The Inefficiency in Finding the Balance Between Supply and Demand: Middleman and Inventory. Are They Necessary Evil?

I recently have a chat with a friend about the possibility to use the subscription model in the retail business. If consumers can predict what they are going to buy in the future, can they pay a deposit in advance in exchange for a lower price? Maybe the sellers are willing to give them a lower price because they have more certainty in future demand and can therefore improve their operational efficiency.

I think there are two pain points for the retail business. I am not an expert in this area. I just think through this using common sense. First, a significant portion of the margin is cut by the middleman, for example, wholesalers and distributors. A study done by the Reserve Bank of Australia said that around 50% of the selling price goes to the distributor’s gross margins. Second, retail business needs to keep inventory and inventory itself is inefficient because they are an idle resource.

Why did the inefficiencies happen in the first place? Why can’t we skip the middleman and maintain zero inventory?

The root cause, in my opinion, is the low predictability of demand and inelastic supply. Consumers’s demand is hard to predict for several reasons. Most of our spending today is not on necessities and therefore, it can be quite impulsive. I probably know how much rice I need in the next month, but it is hard to know whether I will buy a camera, or a Nike shoe next month. Consumers also have too many choices available. Even I know I will buy a shoe next month, I can choose from Nike, Addidas, or Puma. The demand of goods is affected by competitions and alternatives. Demand is also affected by external environment, like weather and economy. On the supply side, it is inelastic. The manufacturers need to prepare machinery, labour, raw materials and logistics long before the goods reach the consumers. It is hard to scale up and down together with changing consumers’ demand.

Part of the middleman value is to share the risk of inaccurate predictions. If they are too optimistic, supply is greater than the demand and they need to sell the goods in very low price or even dump them in landfills, like milk. Vice versa, they may not be able to maximize their revenue because they do not have enough goods to sell. Ever part of the supply chain involves the same kind of risk of inaccurate predictions. Having middleman shares the risk to more parties.

Inventory is like a water tower. The output of water is relatively stable while the consumer need is fluatating. Therefore, we need a buffer to smooth out the fluctuations. Manufracturing of good is relatively stable since it is a cycle. The capacity cannot be changed overnight in both directions. By having inventories/ space of final goods or raw materials, companies can meet fluatating demand or stabilizes prices of raw materials.

Havng middleman and inventory are costly. Are they necessary evil?

I tried to think about one particular navie solution, and I think it won’t work. If the consumers committed to buy a certain quantity of goods on a specific date at a specific price, will the commitment be valuable to sellers? Can consumer exchange the commitment with a lower price? And sellers received the certainty of demand? I found it like Future in derivative market. A future is an obligation to buy/sell at a specific price on a specific date. But the problem is whether future price is lower than spot price on the time of buying the future is uncertain and whether the delivery price is lower than the spot price on the time of delivery is also uncertain. Translating to the solution on retail business, there is no guarantee that the committed price will be lower than the current price, and there is no guarantee that the committed price will be lower than the price you get from the market on the date of delivery. For example, an apple sells for 1 dollar today. The price can be higher if you committed to buy an apple 1 month latter because the farmer may expect the price of apple to go up or he actually needs to store the apple for you. Even the committed price is lower, say 0.8, apple may sell for 0.7 one month latter because orange is much cheaper next month. With those properties, it looks hard.

I think I can also study Costco and Walmart and see how they solve the retail business pain point.