Aligning Capacity Decisions in Supply Chains When Demand Forecasts Are Private Information: Theory and Experiment

We study the problem of a two-firm supply chain in which firms simultaneously choose a capacity before demand is realized. We focus on the role that private information about demand has on firms’ ability to align their capacity decisions. When forecasts are private information, there are at most two equilibria: a complete coordination failure or a monotone equilibrium in which firms earn positive profits. The former equilibrium always exists, while the latter exists only when the marginal cost of capacity is sufficiently low. We also show that both truthful information sharing and pre-play communication have an equilibrium with higher profits. We then test the model’s predictions experimentally. Contrary to our theoretical predictions, we show that private demand forecasts do not have a consistently negative effect on firm profits, though capacities are more misaligned. We show that pre-play communication may be more effective at increasing profits than truthful information sharing. Finally, we document that “honesty is the best policy” when it comes to communicating private information.