Laurence and Ralph: The Basic Economics of Capacity and Inventory

Laurence & Ralph (L&R) is not a case, per se, but a note on the classical Newsboy Problem. This type of problem is exemplary in capacity or inventory economics. It occurs every time a product needs to be ordered or service capacity needs to be set when demand in the forthcoming sales or service period is uncertain. Fundamentally, the inventory decision is equivalent with a capacity decision, as inventory represents a capacity to sell product in the future, while capacity is a form of inventory for future service.

Although the topic is classical, the authors' approach is less so. They do not present the classic newsboy formula utilizing underage and overage costs (Cu and Co, respectively). Instead, they present a mathematically equivalent formula based on a real-option logic, where the cost of the option (C) is the amount that cannot be recovered if the unit is left unsold, (cost ( salvage). This is the capital "at risk" when the option is purchased "that is, when inventory is added. The value from exercising the option (V) is the revenue gained from the sale (revenue) less the exercise price of the option" that is, the salvage value forgone by selling the unit (salvage).