Equity-Based Incentives and Supply Chain Buy-Back Contracts

Decision Sciences, Vol. 43, Issue 4, pp. 661-685, August 2012

44 Pages Posted: 11 Jul 2011 Last revised: 18 Jan 2019

See all articles by Tinglong Dai

Tinglong Dai

Johns Hopkins University - Carey Business School

Zhaolin Li

The University of Sydney Business School

Daewon Sun

University of Notre Dame

Date Written: December 11, 2011

Abstract

We analyse the effect of equity-based incentives in a supply chain with a downstream firm and an upstream supplier. By using the operational decision as a signal to influence external investors’ beliefs, the downstream firm’s manager intends to maximize a convex combination of the interim share price and the terminal cash flows. We show that equity-based incentives create a side-effect. Specifically, with a universal buy-back contract, the deadweight loss of signalling induced by equity-based incentives could spread throughout the supply chain and cause chain-wide damages. To mitigate such undesirable consequences, we propose a new mechanism to eliminate the inefficiency. We derive the optimal mechanism that maximizes the downstream firm’s profits subject to the constraint that the supply chain efficiency is not undermined. In contrast to the full-information benchmark, this mechanism gives positive surplus to the supplier.

Keywords: capacity investment, cost of vertical integration, management accounting, signaling

JEL Classification: D21, D82, G3, L22, M41

Suggested Citation

Dai, Tinglong and Li, Zhaolin and Sun, Daewon, Equity-Based Incentives and Supply Chain Buy-Back Contracts (December 11, 2011). Decision Sciences, Vol. 43, Issue 4, pp. 661-685, August 2012. Available at SSRN: https://ssrn.com/abstract=1636085

Tinglong Dai

Johns Hopkins University - Carey Business School ( email )

100 International Drive
Baltimore, MD 21202
United States

HOME PAGE: http://carey.jhu.edu/faculty/tinglong-dai-phd

Zhaolin Li (Contact Author)

The University of Sydney Business School ( email )

Room 490, Merewether Building
Sydney, NSW 2006
Australia

HOME PAGE: http://www.econ.usyd.edu.au/staff/erickl

Daewon Sun

University of Notre Dame ( email )

361 Mendoza College of Business
Notre Dame, IN 46556-5646
United States

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