Managing a Distribution Channel Under Asymmetric Information with Performance Requirements

In this paper we study how performance requirements may improve the working of a distribution channel when the retailer is better informed about demand conditions than the manufacturer. The idea behind performance requirements is that the manufacturer and retailer agree to (1) have the manufacturer set requirements on retail price or service or both; and (2) jointly invest in the information systems required to monitor retailer compliance with requirements. The question is, will this lead to a more productive channel relationship? We show that the answer is yes if performance requirements are set on both price and service and the cost of the information systems required to monitor compliance with requirements is small. But if requirements cannot be set on both performance dimensions, the choice among the remaining options is not straightforward. Even abstracting from information system costs, price requirements may be worse than no requirements, and service requirements may be no better than no requirements. The central problem with setting requirements on only one dimension is that the retailer then behaves suboptimally on the other. Between the two partial options, service requirements are better than price requirements in aligning the interests of the manufacturer and the retailer, whereas price requirements are better at inducing the retailer to reveal his demand