Is Simplicity the Ultimate Sophistication? The Superiority of Linear Pricing

Abstract

We consider a supply chain with a supplier selling products to a retailer who is boundedly rational. The retailer’s orders are randomly distributed around the optimal order quantity. We develop a behavioral model which incorporates human retailers’ bounded rationality in the supplier’s contractual decisions. In contrast to a supply chain with a fully rational retailer, where a wholesale price contract usually cannot outperform more complicated nonlinear contracts, we find that when the retailer is boundedly rational a wholesale price contract can dominate commonly used nonlinear contracts, such as buyback and revenue sharing contracts, in terms of a supplier’s profit and supply chain profit. We characterize the conditions under which a wholesale price contract outperforms more sophisticated nonlinear contracts for the supplier. In particular, we show that a wholesale price contract is more likely to be implemented by the supplier when the supply chain profit margin is low, the retailer is less rational, the demand variance is large, and the retailer’s reservation value is high. We then conduct a series of laboratory experiments to test whether the behavioral model’s predictions are still salient even when the supplier is not necessarily rational. Our results provide an explanation for the prevalence of wholesale price contracts in business practice where the rationality of a retailer cannot always be guaranteed. We also find that a retailer’s bounded rationality plays a more important role in determining supply chain profit than a supplier’s bounded rationality.