The Informational Content of Buyback Contracts
58 Pages Posted: 11 May 2018
Date Written: April 20, 2018
Retailers often carry inventory in anticipation of potential demand. To encourage retailers to stock sufficient inventory, upstream manufacturers frequently offer a buyback contract and commit to repurchase the retailer’s unsold inventory at a pre-specified returns price. We examine the manufacturer’s use of the buyback contract as a signaling instrument when the retailer is less informed than the manufacturer either about the manufacturer’s reliability of honoring the buyback commitment (e.g., as in the case of a small and less-established manufacturer), or about its product’s demand potential (e.g., as in the case of a large and established manufacturer). While much of prior research has focused on the role of the wholesale price in credibly signaling a manufacturer’s demand information, we show how and why the returns clause of a buyback contract plays a more important role in signaling the manufacturer’s reliability or demand potential. In fact, not only is the returns price a more efficient signaling device than the wholesale price, but it also alters the direction of signaling distortion in the wholesale price. The buyback contract’s signaling mechanism hinges on distorting the retailer’s excess (unsold) inventory carried to meet potential demand and consequently, its order quantity. This mechanism results in contrasting design of the contract to signal manufacturer’s reliability or demand potential. Nonetheless, in both cases, the returns price is more efficient in limiting the distortion to the retailer’s order quantity. Our findings shed some light on the informational role of buyback contracts over and above their oft studied transactional role.
Keywords: Buyback contract, Distribution Channel, Game Theory, Inventory, Returns, Signaling
JEL Classification: D82, C72, L14, M31
Suggested Citation: Suggested Citation