Contract Unobservability and Downstream Competition

Abstract

In this paper, we consider a supply chain with a manufacturer and two retailers who are contracted through wholesale prices or two-part tariffs. We depart from the existing literature by assuming that contract terms between the manufacturer and a retailer are not observed by the rival retailer. While the existing literature typically assumes that they are common knowledge in the market, contract terms may not be observed by rival retailers under certain circumstances. This paper contributes to the literature by studying the effect of contract unobservability on supply chain performance. We use game theoretical methods to find the equilibrium. When there are multiple equilibria, we adopt passive beliefs as an equilibrium refinement criterion. We find that certain established results regarding observable supply chain contracts do not always apply when those contracts become unobservable to competing retailers. In particular, compared to when using two-part tariff contracts, the manufacturer may benefit from using wholesale price contracts when contract terms are unobservable. Moreover, the total industry profit may increase under wholesale price contracts. Our results offer an alternative explanation for the popularity of the wholesale price contracts and suggest that members of the supply chain must take unobservability into account when selecting the right contracts. We also offer new insights into buyback contracts and downstream mergers under unobservable contracts.