The rapid rise in the number of products globally has dramatically increased retailers’ demand for capacity. However, despite the continuous growth in the demand for products, the availability of retail space has not kept pace and the situation is only getting worse. One would assume then that such a shortage of capacity would negatively impact retailers since it limits the number of products they can sell. A question therefore arises as to whether retailers should attempt to build up sufficient capacity to keep up with demand? Surprisingly, many retailers, such as 7-Eleven and Walmart, are not doing so.

Faced with this seemingly counter-intuitive behaviour, Yinliang Tan, Yan Xiong, Haibing Gao, Xi Li, and Huazhong Zhao decided to investigate how retailers’ capacity affects their profitability and that of their upstream suppliers. To better understand the strategic role of retailers’ capacity in channel management, the authors constructed a stylised model with multiple suppliers selling through a common retailer, where products from said suppliers are unrelated and consumer demands are therefore independent. As opposed to the existing literature, the study assumes that the retailer has the capacity limit for the total quantity of products that it buys and sells. Furthermore, the authors endogenize the retailer’s capacity decision to examine the long-term equilibrium of its capacity.

Their research reveals a number of intriguing findings. First, considering a case in which the suppliers and the retailer are contracted through wholesale prices, the authors show that “when capacity is limited, capacity constraint could create competition among upstream suppliers” because the retailer makes the capacity allocation decision and the suppliers that offer better deals end up securing more capacity. Thus, when capacity is scarce, suppliers compete for the retailer’s capacity, driving down wholesale prices.

Second, after endogenizing the retailer’s capacity decision by allowing the retailer to choose any capacity at zero cost, the study shows that when then number of suppliers is large, it is optimal for the retailer to limit its capacity to create fierce competition among its upstream suppliers, even in the absence of capacity cost. These findings are also true when the suppliers and retailer are contracted through two-part tariffs.

Third, when capacity is scarce, the authors find that the retailer prefers (makes more profit) under two-part tariffs compared to wholesale prices, and vice versa for the suppliers because two-part tariffs enhance the retailer’s capacity allocation power. However, the authors point out that when the suppliers have the power to dictate the type of contract, i.e., two-part tariffs or wholesale prices, they always go with the former, resulting in a form of “prisoner’s dilemma” – when two parties, separate and not able to communicate, must each choose between cooperating with the other or not.

Ultimately, the results show that, “even in the absence of capacity cost, the retailer may prefer to limit its capacity to induce competition among its upstream suppliers, thereby driving down wholesale prices and procurement costs”. The authors therefore propose that “capacity shortage can be the result of a retailer’s strategic choice, rather than its inability to set up a larger capacity”. They go on to explain that the findings highlight the vital role of the retailer’s capacity in supply-chain management and provide useful guidelines for companies in regards to capacity and pricing decision making.