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Producer Profit Maximization and Consumer Price Minimization Through Contracting

Wei Wei
Management Science & Engineering
Stanford University
November 2002


A supply chain is a collection of firms from original manufacturer to final retailer who are involved with providing a specific good or service. When there is one person who possesses all information in a supply chain and makes all decision, the supply chain is called centralized. However, this ideal situation is rare. Usually members in a supply chain are independent entities and try to maximize their own profits. Such a supply chain is called decentralized. Profit in a decentralized supply chain is less than that in a centralized supply chain for two reasons: conflict of interests and lack of information sharing. In this research, I try to improve the supply chain efficiency by introducing a new contract that aligns the incentives of, and enforces the information sharing between members in the supply chain.

A supply chain is a collection of firms from original manufacturer to final retailer who are involved with providing a specific good or service. A supply chain is called centralized if there is a central planner who has all the information and tries to maximize the joint profit of all companies involved in the supply chain. In contrast, a supply chain is called decentralized when various decisions are made in different companies that try to maximize their own profits.

The total profit in a decentralized supply chain is typically less than that for the equivalent centralized supply chain for two reasons: conflict of interests and lack of information sharing. In my dissertation, I aim to improve the efficiency of a decentralized supply chain while keeping the decentralized decision making structure through a new kind of contract: advance purchase contract. An advance purchase contract specifies two prices: a discount price at which a customer can place an advance order based on preliminary demand information; and a regular price at which a customer can place an additional order based on updated, and hence more accurate, demand information. I use this contract to analyze two models each of which addresses one particular causes for the efficiency in a decentralized supply chain.

To see how an advance purchase contract mitigates the conflict of interests, I consider a simple supply chain consisting of a manufacturer and a retailer, such as HP and Fry's. The manufacturer sells a product to the retailer; the retailer in turn sells to consumers. The retailer has to place an order before a random demand is realized. In this setting, the conflict of interest is represented by the wholesale price at which the retailer purchases the product from the manufacturer because higher wholesale price benefits the manufacturer but hurts the retailer. Since the retailer does not know the exact demand when she places the order, higher wholesale price leads lower order quantity from the retailer's fear of excess inventory. This in turn affects the availability of the product to consumers. I proved that the advance purchase contract mitigates the conflict of interest and creates a win-win situation for the supply chain. Both the manufacturer's and the retailer's profit increase, and hence the product availability improves.

To see how an advance purchase contract enforces information sharing, I consider a slight different model in which the retailer has better demand information and the manufacturer has to build production capacity before receiving the retailer's order. Without any contracts, credible information sharing is impossible because the retailer has an incentive to overstate the demand in order to persuade the manufacturer to build more capacity. Therefore the manufacturer will not trust what the retailer says. This imposes a problem because the capacity will be either too low or too high, resulting in massive lost sales or excess capacity. In this case, the advance purchase contract requires the retailer to commit a certain quantity before the manufacture builds the capacity, that is, to put your money where your mouth is. It turns out that under this contract, the advance commitment quantity will truthfully reveal the retailer's private information. And as the result, the manufacturer can adjust his capacity to the actual demand forecast.

In the future, I plan to address two of the most important assumptions. First, I assumed that the retail price is fixed. This is a reasonable assumption if the end market is competitive and on single retailer has the power to influence the price. It would be interesting, however, to see how the contract works if the retailer has some control over the price and hence the demand. Secondly, I assumed that the interaction between the manufacturer and the retailer only happens once. Again, this assumption is reasonable in certain industries such as fashions goods. It would also be interesting, however, to see what happens when both the manufacturer and the retailer has to consider their reputation for future interactions.