Asymmetric Cost Information and Enforcement in Supply Contract Design

27 Pages Posted: 1 Feb 2010 Last revised: 6 Apr 2015

See all articles by Ehsan Bolandifar

Ehsan Bolandifar

Washington University in St. Louis - John M. Olin Business School

Tianjun Feng

Fudan University - School of Management

Fuqiang Zhang

Washington University in St. Louis - John M. Olin Business School

Date Written: January 31, 2015

Abstract

This paper studies a supply contracting problem where a buyer sources a product from a supplier to satisfy uncertain market demand. With the increasing length and complexity of today's global supply chains, the buyer may face two issues when designing the supply contract: adverse selection (i.e., the supplier's cost structure is private information) and lack of enforcement (i.e., the supplier's capacity investment is not enforceable). We derive the buyer's optimal contracting strategies and analyze their properties. We find that although the buyer's optimal mechanism is generally complex, it may reduce to a two-part tariff under certain conditions (i.e., a single, linear contract could be optimal for the buyer). Even when the two-part tariff is suboptimal, it performs nearly as well as the optimal mechanism for a wide range of situations. These findings indicate that the value of achieving enforceability and the value of using complex menu are negligible in such a supply chain setting. Therefore, our research demonstrates that the two-part tariff is an attractive option for buyers whose goal is to ensure supply while facing both cost uncertainty and enforcement issues. It also provides a new explanation for the prevalence of such simple contracts in practice.

Keywords: Supply chains, procurement, capacity risks, information asymmetry, enforcement, contracts, mechanism design

Suggested Citation

Bolandifar, Ehsan and Feng, Tianjun and Zhang, Fuqiang, Asymmetric Cost Information and Enforcement in Supply Contract Design (January 31, 2015). Available at SSRN: https://ssrn.com/abstract=1541558 or http://dx.doi.org/10.2139/ssrn.1541558

Ehsan Bolandifar

Washington University in St. Louis - John M. Olin Business School ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States

Tianjun Feng

Fudan University - School of Management ( email )

No. 670, Guoshun Road
No.670 Guoshun Road
Shanghai, 200433
China

Fuqiang Zhang (Contact Author)

Washington University in St. Louis - John M. Olin Business School ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States

HOME PAGE: http://www.olin.wustl.edu/faculty/zhang/

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