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In Online Movie Rental Systems, customer desire to rent can often be observed before the actual consumption occurs. Desire represents uncensored (or true) demand information. Hence, the impact of inventory decisions (numbers of physical copies of different movies) can be accurately traced to the creation of desire (via Word‐of‐mouth), and then to rental. Word‐of‐Mouth (WOM) has been recognized as one of the most influential sources of information transmission, especially for experience goods. Poor inventory decisions may result in lost rentals in two ways: One is the loss of rentals because of low inventory (direct effect), and the other is the loss of the possible demand (rentals) that could have been created through WOM (indirect effect). We use data from an online DVD‐by‐mail firm to estimate the direct and indirect effects of inventory decisions, considering the circular relationship: Rental generates WOM, WOM creates Desire, and Desire turns into Rental. We find that the magnitude of indirect effects is significant, comparable to and sometimes even exceeding direct effects. The value of the empirical findings to facilitate better inventory allocation decisions is examined.
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