Harish Krishnan

Coordinating Contracts for Decentralized Supply Chains with Retailer Promotional Effort

In this paper, a risk-neutral manufacturer sells a single product to a risk-neutral retailer. The retailer chooses inventories ex ante and promotional effort ex post. If the wholesale price exceeds marginal production cost, the retailer orders fewer than the joint profit-maximizing inventories. If the manufacturer attempts to coordinate inventories by buying back unsold units, then the retailers promotional incentives are dulled. Under very general assumptions on the form of the effort function, we show that buy-backs adversely affect supply chain profits, and higher buy-back prices imply lower profits. Also, while a buy-back alone cannot coordinate the channel, coupling buy-backs with promotional cost-sharing agreements (if effort cost is observable), offering unilateral markdown allowances ex post (if demand is observable but not verifiable), or placing additional constraints on the buy-back (if demand is observable and verifiable) does result in coordination. This problem is not limited to returns policies but is shown to hold for a much larger set of contracts. The results are quite robust (e.g., when the retailer chooses effort before observing demand), but coordinating contracts become more problematic if, for example, the retailer also stocks substitutes for the manufacturers product. Other model extensions are also discussed.

Incentives for Transshipment in a Supply Chain with Decentralized Retailers

We examine transshipment incentives in a decentralized supply chain where a monopolist distributes a product through independent retailers. A key insight is that the transshipment price determines whether the firms benefit from, or are hurt by, transshipment. In particular, we show that the manufacturer prefers to set the transshipment price as high as possible, whereas retailers prefer a lower transshipment price. Given the important role of the transshipment price in determining the benefits that each firm gets from transshipment, it is useful to consider transshipment in the case where retailers are under joint ownership (a “chain store”) and the transshipment price does not play a role. This comparison yields two surprising results. First, if decentralized retailers control the transshipment price, they will choose a relatively low transshipment price as a way to mitigate the manufacturers ability to extract profits by increasing wholesale prices; therefore, the manufacturer may prefer dealing with the chain store, which does not have a transshipment price, rather than with decentralized retailers. Similarly, the decentralized retailers can use a low transshipment price to achieve higher total profits than a chain store.

Inventory Dynamics and Supply Chain Coordination

This paper extends the theory of supply chain incentive contracts from the static newsvendor framework of the existing literature to the simplest dynamic setting. A manufacturer distributes a product through retailers who compete on both price and fill rates. We show that inventory durability is the key factor in determining the underlying nature of incentive distortions and their contractual resolutions. When the product is highly perishable, retailers are biased toward excessive price competition and inadequate inventories. Vertical price floors or inventory buybacks (subsidies for unsold inventory) can coordinate incentives in both pricing and inventory decisions. When the product is less perishable, the distortion is reversed and vertical price ceilings or inventory penalties can coordinate incentives.

On the role of revenue-sharing contracts in supply chains

The supply chain coordinating role of revenue-sharing has, to date, been examined only in static models. With downstream competition, the central conclusion in these models is negative: revenue-sharing cannot, except in degenerate form, achieve coordination. Incorporating dynamics, by allowing inventory carryover in discrete time, this paper establishes a foundation for revenue-sharing contracts in aligning incentives.

The Economic Foundations of Supply Chain Contracting

Why do supply chain contracts take the forms that they do? Which contracts should firms adopt to coordinate incentives along a supply chain? This monograph synthesizes the theory of contracts along supply chains. It integrates developments from two largely separate literatures, the management science literature on supply chain coordination and the economic literature on vertical control.

The Strategic Role of Business Insurance

The use of business insurance has been traditionally studied in a single-firm setting, but in reality preventing operational accidents involves the (unobservable) efforts of multiple firms. We show that, in a multifirm setting, insurance can be used strategically as a commitment mechanism to prevent excessive free riding by other firms. In the presence of wealth imbalances, contracts alone leave wealth-constrained firms with inefficiently low incentives to exert effort (because of limited liability) and firms with sufficient wealth with excessive incentives. Insurance allows the latter to credibly commit to lower effort, thereby mitigating the incentives of the wealth-constrained firms to free ride. This finding shows that insurance can improve the efficiency of risk management efforts by decreasing free-riding problems. This paper was accepted by Yossi Aviv, operations management.

The Impact of Working Capital Financing Costs on the Efficiency of Trade Credit

One of the arguments given to explain the widespread use of costly trade credit in supply chains is that trade credit enhances efficiency by resolving moral hazard problems. In this paper, we consider the impact of demand shocks on this efficiency role of trade credit. We show that as the probability of a negative demand shock increases, the amount of trade credit necessary to resolve moral hazard also increases. In other words, as economic conditions weaken (i.e. as the probability of low demand increases), more trade credit is required to coordinate the supply chain. The working capital financing costs associated with trade credit can impose a burden that makes it infeasible to coordinate the supply chain. We show that an appropriately designed reverse factoring program can provide suppliers with access to inexpensive credit necessary to finance the working capital associated with trade credit and restore supply chain efficiency.

Policy Incentives for Dangerous (But Necessary) Operations

In industries where firms perform dangerous (but necessary) operations, liability costs - due to potential harm to third parties - can be significant. Firms may therefore find it optimal to exit the market, and this may lead to an inefficiently low number of incumbents. A social planner can discourage exit by offering appropriately designed subsidies. Ex ante subsidies defray the costs associated with making operations safer (e.g. funds to subsidize the purchase of safety equipment). Ex post subsidies mitigate the financial damages caused by an accident (e.g. funds to defray the cost of cleaning up a toxic spill). We consider a model where (i) firms have private information about their ability to improve reliability and (ii) reliability investments are unobservable. Our results challenge the view that, in the presence of moral hazard, ex post subsidies are always inferior to ex ante subsidies. We demonstrate that when the social value of reliability outweighs the benefit of increased competition, it is optimal to offer ex ante subsidies alone (i.e. to subsidize the cost of making operations safer). Conversely, when the benefits of competition outweigh the benefits of reliability, a combination of ex ante and ex post subsidies is optimal (i.e. not only to subsidize safer operations, but also to share the costs of a potential accident).