Vertical Contracting with Information Asymmetry : Do Secret Offers Hurt A Channel?

We consider the confidentiality of contracts in a vertical structure in which one principal orders different components from two different agents whose production costs are private information. The principal may commit to publicly observed bilateral contracts (the public-offer scenario) or offer secretly observed contracts to each agent (the secret-offer scenario). When the contracts are secretly observed, we follow the vertical contracting literature by restricting agents to hold “passive beliefs” about the other agent's contract terms. We characterize optimal two-part tariff contracts under both scenarios. Compared to the public-offer scenario, under the secret-offer scenario the principal offers a lower total wholesale price and a higher output quantity, resulting in higher profits for the agents. Thus, the principal's profit is reduced due to lack of commitment. Surprisingly, the secret contracts may improve channel profit since the secret contracts may involve either downward or upward distortion and channel coordination can even be achieved under certain conditions. We also show that less high-type agents are excluded from the market when contracts are secret. Our analysis highlights the interplay between the distortion due to the principal's lack of commitment and the distortion caused by private information of the agents, and offers an explanation for why the protection of agents' contract confidentiality is important and common in practice. We also extend our analysis to sequential contracting with an informed principal and show that there does not exist an equilibrium consistent with passive beliefs