An important component of any accurate response program is the creation of more reactive capacity that can effectively respond to uncertain demand. While the operational benefits of reactive capacity in matching supply with uncertain demand are well understood, little is known about its benefits in a competitive environment. We seek to fill this gap by investigating the role of reactive capacity in inventory competition with demand substitution. We show that the effect of reactive capacity on competition strongly depends on customer behavior. If the customers who accept substitutable products are not willing to wait for reactive capacity, more reactive capacity has a negative competitive effect on a firm but a positive competitive effect on its competitor. As a result, the inventory of the firm is lower and its profit may become higher or lower. The inventory and the profit of the competitor are always higher. When the customers who accept substitutable products are willing to wait for reactive capacity, more reactive capacity has a positive competitive effect on a firm but a negative competitive effect on its competitor. In this case, the total supply (inventory and reactive capacity) and the profit of the firm are higher while its inventory may become higher or lower. The inventory and the profit of the competitor as well as the total inventory of the two firms are always lower. One interesting insight from our analysis is that under certain conditions, more reactive capacity of a firm always benefits its competitor but may hurt the firm.
(The talk is based on a paper coauthored with Albert Ha)