Professor Lijian Lu Fall 2021

ISOM2700 Operations Management

Practice Questions Set #7

(Solutions)

1. (Supply Chain Coordination)

Dan’s Independent Book Store is trying to decide on how many copies of a book to purchase at the start of the
upcoming selling season. The publisher produces the book at the cost of $16 per unit and sells it to Dan at $20. The
book retails at $28. Dan will dispose of all of the unsold copies of the book at 50% off the retail price, at the end of
the season. Dan estimates that demand for this book during the season is Normal with a mean of 1000 and a standard
deviation of 250.

a. What is the quantity that Dan should order to maximize his expected profit?

Cu = 28 – 20 = $8
Co = 20 – 28*0.5 = 20 – 14 = $6
Critical Fractile = $8 / ($6 + $8) = 0.5714
From the z-table, z(0.5714) = 0.18
Order quantity = 1000 + 0.18*250 = 1045 books

b. Imagine the integrated supply chain where the publisher and Dan make decisions as if they are in a single
firm. What is the quantity that the integrated firm should order to maximize their expected profit?

Cu = 28 – 16 = $12
Co = 16 – 28*0.5 = $2
Critical Fractile = $12 / ($2 + $12) = 0.8571
From the z-table, z(0.8571) = 1.07
Order quantity = 1000 + 1.07*250 = 1267.5 books

c. The optimal order quantity in part b can be considered as the first-best solution for the supply chain. However,
Dan found the integration with the publisher is not possible due to other financial issues. Alternatively, Dan
is thinking of offering the following scheme to the publisher. At the end of the season, the publisher will buy
back unsold copies at a pre-determined price of $r. How should Dan set the return price $r so that the optimal
order quantity under this scheme is equal to the first-best solution in part b?

Cu = 28 – 20 = $8
Co = $(20 – r)
Target Critical Fractile = 12/ (2 + 12) = 12/ 14
8 / (8 + (20 – r)) = 12 / 14
8 / (28 – r) = 12 / 14
r = 18.67 (Corrected to 2 decimal places)
The return price should be $18.67.
 ISOM2700 Practice Questions Set 7

2. (Supply Chain Coordination)

Smith and Jackson (SJ) sells an outdoor grill to Cusano’s Hardware Store. SJ’s wholesale price for the grill is $185.
Cusano sells the grill for $250 and SJ’s variable cost per grill is $100. Suppose Cusano’s forecast for season sales
can be described with a Normal distribution with mean 10 and standard deviation 5. Grills left over at the end of the
season are sold at $62.5.

a. How many grills should Cusano order to maximize its own profit?

Cu = 250 – 185 = $65

Co = 185 – 62.5 = $122.5
Critical Fractile = $65 / ($65 + $122.5) = 0.3467
From the z-table, z(0.3467) = -0.39
Order quantity = 10 + (-0.39)*5 = 8.05 grills

b. To maximize the supply chain’s total profit (SJ’s profit plus Cusano’s profit), how many grills should be
shipped to Cusano’s hardware?

Cu = 250 – 100 = $150

Co = 100 – 62.5 = $37.5
Critical Fractile = $150 / ($150 + $37.5) =
0.8 From the z-table = z(0.8) = 0.85
Order quantity = 10 + 0.85*5 = 14.25 grills

c. Suppose SJ and Cusano agree on the following revenue sharing contract: the wholesale price is $80 (as
opposed to $185 in the original contract) and the per-unit revenue of $250 is shared with SJ; that is, Cusano
keeps $250(1-y) and SJ keeps $250y of the revenue per grill. To achieve the first-best profit in part b, what
should y be?

Cu = $(250(1-y) – 80)
Co = 80 – 62.5 = $17.5
Target Critical Fractile = 150 / (150 + 37.5) = 0.8
(250(1-y) – 80) / (250(1-y) – 80 +17.5) = 0.8
(250(1-y) – 80) / (250(1-y) – 62.5) = 0.8
(250(1-y) – 80) = 200(1-y) – 50
50(1-y) = 30
(1-y) = 3/5
y = 0.4
To achieve the first-best profit in part b, y should be 0.4.

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 ISOM2700 Practice Questions Set 7

3. (Supply chain coordination)

Dan’s Independent Book Store is trying to decide on how many copies of a book to purchase at the start of the
upcoming selling season. The publisher incurs a production cost of $20 for every copy of the book. The book sells
at retail price $100. Any unsold copies at the end of the season have zero salvage value. It is estimated that demand
for this book during the season is normally distributed with mean 1000 and standard deviation 100.

a. Suppose the publisher offers a wholesale price contract with the wholesale price $40. What is the book
store’s optimal order quantity?

Cu = 100 – w = $60
Co = w = $40
Critical Fractile = $60 / ($60 + $40) = 0.6
From the z-table = z(0.6) = 0.26
Order quantity = 1000 + 100*0.26 = 1026 books

b. The publisher is considering a revenue-sharing contract. For each copy sold to the end customer, the
publisher can get $50 from the book store. How much should the supplier charge the retailer for the wholesale
price so that the total supply chain’s expected profit can be maximized?

Cu = 100 – c = $80
Co = c = $20
Critical Fractile = $80 / ($80 + $20) = 0.8
To achieve centralized optimal solution, we should incentivize the bookstore to order according to
critical fractile= 0.8
Hence, bookstore’s problem is formulated as follows:
Cu = $(50 – w)
Co = $w
Cu/(Cu+Co) = $(50 – w)/ $(50 – w + w) = 0.8
w* = $10

c. Instead of the revenue-sharing contract in part (b), the publisher is now considering a returns policy. Now
the publisher sells the book to Dan at the wholesale price $50. At the end of the season, the publisher will
buy back unsold copies at a pre-determined refund of $r. However, Dan would have to bear the costs of
shipping unsold copies back to the publisher at $4 per copy. What is the value of r under which the retailer’s
optimal order quantity also maximizes the total supply chain’s expected profit?

Bookstore’s problem is formulated as follows:

Cu = 100 – w = $50
Co = w + shipping - r = $(54 – r)
Target Critical Fractile = 0.8
50/ (50 + 54 – r) = 0.8
r* = $41.5

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 ISOM2700 Practice Questions Set 7

4. (Supply chain coordination)

DS Entertainment is a Korean company that hosts concerts in Hong Kong. After an event is organized, DS sells
tickets to Viagogo at a wholesale price $w, which in turn sells tickets to customers at a retail price $p. The demand
for the ticket is not random, but is sensitive to price, given by D(p) = 480-120p.

a. What is the first-best profit, i.e., the maximum total profit (the sum of the profits of DS and Viagogo) that
they can achieve if they were integrated into a single firm?

R(p) = p*(480 – 120p)

Calculate p by setting dR(p)/dp = 0
d(480p – 120p2) = 0
480 – 240p = 0
p=2
The maximum total profit is 2*(480 – 120*2) = 480.

b. Suppose now that the two firms make separate decisions; that is, they choose wholesale and retail prices to
maximize their own profits. How much the demand change and what is the total revenue of the two firms?

Wholesale price
DS Entertainment Viagogo Retail price Customer
w
p
(Upstream firm) (Downstream firm) D(p) = 480-120p

Downstream firm’s profit = Rd(p) = (p-w)*D(p) = (p-w)*(480 – 120p)

Calculate p by setting dRd(p)/dp = 0

d[(p-w)*(480 – 120p)] = 0
d(480p – 120p2 – 480w + 120pw) = 0
480 – 240p +120w = 0
p* = 2 + w/2

Upstream firm’s profit = Ru(w) = w*D(p*) = w*(480 – 120p) = w*[480 – 120(2 + w/2)]

Calculate w by setting dRu(w)/dw = 0

d[w*[480 – 120(2 + w/2)]] = 0

d[w*(240 - 60w)] = 0
d(240w - 60w2) = 0
w* = 2

Hence, p* = 3; w* = 2

Total revenue = Rd(p*) + Ru(w*) = 360

c. Continue to suppose that the two firms make separate decisions. In order to achieve the first-best profit in
(a), propose a contract between DS Entertainment and Viagogo.

A revenue sharing contract could allow a decentralised supply chain to achieve the same profit as in a
centralised supply chain.

Based on (a), the first-best profit could be achieved with p* = 2, therefore, w* could arbitrarily be any value
within the range 0 ≤ w* ≤ 2.
In addition, we could infer from (b) that both DS Entertainment and Viagogo are strictly worse off than when
revenue sharing takes place, vice versa.

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 ISOM2700 Practice Questions Set 7

Suppose w* = 0:
Downstream firm’s profit = Rd(p) = 480*(1 – y) ≥ 120, y ≤ 0.75
Upstream firm’s profit = Ru(w) = 480y ≥ 240, y ≥ 0.5

Hence, any revenue sharing contract that proposes y within the range of 0.5 ≤ y ≤ 0.75 would allow the
supply chain to achieve the first-best profit in (a), when w* = 0.

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