel set B [c, pm ]. We write pe and pb for sup {p [c, pm ] | p ([c, p)) = 0}
and inf {p [c, pm ] | p ((p, pm ]) = 0} respectively. Thus, p ([pe , pb ]) = 1. In
what follows we will omit the subscripts when it is clear which symmetric
equilibrium strategy is meant, and we will write simply e , s, pe and pb instead
of e , s , pe and pb respectively.
From now on we will restrict ourselves in the analysis of the production-inadvance version of the game to those cases in which the equilibrium is in
nondegenerated mixed strategies; that is, p < p by Proposition 2. Clearly,
e 0 holds true since each firm can assure zero profit by zero production.
Hence, e = 0 if pe = c. The following two lemmas investigate the case of
pe > c.
Lemma 1 If (, ) is a symmetric mixed-strategy equilibrium of the production-in-advance game, then under Assumptions 1, 2, 3, p < p and pe > c, we
have s (pe ) = {min {k, D (pe )}} and p ({pe }) = 0.
From Lemma 1 we see that e = (pe c) min {k, D (pe )}. Lemma 2 and
Lemma 4 extend the results of Lemma 1 to the bottom part of the support of
equilibrium prices. Lemma 2 considers the case in which the lowest possible
price pe is high enough so that the firms are demand constrained rather than
capacity constrained; that is, s (pe ) = {D (pe )}.
Lemma 2 If (, ) is a symmetric mixed-strategy equilibrium of the production-in-advance game, then under Assumptions 1, 2, 3, p < p, pe > c and
s (pe ) = {D (pe )}, there exists a price p0 (pe , pm ] such that s (p) = {D (p)}
e p0 ].
and p ({p}) = 0 for all p [p,
1 ((p, q) , ) = p
[pe,p)[0,k]
q
D (p) , q d (p2 , q2 ) +
p
min
q + q2
{p}[0,k]
b cq,
pqp ((p, p])
Z
(4)
where (p, q) supp (). Note that (p, q) supp () implies q D (p). Clearly,
the two integrals in the above expression are both increasing in q. Therefore,
b c > 0 implies that 1 is strictly increasing in q whenever p and
pp ((p, p])
e pm ] such
are fixed. Hence, by pe < pm and Lemma 1 there exists a p0 (p,
e p0 ).
that s (p0 ) = {D (p0 )}, and s (p) = {D (p)} or s (p) = for all p [p,
9
1 ((, D ()) , ) = n
lim 1 ((p?n , D (p?n )) , )
and
= e
e pk and thus, 1
on p,
pk , D p k
e pk . Thus,
b c 0 for all p p,
must have pp ((p, p])
pk p
Let H (q) = pk qp
h
i
pk , pb
h
b c 0.
c = lim
pp ((p, p])
k
(5)
pp 0
i
pk , pb
cq. Obviously, 1
e pk by the definition
q [0, k]. We have e = 1 ((p, D (p)) , ) for all p p,
of pk and Lemma 2. By applying the first part of (5), it can be verified that
e = lim
1 ((p, D (p)) , ) = H D pk
k
pp 0
(6)
h
i
pk , pb c =
i
i
pk , pb c > 0. Then p
> 0 and e =
o
implies p
n
pk
o
i
pk , pb
H D pk
D pk
h
> H (q) 1
h
pk , q , for all q 0, D pk
. Thus, s pk =
h
i
pk , pb c > 0
> 0. Hence,
pk , D pk
, < 1
pk , D pk
, = e
o
Lemmas 1, 2 and 3 are valid for any case in which a pure-strategy equilibrium
does not exist, that is, for large capacities as well as intermediate capacities. In
fact, Lemmas 1 and 3 will be also applied in Section 5 where we will investigate
the case of intermediate capacities. Now we separate our analysis into two
parts: the case of D (c) k (large capacities) and the case of p > max {p , c}
(intermediate capacities). Proposition 2 already covers the case of p p. The
following proposition contains our result for the case of D (c) k.
Proposition 3 If (, ) is a symmetric mixed-strategy equilibrium of the production-in-advance game, then under Assumptions 1, 2, 3 and D (c) k, we
11
have e = = 0.
Proof. From Proposition 1 we already know that the production-to-order
game has an equilibrium in pure strategies with = 0 and both firms setting
their prices equal to their marginal costs c.
Now, we turn to the production-in-advance game. Of course, if pe = c, then
e = 0, and we are finished. If pe > c, then we can apply Lemma 1. Note that
e = {D (p)}.
e
D (c) k implies s (p)
Therefore, we can apply Lemma 3 and
obtain e = 0. 2
We can also observe that under the assumptions of Proposition 3 the production-in-advance prices dominate, in the sense of first-order stochastic dominance, the production-to-order prices, since in the production-in-advance game
the firms never set prices below c and in the production-to-order game the
firms set prices equal to c. In addition, Proposition 3 is consistent with Levitan and Shubik (1978), since they also obtained that the firms make zero
profits in case of advance production. However, they assumed the presence of
unlimited capacities.
In this Section we will consider the remaining case, that is, the case of p >
max {p , c}. We start with the observation that in this case each firm can
guarantee itself > 0 profits in the production-in-advance version of the
game by setting its price to p and its quantity to D (p) k. Thus, e . This
observation also implies that pe p > max {p , c} c.
Before stating our result concerning the case of p > max {p , c}, we need
another lemma, which is analogous to Lemma 2 in that it extends the result of
Lemma 1 to the bottom part of the symmetric equilibrium price distribution.
Lemma 4 If (, ) is a symmetric mixed-strategy equilibrium of the production-in-advance game, then under Assumptions 1, 2, 3 and p > max {p , c}
we have k < D (pe ) and there exists a price p0 (pe , pm ] such that s (p) = {k}
and p ({p}) = 0 for all p [pe , p0 ].
Proof. Let (, ) be an arbitrary symmetric mixed-strategy equilibrium of
e
the production-in-advance game. First, observe that we must have k < D (p)
e = {k} because s (p)
e = {D (p)}
e would imply by Lemma 3 that
e = 0,
and s (p)
which cannot be the case since 0 < e .
12
b c > 0
The two integrals in (4) are both increasing in q. Hence, pp ((p, p])
implies that 1 is strictly increasing in q whenever p and are fixed. Then it
e pm ] such that
can be checked that by Lemma 1 there exists a price p0 (p,
e p0 ].
s (p0 ) = {k}, and s (p) = {k} or s (p) = for all p [p,
e Suppose
We already know by Lemma 1 that p does not have an atom at p.
p
0
e p ]. Then it follows that
that has an atom at price p (p,
1
kp ({p}) > D (p) p ({p}) .
2
(7)
Since p has at most countably many atoms we can select a sufficiently small
e p ({p }) = 0 and
> 0 such that p > p,
n
e p )) +
1 ((p , k) , ) = (p ) min (D (p ) k)+ , k p ([p,
b ck
(p ) kp ((p , p])
n
e p )) +
(p ) min (D (p) k)+ , k p ([p,
e p)) +
(p ) min (D (p) k)+ , k p ([p,
b ck
(p ) kp ({p}) + (p ) kp ((p, p])
n
e p)) +
> p min (D (p) k)+ , k p ([p,
1
b ck
p D (p) p ({p}) + pkp ((p, p])
2
= 1 ((p, k) , ) ,
and
= e
13
h
p, p
h
(p c) k
p (2k D (p))
p, p , {k} =
(8)
for any p p, p .
pk , min k, D pk
o
, = lim
1 ((p, min {k, D (p)}) , ) = e ,
k
pp 0
b c 0 for all p p,
e pk . Let
must have pp ((p, p])
G (q) = pk qp
Obviously, 1
h
i
pk , pb
+ pk D pk k
+
h
cq.
oi
e pk
p,
. We have
e pk by Lemma 4. In addition, by
e = 1 ((p, min {k, D (p)}) , ) for all p p,
applying the first part of (5) it can be verified that
e = lim
1 ((p, min {k, D (p)}) , ) = G min k, D pk
k
pp 0
o
(9)
k
In order to prove that
h p i= p we split (5) into two separate
n cases.
First,
o we
k p
k b
k
suppose that p p , p c = 0. Then G (q) = G min k, D p
= e
14
G D pk k = 1
oi
pk , D pk k , , which implies e = , pe = p
h
i
o
pk , pb
e = G min k, D pk
h
h
i
pk , pb
c > 0. Then
> G (q) 1
o
pk , q ,
n
. Thus, s pk = min k, D pk
oo
. Clearly,
c > 0 implies p
1
n
pk
o
n
h
i
pk , pb
pk , min k, D pk
o
, < G min k, D pk
o
= e
oo
. Therefore,
Now from Lemma 4 firm 1s profit, given that firm 2 plays its own equilibrium
strategy , equals
b + p (D (p) k) p ([p,
e p)) ck
1 ((p, k) , ) = pkp ((p, p])
h
(10)
Concluding remarks
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