Contract Unobservability and Downstream Competition

1 Oct 2020

Operations Research and Operations Management

Xi Li, Qian Liu

Published in Manufacturing and Service Operations Management, October 2020

The successful delivery of products requires close cooperation between manufacturers and retailers. The prevailing contract between manufacturers and retailer is the wholesale price contract: the manufacturer sets a unit wholesale price for the product at which it sells to retailers. For example, your retailer may purchase a can of Coke at $0.6 from Coca-Cola and sells to you at $1. The difference between the retail and wholesale prices, $0.4 here, is called the retailer’s margin.

Economists and marketers have long viewed the wholesale price contract as ineffective and inefficient. Wholesale price contracts lead to the problem of double marginalization: both the manufacturers and retailers add margins to the prices, leading to higher retail prices and lower consumer demand. As a result, manufacturers, retailers and consumers are all worse off with wholesale price contracts. Because of this, researchers suggest that manufacturers design more complex contracts such as two-part tariff contracts or quantity-discount contracts.

Yet manufacturers are unwilling to change. It is puzzling why manufacturers give away profits and stick to the seemingly inefficient wholesale prices. To solve this puzzle, Xi Li, Assistant Professor of Marketing at City University of Hong Kong, and Qian Liu, Associate Professor of Industrial Engineering at Hong Kong University of Science and Technology, collaborated on a study to understand the role of wholesale price contract.

“We think that an important factor has been largely ignored in previous studies: the unobservability of contracts,” says Xi Li.

That is, supply chain contracts are typically business secrets that are only known to firms signing the contracts. The authors find that in industries where supply chain contracts are secretly signed, wholesale price contracts help manufacturers better manage their retailers and, in most cases, maximize the manufacturer’s profit. This finding is in sharp contrast to the previous findings obtained under the assumption that contracts are publicly observed.

“Firms are cleverer than economists thought them to be. They know what to choose, and they know how to optimize their profits.”

However, the use of wholesale price contracts may not be such good news for consumers.

“Wholesale price contracts reduce market competition and hurt consumers,” Xi Li added. “As a result, public policies may be needed to induce manufacturers to adopt other contracts to restore market competition and protect consumer welfare”.