Contract efficiency: demand uncertainty, price sensitivity and information asymmetry

Abstract

Consider a supplier who is concerned with choosing a contract offered to the retailer. In addition to a wholesale price, the supplier looks for additional contract levers to improve performance. The three commonly used levers are inventory buyback, fixed payment and revenue sharing. This paper shows that the effectiveness of each of these contracts depends critically on the presence of three characteristics that define the complexity of the operating environment: demand uncertainty, demand price-sensitivity and information asymmetry. When the complexity is only about demand uncertainty, it is known that any of the three contracts can be utilised effectively by the supplier to extract all the first-best channel profit. When price-sensitivity of demand is added to the complexity, both revenue sharing and fixed payment remain perfectly effective. Inventory buyback, however, becomes a useless contract lever. We show that when the system is further complicated with information asymmetry, revenue sharing continues to be (almost) perfectly effective and inventory return stays to be useless. On the other hand, fixed payment proves to be useful, allowing the supplier to improve performance, but not to the degree of achieving first-best channel profit.