Contract preferences and performance for the loss-averse supplier: Buyback vs. revenue sharing

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Abstract

Prior theory claims that buyback and revenue-sharing contracts achieve equivalent channel-coordinating solutions when applied in a dyadic supplier-retailer setting. This suggests that a supplier should be indifferent between the two contracts. However, the sequence and magnitude of costs and revenues (i.e., losses and gains) vary significantly between the contracts, suggesting the supplier's preference of contract type, and associated contract parameter values, may vary with the level of loss aversion. We investigate this phenomenon through two studies. The first is a preliminary study investigating whether human suppliers are indeed indifferent between these two contracts. Using a controlled laboratory experiment, with human subjects taking on the role of the supplier having to choose between contracts, we find that contract preferences change with the ratio of overage and underage costs for the channel (i.e., the newsvendor critical ratio). In particular, a buyback contract is preferred for products with low critical ratio, whereas revenue sharing is preferred for products with high critical ratio. We show these results are consistent with the behavioral tendency of loss aversion and are more significant for subjects who exhibit higher loss aversion tendencies in an out of context task. In the second (main) study, we examine differences in the performance of buyback and revenue-sharing contracts when suppliers have the authority to set contract parameters. We find that the contract frame influences the way parameters are set and the critical ratio again plays an important role. More specifically, revenue-sharing contracts are more profitable for the supplier than buyback contracts in a high critical ratio environment when accounting for the supplier's parameter-specification behavior. Also, there is little difference in performance between the two contracts in a low critical ratio environment. These results can help inform supply managers on what types of contracts to use in different critical ratio settings.

Original languageEnglish (US)
Pages (from-to)1734-1754
Number of pages21
JournalManagement Science
Volume62
Issue number6
DOIs
StatePublished - Jun 2016

Bibliographical note

Funding Information:
The authors thank seminar attendees at Georgia Tech, the University of Michigan, the University of Texas at Austin, the University of Illinois, and Duke University for helpful feedback on an earlier version of the paper. The research also benefited from discussions with Saif Benjaafar and Enno Siemsen. The authors thank Martin Lariviere, the associate editor, and the three referees who helped improve the paper immensely. Part of this research was completed while the third author was visiting the Shanghai Advanced Institute of Finance (SAIF), Shanghai Jiao Tong University, China; special thanks are given to SAIF for its generous hospitality. The second author's research was partially supported by the Center for Transportation Studies at the University of Minnesota. The third author's research was partially supported by the National Natural Science Foundation of China [Project 71331004].

Keywords

  • Behavioral operations
  • Buyback
  • Loss aversion
  • Revenue sharing
  • Supply contracts

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