Quantity flexible contract under information asymmetry

Abstract

ABSTRACT In this paper a quantity flexible contract is designed in a two-echelon supply chain with a single manufacturer and a retailer. Specific type of products are considered for which the customers place orders with the retailer prior to the beginning of the selling season. The exact demand is known to the retailer only at the beginning of the selling period once all the orders have been placed. The demand patterns during the period of the placement of orders from the customers are considered to be the private information of the retailer. Under such an environment of information asymmetry a contract between the manufacturer and the retailer is proposed which enables the retailer to order the exact realized demand from the manufacturer. The underlying adverse selection model is developed and analyzed in a principal-agent framework. The quantity flexible contract derived in this paper enables the retailer to place an order equal to the exact market demand for all types of demand patterns which the retailer may encounter; thus, the manufacturer receives his market share to the fullest extent. Under normal circumstances, the retailer may have to forego sales when situations of unusually high demand pattern arise, resulting in an opportunity cost. However, the quantity flexible contract derived in this paper enables the retailer to satisfy even such high demand. The contract design thus enables a win-win situation for the manufacturer as well as the retailer.