Ratcheting of Profitability Expectations and its Consequence for Supply Chains
26 Pages Posted: 18 Aug 2015 Last revised: 2 Dec 2015
Date Written: August 17, 2015
Supply chains exhibit a curious mixture of collaboration and self-interest, and this mixture gives rise to firms working toward a common goal while simultaneously taking actions to shield themselves from one another’s exploitation. This paper studies one such case, where the incentive of a retailer to invest in boosting demand when facing the strongest demand potential is muted due to the fear that the ensuing spike in profits will ratchet the expectations and pricing of its supplier. In a simple model of multi-period supply chain interactions, we demonstrate that such a desire to stave off ratcheting has the potential to undermine supply chain profitability, but such concerns may be mitigated by self-interest on the part of the supplier when we endogenize the supplier's response to such concerns. In particular, the supplier uses deep discounts of initial input prices to convince the retailer to focus on short-run profits rather than long-run ratcheting concerns. These deep discounts not only encourage mutually beneficial investments, but also alleviate double-marginalization inefficiencies along the supply chain. Therefore, our model not only presents a scenario where ratcheting concerns are endogenous, but also one where it can be socially optimal to permit firms to withhold forward looking information and only disclose realized performance results, a key tenet of public policy for financial accounting regulations.
Keywords: ratcheting, information disclosure, supply chain, and pricing
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