Decision Making Under Service Level Contracts – An Experimental Analysis

The ordering behavior of human decision makers under stochastic demand has been analyzed for various supply contracts. A consistent finding is that people place orders that both deviate from expected profit-maximizing quantities and exhibit high variability. We consider service level contracts, commonly used in practice but receiving little attention in the behavioral operations literature. Service level contracts have an interesting property that other supply contracts do not offer. They can be parameterized, such that they have steep expected profit functions around the expected profit-maximizing order quantity. We provide analytical models and use a laboratory experiment to analyze ordering behavior under service level contracts and compare the performance with that under wholesale price contracts, which have flat expected profit functions. Our results indicate that properly designed service level contracts can incentivize people to place close-to-optimal order quantities with low variability, resulting in high efficiency. In our experiment, the efficiency that human subjects achieved under a service level contract was 97.2%, compared with an efficiency of 88.1% under a wholesale price contract