Is Simplicity the Ultimate Sophistication? The Superiority of Linear Pricing

Cui, Tony Haitao, Kong, Guangwen and Pourghannad, Behrooz, Is Simplicity the Ultimate Sophistication? The Superiority of Linear Pricing, Forthcoming, Production and Operations Management.

34 Pages Posted: 8 Dec 2017 Last revised: 7 Apr 2020

See all articles by Tony Haitao Cui

Tony Haitao Cui

University of Minnesota - Twin Cities

Guangwen Kong

Temple University-Fox School of Business

Behrooz Pourghannad

University of Minnesota, Minneapolis, MN 55455; Mayo Clinic, Rochester, MN 55905

Date Written: September 1, 2017

Abstract

We consider a supply chain with a supplier selling products to a retailer who is boundedly rational. The retailer's orders are randomly distributed around the optimal order quantity. We develop a behavioral model which incorporates human retailers' bounded rationality in the supplier's contractual decisions. In contrast to a supply chain with a fully rational retailer, where a wholesale price contract usually cannot outperform more complicated nonlinear contracts, we find that when the retailer is boundedly rational a wholesale price contract can dominate commonly used nonlinear contracts, such as buyback and revenue sharing contracts, in terms of a supplier's profit and supply chain profit. We characterize the conditions under which a wholesale price contract outperforms more sophisticated nonlinear contracts for the supplier. In particular, we show that a wholesale price contract is more likely to be implemented by the supplier when the supply chain profit margin is low, the retailer is less rational, the demand variance is large, and the retailer's reservation value is high. We then conduct a series of laboratory experiments to test whether the behavioral model's predictions are still salient even when the supplier is not necessarily rational. Our results provide an explanation for the prevalence of wholesale price contracts in business practice where the rationality of a retailer cannot always be guaranteed. We also find that a retailer's bounded rationality plays a more important role in determining supply chain profit than a supplier's bounded rationality.

Keywords: bounded rationality, non-linear contract, newsvendor, buy-back, revenue sharing

Suggested Citation

Cui, Tony Haitao and Kong, Guangwen and Pourghannad, Behrooz, Is Simplicity the Ultimate Sophistication? The Superiority of Linear Pricing (September 1, 2017). Cui, Tony Haitao, Kong, Guangwen and Pourghannad, Behrooz, Is Simplicity the Ultimate Sophistication? The Superiority of Linear Pricing, Forthcoming, Production and Operations Management. , Available at SSRN: https://ssrn.com/abstract=3081877 or http://dx.doi.org/10.2139/ssrn.3081877

Tony Haitao Cui

University of Minnesota - Twin Cities ( email )

321 19th Ave S
Suite 3-150
Minneapolis, MN 55455
United States

Guangwen Kong (Contact Author)

Temple University-Fox School of Business ( email )

531 Alter Hall
1801 Liacouras Walk
Philadephia, PA 19122
United States
19122 (Fax)

HOME PAGE: http://https://www.fox.temple.edu/about-fox/directory/guangwen-kong/

Behrooz Pourghannad

University of Minnesota, Minneapolis, MN 55455 ( email )

110 Wulling Hall, 86 Pleasant St, S.E.
308 Harvard Street SE
Minneapolis, MN 55455
United States

Mayo Clinic, Rochester, MN 55905 ( email )

200 First Street SW
Rochester, MN (507) 284-2511 55905
United States

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