Supply Chain Contract Design : Impact of Bounded Rationality and Individual Heterogeneity

Recent behavioral studies have demonstrated that decision makers may not always optimize their performance, and several modeling approaches have been proposed to explain this boundedly rational behavior. In this paper we model two forms of bounded rationality in a newsvendor setting: the tendency to err and the tendency to anchor. Our model is motivated by observations under several types of commonly used supply chain contracts in the laboratory. Our experiments show that the behavior of newsvendors follows some multi-modal distribution that responds to contract structures and incentives. Moreover, we discover heterogeneity in decision makers’ tendencies to err and anchor. Applying our model to contract optimization, we find that the coordinating contracts do not always behave as the normative theory predicts. Furthermore, our analysis shows that contract performance can be sensitive to behavioral differences. Thus, this study establishes the importance of incorporating individual heterogeneity into incentive mechanism design. Our research approach also suggests how historical data can be used to calibrate contracts for empirical retailers