Optimal Contract Design for a National Brand Manufacturer Under Store Brand Private Information

Abstract

Problem definition: We study an optimal contract design problem for a national brand (NB) manufacturer, which sells her product via a retailer. The retailer may introduce his store brand (SB) with private cost information. The manufacturer estimates that the retailer’s SB cost may be high or low with certain probabilities and offers a menu of two-part tariff contracts to screen the retailer’s cost information. Methodology/results: Following the mechanism design theory, we formulate the problem as a two-stage screening game to analyze the strategic interaction between the two players under asymmetric information. Despite the complexity resulting from type-dependent reservation profit of the retailer, we derive the NB manufacturer’s optimal contracts analytically. We prove that there exists a unique threshold such that when the NB cost is below the threshold, the manufacturer offers both types of retailers incentive-compatible contracts; when the NB cost is above the threshold, the manufacturer offers a menu of contracts to shut down the low-type retailer and engage the high-type retailer only. Managerial implications: We find that when the NB product becomes more competitive (i.e., a higher quality or a lower cost), both the NB manufacturer and the retailer are better off. This result implies that under asymmetric information, the retailer has incentive to enhance the NB product quality or reduce its cost. Additionally, the private information is valuable to both members only when a contract without shutdown is offered. Moreover, such information is more valuable to both players when the NB product becomes more competitive. However, when SB quality improves or when SB cost decreases, the value of information may increase or decrease to both supply chain members. Finally, we derive a surprising result that under asymmetric information, the expected consumer surplus may increase because of a lower SB quality or a higher low-type SB cost. Funding: G. Xiao acknowledges financial support from the Research Grants Council of Hong Kong [General Research Fund Grant PolyU 15505621]. Supplemental Material: The online appendix is available at https://doi.org/10.1287/msom.2021.0187 .