The Role of Market Evolution in Channel Contracting

Real markets evolve over time. They often exhibit complex behaviors, such as autocorrelation, continuity, and nonstationarity. How do these behaviors affect channel contracting? We study the problem in a bilateral channel where the retailer has private information on evolving market conditions. We characterize the optimal contract under arbitrary market evolution. The central notion is market inertia: it prices retailer’s information advantage, dictates price and quantity response over time, and determines the contract complexity. Using market inertia, we identify a general property—stochastic linearity—that justifies the use of simple contracts for a much larger class of channel conditions. For practitioners, we offer refined guidance: (i) when the market has linear dynamics, simple contracts are sufficient; (ii) when the market is continuous, the quantity distortion should be pervasive; and (iii) when the market is nonstationary, the distortion can vanish, intensify, stay constant, or even go nonmonotonic over time. By highlighting the central role of realistic market behaviors, this paper advances our understanding of channel theory and practice.The online appendix is available at https://doi.org/10.1287/mnsc.2018.3057 . This paper was accepted by J. Miguel Villas-Boas, marketing.