Mechanism design for capacity planning under dynamic evolutions of asymmetric demand forecasts

Abstract

This paper investigates the role of time in forecast information sharing and decision making under uncertainty. To do so, we provide a general framework to model the evolutions of forecasts generated by multiple decision makers who forecast demand for the same product. We also model the evolutions of forecasts when decision makers have asymmetric demand information and refer to it as the Martingale Model of Asymmetric Forecast Evolutions. This model helps us study mechanism design problems in a dynamic environment. In particular, we consider a supplier's (principal's) problem of eliciting credible forecast information from a manufacturer (agent) when both firms obtain asymmetric demand information for the end product over multiple periods. The supplier uses demand information to better plan for a capacity investment decision. When the supplier postpones building capacity and screening the manufacturer's private information, the supplier and the manufacturer can obtain more information and update their forecasts. This delay, however, may increase (respectively, decrease) the degree of information asymmetry between the two firms, resulting in a higher (respectively, lower) cost of screening. The capacity building cost may also increase because of a tighter deadline for building capacity. Considering all such trade-offs, the supplier has to determine (i) when to stop obtaining new demand information and build capacity, (ii) whether to offer a screening contract to credibly elicit private forecast information or to determine the capacity level without information sharing, (iii) how much capacity to build, and (iv) how to design the overall mechanism so that both firms benefit from this mechanism. This paper provides an answer to these questions. In doing so, we develop a new solution approach for a class of dynamic mechanism design problems. In addition, this paper provides a framework to quantify the option value of time for a strategic investment decision under the dynamic evolutions of asymmetric forecasts. © 2013 INFORMS.