Optimal Buy-Back Contracts with Asymmetric Information

When demand is uncertain and it is costly for the retailer to forecast demand information more accurately, the supplier faces a moral hazard problem. The supplier wishes to induce the retailer to forecast more accurate information which will improve the total profit of the supply chain. This paper provides a theoretical analysis of the optimal buy-back contract, in which the supplier chooses the wholesale and buy-back price to maximize his profits given that the retailer’s inventory order level and private information acquisition decision are both chosen to maximize the retailer’s profits. In contrast to the standard buy-back contract model in which the first best of the system can always be implemented, our model suggests that the supplier pays not only the cost of acquiring information, but also the information rent to induce the retailer to invest in acquiring information. Consequently, the first best of the system cannot be always implemented. Our model explains that Vendor Managed Inventory systems are prevalent while the retailer is better informed than the supplier. Nevertheless, the standard buy-back contract theory contradicts with the empirical facts.