Efficient Contracting in a Make-to-Order Supply Chain with Asymmetric Information and Hidden Action

Abstract

We consider a make-to-order supply chain where a retailer sells a product for a manufacturer. There is a single selling season, during which the retailer receives customer orders and then sends the orders to the manufacturer for fulfillment. The manufacturer privately exerts effort to install production capacity prior to the season. Further, the manufacturer has superior information about the product potential than the retailer. Our focus is on the retailer's optimal design of incentive contracts facing the combination of adverse selection (due to the manufacturer's superior information about the demand) and moral hazard (due to the manufacturer's private effort decision). A contract is efficient if it renders the retailer the first-best profit (i.e., the integrated system's maximum profit). It is often true that the first-best profit can not be achieved even in settings with pure adverse selection. Indeed, we show that contracting based on sales is inefficient and illustrate the causes of inefficiency by studying a menu of revenue sharing contracts. However, we propose two simple mechanisms and show both are efficient: in the first, contracting is based on demand; in the second, contracting is based on the conjunction of sales and the binary information of whether or not demand exceeds the capacity. The insight obtained from these two mechanisms could offer useful guidelines for efficient contract design in more general principal-agent settings with both adverse selection and moral hazard.