The Informational Role of Buyback Contracts

Abstract

Manufacturers often offer retailers buyback contracts to reduce retailers' inventory costs by repurchasing unsold inventory at a pre-specified returns price. We examine the signaling role of buyback contracts when the retailer is less informed about either the manufacturer's reliability of honoring the buyback commitment (e.g., for a small/less-established manufacturer) or its product's market potential (e.g., for a national brand manufacturer). We find that these two situations yield contrasting buyback designs: the manufacturer must distort the wholesale and returns prices downward to signal higher reliability but upward to signal higher market potential. Nevertheless, the signaling mechanism in both cases hinges on suitably distorting the manufacturer's returns cost (i.e., the cost of repurchasing retailer's unsold inventory) by influencing the retailer's regular stock (i.e., the portion of inventory carried to meet average demand) and safety stock (i.e., the extra inventory carried to meet potential high demand). Notably, while prior research has highlighted the signaling role of the wholesale price, we show how and why, in a channel with inventory, the returns price plays a relatively more important role. In particular, efficient signaling entails that the returns price is used to distort the manufacturer's returns cost, whereas the wholesale price is used only to mitigate the resulting distortion in the retailer's order quantity. In fact, the returns price emerges as a more efficient signaling instrument and reverses the direction of wholesale price distortion from what is necessary if wholesale price alone is used to signal. We also examine the implications when the two dimensions of manufacturer's private information are correlated.

Keywords: Buyback Contract, Distribution Channel, Game Theory, Inventory, Returns, Signaling

JEL Classification: D82, C72, L14, M31