Contract Preferences and Performance for the Loss-Averse Supplier: Buyback vs. Revenue Sharing

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.Data, as supplemental material, are available at http://dx.doi.org/10.1287/mnsc.2015.2182 . This paper was accepted by Martin Lariviere, operations management .