sharing demand information in a value chain: implications for pricing and profitability

Review of Quantitative Finance and Accounting, 24: 23–45, 2005c© 2005 Springer Science + Business Media, Inc. Manufactured in The Netherlands.

Sharing Demand Information in a Value Chain:Implications for Pricing and Profitability

SURESH RADHAKRISHNANSchool of Management, SM 41, University of Texas at Dallas, Richardson, TX 75083, USA, Tel.: 972.883 4438E-mail: [email protected]

BIN SRINIDHICity University of Hong Kong, 83 Tat Chee Avenue, Kowloon Tong, Hong Kong; 312A School of Business, Universityat Albany, State University of New York, Washington Avenue, Albany, NY 12222

Abstract. While it is known that information exchange (IE) in a value chain improves resource coordination,scant attention has been paid to two issues. The first issue is the effect of relative bargaining strengths of theparties on whether and how IE will be implemented. The second issue is whether a resource-based costing systemis adequate to motivate the implementation of information exchange. In this paper, we model a value chainconsisting of a manufacturer and a retailer, where the retailer gets (private) demand information that has thepotential of improving the manufacturer’s resource decisions. In this model, it is always beneficial for the valuechain to implement IE. We show that in a monopsony or in a bilateral monopoly when the retailer has sufficientbargaining power, IE can be implemented if and only if the wholesale price compensates him for the loss of theinformation rent that he would get without IE. Using this model as the benchmark, we also examine other settingswhere the retailers have less bargaining power due to competition or size. In such settings, even though the retailersare better informed, the manufacturer can implement the IE regime costlessly and appropriate the informationrent partially or fully. In effect, the manufacturer benefits both by improved resource coordination and by reducedpayment for information rent. In all these settings, we find the retailer will not be motivated to adopt IE solely bya resource-based costing and pricing system.

Key words: supply chain, information sharing, game theory, mechanism design

JEL Classification: L1, M1, M2, M4

1. Introduction

Recent developments in information technology have enabled closer coordination of activ-ities among value chain players.1 In particular, information exchange technology such asElectronic Data Interchange (EDI) permits close coordination of inventory between seg-ments of the value chain.2 Information sharing constitutes a significant aspect of successfulvalue chain management (Baiman and Rajan, 2002). In tandem with the recognition ofinformation exchange benefits in value chains, the emphasis on obtaining resource-based(activity based) cost estimates for various decisions, particularly for pricing, has increased(for instance, see Cooper and Kaplan, 1988; Cooper and Slagmulder, 1998). In a resource-based costing system, resource consumption is tracked and product costs are computed aslinear aggregates of the costs of consumed resources. The increased use of resource-based

24 RADHAKRISHNAN AND SRINIDHI

costing by firms that are also seeking to adopt information exchange systems leads to thequestion of whether resource-based costing can adequately help set wholesale prices so asto motivate transition to information exchange.

In this paper, we examine two issues: first, how the players’ bargaining powers affectthe adoption of information exchange and second, whether the wholesale prices based on aresource-based costing system can motivate the implementation of information exchange.We consider a bilateral monopoly with a manufacturer and a retailer where the retailergets private demand information that has the potential of improving the manufacturer’sresource decision. We compare two regimes: the blocked communication regime wherethe retailer does not share his private demand information with the manufacturer and theinformation exchange regime where the retailer provides his private demand informationto the manufacturer. The retailer participates in the value chain only if he expects to get apayoff that is either greater than or equal to his reservation payoff.

Consistent with earlier studies, the value chain profits are higher in the informationexchange regime than in the blocked communication regime due to better resource coor-dination. We find that the incremental benefit from information exchange decreases whenresources are costly but increases when demand profiles are more variable. In the blockedcommunication regime, the retailer gets not only his reservation payoff but also informationrent in the medium demand profile. In a bilateral monopoly, where the retailer has sufficientbargaining power, the retailer can be induced to adopt the information exchange regime onlyif he is compensated for lost information rent. For this purpose, the retailer’s informationrent for the medium demand profile in the blocked communication regime is spread overall the demand profiles in the information exchange regime. In the low and high demandprofiles, the manufacturer pays no information rent in the blocked communication regimebut pays more in information exchange regime to induce the participation of the retailer.Consequently, the expected profit for the manufacturer could be lower for high and lowdemand profiles in the information exchange regime than in the blocked communicationregime.3 In the medium demand profile, the manufacturer saves on the information rent andthereby increases his expected profits.

We further examine whether a resource-based costing system is adequate for imple-menting the information exchange regime. A resource-based costing system tracks theconsumption of resources and computes the product cost as a linear aggregate of the costsof consumed resources. We show that when moving from the blocked communicationregime to the information exchange regime, there exist settings where the manufacturerwill consume less resources but increase wholesale prices, and vice versa. Specifically, ouranalysis shows that (a) for the high demand profile the information rent effect is negativeand resource consumption increases; hence, the optimal wholesale prices could be lower ininformation exchange regime even though more resources are consumed; (b) for the mediumdemand profile the information rent effect is positive (i.e., information rent is extracted);hence, the optimal wholesale-price is higher even when the resource consumption remainsthe same; and (c) for the low demand profile the information rent effect is negative and theresource consumption decreases; hence, the wholesale-price moves in the same directionas resource consumption. Therefore, the optimal wholesale prices do not move in conso-nance with resource consumption in two out of these three demand profiles. This suggests

SHARING DEMAND INFORMATION IN A VALUE CHAIN 25

resource-based pricing may not be adequate to induce a move to information exchangeregime. The implication of this result is that in order to successfully implement informationsharing across the value chain, the value chain participants have to explicitly provide forinformation incentives to all the involved parties in addition to compensating their resourceconsumptions.

Subsequent to our analysis of the bilateral monopoly setting, we examine settings withretail competition. In particular, we consider one manufacturer and two identical but inde-pendent (non-collusive) retailers. In such a setting, we find that the information exchangeregime will be implemented by both retailers who give up their information rent partiallyor fully. Thus the manufacturer benefits from information exchange not only because ofimproved resource coordination but also because of reduced information rent. In thesecases, even though the resource consumption remains unchanged across the regimes forthe medium demand profile, the information rent is extracted by a higher wholesale price.Consequently, wholesale prices do not move in consonance with resource consumption,making resource-based pricing inadequate in inducing a move to information exchangeregime.

The main insights from the paper can be summarized as follows. First, the value ofinformation exchange is derived from improved resource coordination. Information that isrelevant for upstream resource decisions might be available privately to another participantdownstream or vice versa. In the absence of information exchange, this information iswasted which results is lower profits for the value chain. The second insight is that byextracting information rent, privately informed parties can get bigger shares of the valuechain profits than in traditional arms-length settings. Information exchange enables playerswith sufficient bargaining power to get a greater proportion of profits from the value chain.The third insight is that resource consumption alone is not sufficient for pricing withina value chain. Wholesale prices schemes that implement information exchange need toconsider both resource consumption and information rent effects.

Baiman and Sivaramakrishnan (1993) and Penno (1984) examine the value of pre-decision information using a principal-agent model. Both these papers compare two regimes—one where pre-decision information can be used and one where no such information isavailable. In general, they find that allowing for pre-decision information leads to higherprofits because of improved decisions and incentives. Baiman and Sivaramakrishnan (1993)also show the existence of settings in which welfare decreases when more information be-comes available. Our results are consistent in that the information exchange regime leadsto improved resource coordination and hence improved decisions. However, this study dif-fers from the above-mentioned studies in three aspects. First, we examine the move fromthe blocked communication regime to the information exchange regime when the retailershave different bargaining strengths. Second, we consider a setting that requires coordi-nation between unobserved actions by both the manufacturer and the retailer. Third, wefocus on studying the implications for pricing and profitability that arise from the shift inregimes.

Baiman and Rajan (1995) and Aghion and Tirole (1997) examine task assignment de-cisions under double moral hazard. Baiman and Rajan (2002) deal with incomplete con-tracts with moral hazard and information asymmetry with a focus on the efficiency of


investment by the supplier in a non-cooperative relationship. Baiman, Fischer and Rajan(2001) examine the incentive effects of contracting on quality costs of internal and exter-nal failure. In contrast, we focus on the adequacy of resource-based pricing for inducinginformation exchange.

Other studies have examined value-chain relationships. Desai and Srinivasan (1996)study the signaling problem when the retailer is subject to moral hazard, and the manu-facturer has private information. They examine the effects of the two-part pricing schemeand also find that a non-linear pricing scheme (a quadratic scheme) is first best optimal.Narayanan and Raman (1996) study the impact of inventory levels in a value chain. Theyconsider only hidden-action effects and offer branding and EDI as alternative mechanismsto mitigate the information asymmetry effects. In contrast to these studies we focus onthe retailer’s private information on demand and let the manufacturer use wholesale pricesto mitigate the problem of adverse selection and moral hazard. By examining how in-formation exchange alters the sharing of value chain profits and setting the wholesaleprices, we provide insights about the costs/benefits of moving to the information exchangeregime.

The rest of the paper is organized as follows: Section 2 develops the model. Section 3contains the analysis and results for a bilateral monopoly setting. Section 4 presents adiscussion of retail competition and settings when the retailer’s bargaining power is low.Section 5 discusses the impact of relaxing some of the assumptions and provides concludingremarks.

2. The model

We consider a value chain with a manufacturer and a retailer. The manufacturer commits toa jointly observable promotion effort that helps the retailer market the product to the finalconsumers. The retailer exerts an unobservable service effort that improves service qualityand marketability of the product. The promotion and service efforts enable the retailer toobtain higher expected revenues. The manufacturer also takes an unobservable cost controlaction. The retailer has private information on demand distribution, i.e., the retailer knowsthe particular demand distribution, but the manufacturer does not. The retailer pays themanufacturer a wholesale price based on the realized demand.

In the blocked communication (BC) regime, the retailer does not communicate his pri-vate demand information to the manufacturer. Consequently, the manufacturer chooses hispromotional effort without the knowledge of the particular demand profile resulting in inef-ficient resource consumption. In the information exchange (IE) regime, communication ofprivate demand information eliminates the inefficiency in resource consumption. We callthis the resource coordination effect. However, to induce the retailer to choose the IE regime,the manufacturer has to compensate the retailer for lost information rent. In cases where theretailer has significant bargaining power, the manufacturer needs to fully compensate theinformation rent but in cases where the retailer has less bargaining power, the manufacturermight be able to partially or fully appropriate the information rent. The model is formallydescribed below.


2.1. Demand and information asymmetry

The unconditional distribution of demand x ∈ (0, ∞) is given by f (x) with mean µ andvariance ξ 2. The retailer has finer demand information in that he knows the particular condi-tional distribution f (x | X ) where X is the mean and σ 2 is the variance.4 The manufacturer’sprior probability of X is φ(X ) and consistent belief requires that

∫x x f (x | X )φ(X ) = µ.

2.2. Retail price, costs, retailer service effort and manufacturer’s promotionaland manufacturing efforts

The retail price per unit is set by the retailer based on X and is given by g(X, K , S) =a + 2K + 2S − bX where K is the committed and jointly observable promotional effortof the manufacturer, S is the service effort of the retailer, and {a, b} are the parameters ofthe inverse demand function. While the demand quantity is exogenous, the retail price isendogenous in that the retailer can influence the retail price is by choosing his the serviceeffort.5 The retail price is fixed ex-ante as g(X, K, S) based on expectations so as to clearthe product market demand. The retailer’s expected revenue is

G(X, K , S) = E{g(X, K , S)∗x} = g(X, K , S)E(x) = [a + 2K + 2S − bX ]X.

The expected revenue increases linearly in both the retailer’s service effort and the manu-facturer’s promotional effort. We assume that [a−2bX ] > 0, which ensures that the expectedrevenue increases at a decreasing rate with expected demand.6

The manufacturer incurs a cost, F(K ) = [K 2/2 f ] for the promotional effort, and theretailer incurs a cost, H (S) = [S2/2h] for service effort where f and h are parametersof the cost functions. The manufacturer exerts a manufacturing effort M that representsproduct-level costs V (M) = [M2/v], which are independent of volume. For example, Mcould be the set of production programs and technology that determine the volume-relatedmanufacturing costs. The manufacturing effort reduces the expected volume-driven costgiven by C(X, M) = (c − 2M)X that increases with expected demand.

2.3. Wholesale prices and profits

Only the realized product demand and the manufacturer’s promotional effort are con-tractible. The retailer’s realized revenue and cost and the manufacturer’s realized manu-facturing cost are not jointly observable and are therefore not contractible.7 We considerlinear wholesale prices, i.e., the expected wholesale price is α + δE(x), where α denotes aconstant and δ is the unit price per realized demand.8

The expected profits for the manufacturer (U ), the retailer (T ) and the joint-profits (π )are given by

U (.|X ) = α + δX − F(K ) − C(X, M) − V (M),

T (.|X ) = G(X, K , S) − H (S) − α − δX,

π (.|X ) = U (.|X ) + T (.|X ).


2.4. Model simplifications

Without qualitatively affecting the results of the paper, we assume that the retailer’s privateinformation consists of X ∈ {X1, X2, X3} with X3 (high demand profile) > X2 (mediumdemand profile)> X1 (low demand profile). The retailer observes the specific demand profilewhose expected demand is X ∈ {X1, X2, X3} and variance is σ 2. We assume µ = X2 andlet (X3 − X2) = (X2 − X1) = η. We also assume a non-shifting support for the demanddistribution, i.e., Prob(x |Xi ) �= 0 for all i, x . This assumption ensures that the retailer’sprivate information cannot be perfectly inferred ex-post by the manufacturer, for any givenrealization of demand (x).

3. Bilateral monopoly with significant retailer bargaining power

In this section, we analyze a bilateral monopoly setting in which the retailer has significantbargaining power.

Information regimes and sequence of events

The event sequence unfolds as follows.

1. The manufacturer and the retailer agree to participate in the value chain and choose theinformation regime to be either BC or IE.

2. The retailer observes private information on demand Xi for i = 1, 2, 3.3. If the IE regime is chosen the retailer communicates Xm ∈ {X1, X2, X3}. If the BC

regime is chosen the retailer does not communicate his private information on demand.4. The manufacturer commits to promotional effort (K ) and a wholesale-price schedule

(α, δ). In the IE regime, {K , α, δ} can be made contingent on the private demand infor-mation communicated by the retailer Xm . The promotional effort is like an advertisingcommitment which is also part of the contract.

5. The manufacturer and the retailer choose their manufacturing and service efforts (M, S),respectively.

6. The retail price is set by the retailer as g(X, K, S).7. Demand, x is realized. The retailer gets the product from the manufacturer and pays the

manufacturer the wholesale price and sells the product to the final consumer to get hisretail revenue.

The retailer’s expected reservation profit for each demand profile is W . We also assumethat the expected profits to the manufacturer and the retailer in BC are sufficient for themto form the relationship and that after accepting the contract neither the retailer nor themanufacturer can renege on the contract. Before we proceed with the derivations we definethe first best (full-information) solution.

Definition (First-best solution). A first-best solution for the value-chain obtains if opti-mum {K , S, M} maximizes the total expected profit of the value-chain without any con-straints. Technically, given the concavity assumptions, first-best {K , S, M} satisfies the


following first-order conditions:

∂π (S, M, K )

∂S= ∂π (S, M, K )

∂ M= ∂π (S, M, K )

∂K= 0. (1)

We proceed by deriving the optimum wholesale prices and resources under each regime.

3.1. Preliminary results: Wholesale prices under BC and IE

In this section we derive the optimum wholesale price schedule, promotional effort, man-ufacturing effort and service effort for both the BC and IE regimes. Program BC gives theproblem for the manufacturer in the blocked communication regime.Program BC

maxα,δ,K ,SI ,M

E[U (.|X )] =∑

i

[α + δXi − F(K ) − C(Xi , M) − V (M)]φi (BC-OBJ)

s.t. T (.|S, M, α, δ, K , X ) = G(Xi , K , Si ) − H (Si ) − α − δXi ≥ W

for each i ∈ 1, 2, 3, (BC-PCR)∂T (Si , M | α, δ, K , X )

∂S= GS(Xi , Si , K ) − H ′(Si ) = 0 for each i, (BC-ICR)

∂ E[U (Si , M | α, δ, K , X )]

∂ M= −

∑i

CM (Xi , M)φi − V ′(M) = 0. (BC-ICM)

Equations (BC-PCR) show the retailer’s participation constraints. Since the retailer’sprivate information on demand is obtained before contracting with the manufacturer, toensure participation the wholesale-price should be such that the participation constraint issatisfied for every demand profile. Equations (BC-ICR) and (BC-ICM) are the incentivecompatibility constraints. The wholesale price and the promotional and manufacturingefforts are chosen by the manufacturer without the retailer’s private demand information.

The optimum solution to Program BC is characterized in following observation.9

Observation 1. The solution to Program BChas the following properties.

1.1 The retailer’s expected profit equals the reservation profit for the low and high demandprofiles and is strictly higher than the reservation profit for the medium demand profile,i.e.,

T (.|X1) = T (.|X3) = W and T (.|X2) > W.

1.2 Inducing the retailer’s service effort is not costly to the manufacturer.1.3 The incentive compatibility constraint with respect to manufacturing effort is costlessly

satisfied.1.4 The first-best promotional and manufacturing effort {K , M} does not obtain.


1.5 The optimum wholesale price and resources (efforts) are given below.

1.5.1 α(BC) = (b − h)(µ2 − η2) − W,

1.5.2 δ(BC) = [a − 2(b − h − f )µ], K (BC) = f µ,

1.5.3 S(·|Xi , BC) = h Xi for i = 1, 2, 3,

1.5.4 M(BC) = vµ.

1.6 The retailer’s expected information rent collected by the retailer is given by E(Ti | BC)−W = (b − h)(η2 − σ 2).

Observation 1.1 shows that with the linear wholesale price, the manufacturer can ex-tract the information rent completely in the two extreme demand profiles. This is a directconsequence of the concavity of the retailer’s expected profit prior to the payment of thewholesale price, i.e., Gi − Hi . This is illustrated in Figure 1. This differs from the result inthe typical adverse selection principal-agent model where such rent is extracted only in thelow demand profile. The distinguishing difference in this setting is that the realized demandprovides the manufacturer with an unconditional and unbiased estimate of demand. Thisdemand structure, in conjunction with the concavity of the retailer’s expected profits allowsinformation rents to be extracted in the extreme demand profiles.

Observations 1.2 and 1.3 show that the retailer’s and the manufacturer’s hidden-actions donot create additional friction. This is primarily due to the lack of direct interaction (comple-mentarity or substitutability) between the actions. Also, Observation 1.4 shows that becausethe promotional effort (K ) and the manufacturing effort (M) cannot be made contingent onthe private information of the retailer, first-best resource decision cannot be made by themanufacturer. In effect, the lack of demand information affects the manufacturer’s profitsin two ways: (a) the payment of information rent, and (b) sub-optimal promotional and

Figure 1. Illustration of information rent at the medium demand profile.


manufacturing effort decisions. Hidden-actions per se do not create inducement problems,because costs are completely internalized by the parties.10 Observation 1.5 provides theoptimal wholesale prices and resources in the BC regime. Observation 1.6 provides the re-tailer’s expected information rent in the BC regime, which is the retailer’s expected profitsminus the minimum reservation profit.

We now proceed to derive the optimum solution for the IE regime. In the IE regimethe revelation principle (see Myerson, 1979) applies and thus, the search for the optimalsolution is restricted to truthful strategies. The problem for the manufacturer is provided inProgram IE, where U (i j) and T (i j) denote that the retailer has observed Xi and reportedX j , i.e., U (i i) indicates that the retailer has reported truthfully.

We assume that the retailer has a high bargaining power. In fact, the retailer can refuseto move from the BC regime to the IE regime. Therefore, the only way the retailer can beinduced to choose the IE regime is to offer him an expected profit in the IE regime that is atleast as good as the expected profit he gets in the BC regime. Thus, the minimum reservationprofit in the IE regime is W (I E) = E(Ti | BC) = W + (b − h)(η2 − σ 2).

Program IE

maxα(i),δ(i),K (i),S(i i),M(i)

U (i i) (IE-OBJ)

s.t. T (i i) ≥ W (IE) for each i, (IE-PCR)∂T (i j)

∂S= 0 for each i, j, (IE-ICR)

U ( j j)

∂ M= 0 for each j, (IE-ICM)

T (i i) − T (i j) ≥ 0 for each i, j. (IE-TTR)

Equations (IE-PCR) are the retailer’s participation constraints for each Xi that is truth-fully reported. Equations (IE-ICR) and (IE-ICM) are the incentive compatibility constraintswith respect to the retailer’s service and manufacturer’s manufacturing efforts, respectively.Equations (IE-TTR) are the truth-telling constraints.

The following observation characterizes the solution to Program IE.

Observation 2. In Program IE, a two-part wholesale price exists such that the first-bestsolution for each demand profile obtains. Specifically, the two-part pricing scheme

2.1 induces the retailer’s service effort costlessly,2.2 induces the manufacturer’s manufacturing effort costlessly,2.3 induces truthful reporting of the retailer’s private information costlessly,2.4 ensures that the retailer’s expected profit equals W (I E) for each i , j .2.5 The optimum wholesale prices and resources (efforts) are:

2.5.1 α(Xi | IE) = (b − h)X2i − W (IE), where W (IE) = W + (b − h)(η2 − σ 2),

2.5.2 δ(Xi | IE) = [a − 2(b − h − f )Xi ],


2.5.3 K (Xi | IE) = f Xi ,

2.5.4 S(Xi | IE) = h Xi , and

2.5.5 M(Xi | IE) = vXi .

Observation 2 shows that the first-best solution for each demand profile is achieved bythe two-part wholesale price comprising a part that varies linearly with realized demandand a part that is constant. The realized demand provides a noisy signal to the manufacturerabout the retailer’s private information. The manufacturer can use the noisy signal to extractthe information rent. The intuition for the result is similar to that of Demski and Sappington(1984), where in a risk-neutral setting with multiple agents and correlated environment, thefirst-best solution obtains.11

We now proceed to analyze the effects of moving from BC to IE.

3.2. Analysis of moving from BC to IE

In this section we examine (a) the value of moving from the BC regime to the IE regime,and the factors influencing the difference in expected profits for the manufacturer across theregimes; and (b) the factors affecting the manufacturer’s resource decisions and wholesaleprices so as to assess the validity of resource-based pricing.

3.2.1. Value to the manufacturer. The retailer gets an information rent in BC that is com-pletely extracted in IE. However, the retailer will not agree to move from BC to IE unlessthe manufacturer can guarantee at least the payoff that the retailer expects in BC. This ismodeled by making reservation expected profit for the retailer in IE equal to the expectedprofit for the retailer in BC, i.e., E[T |BC] = W (I E). First, we examine whether the man-ufacturer benefits incrementally by moving to IE even if he pays the foregone informationrent to the retailer. We characterize this incremental benefit as the value of informationexchange. Second, we examine how the resource costs and demand variability might affectthe value of information exchange. The following proposition addresses these questions.

Proposition 1.

1.1 The manufacturer’s value from information exchange, VIE, i.e., the improvement inthe manufacturer’s expected profits from the BC regime to the IE regime, is given byVI E = E[U | IE] − E[U | BC] = ( f + v)σ 2, while the retailer is indifferent betweenthe regimes, i.e., E[T | BC] = (b − h)(η2 − σ 2) + W = W (IE) = E[T | IE].

1.2 The value of information exchange

a. decreases with increases in the cost of resources, i.e., dVI Ed f > 0, dVI E

dv> 0, and

b. increases with demand variability, i.e. dVI Ed[σ 2] > 0, where Variance (X ) = σ 2.

Proposition 1.1 shows that in this setting the value of information exchange is alwayspositive, i.e., the value-chain always benefits from moving to the IE regime. The valuefrom information exchange arises due to a better resource coordination decision by the


manufacturer.12 Proposition 1.2 (a) shows that the value from information exchange de-creases as the cost of either promotional or manufacturing effort increases. The reasoningis that when a resource cost increases, the marginal change in resource consumption dueto changes in expected demand is small. Consequently, there is less value to knowing theinformation on demand. Proposition 1.2 (b) shows that the value of information exchangeincreases with the variability across the demand profiles. The reasoning is that in a BCsetting with low variability, the resource decisions will not deviate from the full informa-tion optimum. Hence, the value of moving to the IE regime is smaller. Similarly, whenthe distance between demand profiles (η) increases, the “mistakes” in resource decisionsmade in the BC regime become costlier, thereby increasing the value of moving to the IEregime.

We now examine the change in manufacturer’s expected profit across the regimes, con-ditional on the demand profile in the following proposition.

Proposition 2.2.1 The incremental expected net value for the manufacturer conditional on the expected

demand, DU(Xi ) is given by the sum of the resource coordination value and the rentextraction value, i.e.,

DU(Xi ) = ( f + v)(µ − Xi )2 − (b − h)[(µ − Xi )

2 − σ 2] for i = 1, 2, 3

where DU(Xi ) = E[U | Xi , I E] − E[U | Xi , BC].

2.2 The incremental expected net value for the manufacturer in the medium demand profileX2, is derived solely from decreased information rent; and increases with both the slopeof the demand function and the variability of demand i.e., dDU(X2)

db > 0; dDU(X2)d(σ 2) > 0.

2.3 The incremental expected net values for the manufacturer in the low and high demandprofiles are the result of value from better resource coordination less the additionalpayment to the retailer for lost information rent. It decreases with the cost of promotionaland manufacturing efforts and decreases with the slope of the price function, i.e.,dDU(Xi )

d f > 0, dDU(Xi )dv

> 0, dDU(Xi )db < 0 f or i = 1, 3.

2.4 The incremental expected net value for the manufacturer in the low and high de-mand profiles can either increase or decrease with the variability of the demandprofiles.

In the expression for DU(Xi ) in 2.1, the first term is the incremental value from re-source coordination and the second term is the value from information rent extraction.For the medium demand profile X2, there is no resource coordination value because themanufacturer’s unconditional expectation coincides with X2 and his actions reflect thisexpectation already. Therefore the manufacturer’s incremental expected net value for themedium demand profile comes solely from the extraction of information rent. For the lowand high demand profiles the benefit arises from the better resource coordination given bythe first term of DU(Xi ), while the second term is the additional cost required to maintainthe retailer’s expected profit to be the same as that in BC. The incremental expected netvalue could be either positive or negative. For example, if the cost of manufacturing andpromotional effort are sufficiently high (small f and v) then the incremental expected net


value from information exchange for the low and high demand profile is negative (becauseb > h). This is because the value from the information exchange is below the cost ofinformation rent that has to be paid. Propositions 2.2 and 2.3 examine the factors that affectthe incremental net value under the medium and extreme demand profiles, respectively.

At the medium demand profile X2,the manufacturer derives benefit only by reducing theinformation rent. Therefore, the same factors that affect the information rent of the retailerin BC determine the incremental expected net value for the manufacturer. The informationrent is caused by this concavity of the revenue function which is determined by the slopeof the demand function, b (see Figure 1). Therefore, the information rent for the retailerincreases with increases in slope of the price function. Intuitively, the retailer’s informationrents should increase with increases in variability of demand. When (X2 − X1) = (X3 − X2)is higher, the variance in demand is higher, and thus the retailer commands more informationrent. These results are provided in Proposition 2.2.

Proposition 2.3 shows that the manufacturer’s incremental expected net value for the lowand high demand profiles increase with decreases in the cost of resources. This is consistentwith the result in Proposition 1 that the value of improved resource coordination decreaseswith cost of resources. Also, an increase in the slope of the price function increases lostinformation rent for the retailer and consequently, increases the amount to be compensatedto the retailer. This increased payment to the retailer decreases the incremental net benefit.

Proposition 2.4 shows that the manufacturer’s incremental expected net value on theextreme demand profiles could either increase or decrease with the variability of demandprofiles. This is because the variability of demand increases both the information rent forthe retailer and the value from better resource coordination. In effect, both the costs andbenefits increase with variability of demand for the high and low demand profiles.

3.2.2. Coordination of resources and wholesale prices. First, we examine the differ-ences in resource deployment across the regimes which are summarized in the followingproposition.

Proposition 3. Moving from BC to IE, at the low (high) demand profile the product leveland promotion costs decrease (increase) and the volume driven costs increase (decrease).These costs do not change for the medium demand profile X2, i.e.,

V (M | BC, X1) > V (M | I E, X1), F(K | BC, X1) > F(K | I E, X1), C(.| BC, X1)

< C(.| I E, X1);

V (M |BC, X3) < V (M |I E, X3), F(K |BC, X3) < F(K |I E, X3), C(.|BC, X3)

> C(.|I E, X3); and

V (M | BC, X2) = V (M | I E, X2), F(K |BC, X2) = F(K | I E, X2), C(.| BC, X2)

= C(.| I E, X2).

Proposition 3 shows that the costs of committed resources such as promotional effort andproduct level costs decrease with the expected demand. Surprisingly, the volume driven costsincrease for the low demand profile. This result can be explained using the structure of theproduct level and volume driven costs. The main decision variable is the product level effort,


M . Increasing M increases the product level (fixed) costs and reduces the volume driven(variable) costs, and vice versa. If the expected demand is low, the product level effort Mis also low, which increases the volume driven costs. The opposite is true for high expecteddemand. For example, consider the tradeoff between product design effort (resulting in aproduct level cost), and the manufacturing effort (resulting in a volume driven cost). Inthe low demand profile a smaller product design effort is sufficient because the marginalcost of rework due to possible design variations is sufficiently low. Therefore, deploying asmaller product level resource is optimal, which results in a higher volume driven cost. Inthe medium demand profile, there is no difference in resource coordination because the ex-ante expected demand in BC equals the expected demand in the medium demand profile.The take-away point from this proposition is that the resource coordination changes notonly in the level but also in the mix of resources. In the BC regime, the manufacturer wouldhave exerted too much product level manufacturing and promotion effort in the low demandprofile and too little in the high demand profiles. In the IE regime, the allocation of effortwill be better aligned with the demand realization.

In the next proposition, we examine the changes in expected wholesale revenues acrossthe regimes, DR(Xi ) = R(.|I E, Xi ) − R(.|BC, Xi ) where R(.|, Xi ) = α() + δ()Xi

and ∈ {BC, I E}.

Proposition 4. Moving from BC to IE, the expected wholesale revenues decrease in thelow demand profile, increase in the medium demand profile, and could either increase ordecrease in the high demand profile, i.e.,

DR(X1) = −(b − h)[(µ − X1)2 − σ 2] − 2 f X1(µ − X1) < 0;

DR(X2) = (b − h)[σ 2] > 0 and

DR(X3) = −(b − h)[(µ − X3)2 − σ 2] − 2 f X3(µ − X3) > or ≤ 0.

Proposition 4 shows that the change in expected wholesale revenues comprises the in-formation rent effect and the promotional resource cost effect. For the low demand profilethe wholesale expected revenues are lower in IE for two reasons. First, the retailer is paida portion of the information rent that he commanded only at X2 in BC; second, there is adecrease in promotional effort. Thus, overall the expected revenues are lower in IE. For themedium demand profile the expected wholesale revenues increase due to the extraction ofthe information rent and also a balancing of the promotional effort cost. Note that resourcedecisions are identical for the medium demand profile. For the high demand profile, the dif-ference in expected wholesale revenues could be positive or negative depending on whetherthe information rent effect dominates the promotional effort effect. For instance if the costof the promotional effort is sufficiently large (i.e. f is sufficiently small) the difference inexpected wholesale revenues could be negative, even though more promotional effort costis incurred for the high demand profile (see Proposition 3). Thus, the difference in expectedrevenues could go in a direction that is opposite to resource consumption. This propositionclearly shows that a resource-based pricing system is inadequate for motivating informationexchange in this circumstance.

The factors influencing the difference in wholesale expected revenues are (a) the varianceof the demand profile, (b) the slope of the price function, (c) the cost of the manufacturer’s


promotional effort, and (d) the cost of the retailer’s service effort. The variance of thedemand profile, the slope of the price function and the cost of service effort influencethe difference in expected wholesale revenues through the information rent effect. Thecost of promotional effort and the variance of demand influence the difference in expectedwholesale revenues through the resource utilization effort. The information rent effect coulddominate the resource utilization effect under one of three conditions: (i) the slope of thedemand function is high, (ii) the variance of the demand profile is high or (iii) the cost ofpromotional effort is high. This could lead to a condition where even though more resourcesare used the wholesale prices need to be set such that the expected revenue decreases whilemoving from BC to IE.

4. Discussion of scenarios with different relative bargaining strengths

In this section, we discuss settings in which the retailer does not have as much bargainingpower as in the bilateral monopoly setting that was examined in the previous sections. Inparticular, we consider a case where there is one manufacturer and two competing identicalbut independent (non-collusive) retailers, each of whom is capable of selling the entiresupply from the manufacturer. Each retailer’s reservation profit is denoted by W . As in theearlier section, each of the two retailers is privately informed of the conditional demanddistribution f (x | Xi ) but the manufacturer is not. However, the manufacturer knows thatthe retailers have the finer demand information. The adoption of the IE regime is feasibleand is an available option.

In the BC regime with retail competition both retailers will share the product sales,and thus will get equal profits, i.e., the expected profit for each retailer is Tk(BC) =W + .5(b − h)(η2 − σ 2) where k indexes the retailers.13 However, unlike the bilateralmonopoly case, retail competition will dissipate the retailer’s bargaining strength whenmoving to the IE regime. Similar to the findings of numerous papers in marketing, itfollows that in the IE regime information rents can be extracted from the retailers (seeLal and Narasimhan, 1996), if the manufacturer offers a contract such that the retailerwho accepts the offer will get the reservation profit, while the other retailer will lose thebusiness. In the Nash equilibrium, the manufacturer offers a wholesale price such that theexpected profit is Tk(I E) = W + .5w(b − h)(η2 − σ 2) with w < 1. In effect, with retailcompetition the manufacturer increases his expected profit by ( f + v)σ 2 + (1 − w)(b −h)(η2 − σ 2) > 0 when moving from the BC regime to the IE regime. The first term inthe above expression is the additional value generated by better resource coordination. Thesecond term in the expression is the information rent of the retailers that the manufacturerappropriates.

In the case of a bilateral monopoly where the retailer has sufficiently high bargainingpower or in the case where there is competition among the manufacturers who seek toplace their product with one retailer, such as Wal-Mart, our previous analysis of the bi-lateral monopoly case holds and all the information rent that the retailer earns in the BCregime will have to be conceded in the IE regime. The only additional value that is de-rived by the manufacturer in such a case is the incremental value from better resourcecoordination.


In the model and the discussion so far, the direct cost of implementing the IE modelhas not been considered. This makes the implementation of IE Pareto-dominant for thevalue chain. Casual observation indicates that EDI does not always get implemented. Inparticular, in the case of many small retailers who may be better informed about a smallpart of the demand, the IE regime requires considerable cost and effort in consolidatingand aggregating the information from a large number of retailers. Moreover, the credibilityof information that is collected from the small retailers might be suspect and the uncer-tainties could be quite high. All these increase the cost of collecting and aggregating theinformation but reduce the expected benefit from it. If the aggregate cost of implementingthe IE regime is higher than the expected total benefit from resource coordination and re-duced information rent, it is no longer in the manufacturer’s interest to offer the IE to theretailers.

These insights suggest that IE regimes are more likely to be implemented when thereare few large retailers rather than when there are many small retailers. When the IE regimeis implemented the value chain partners with more bargaining power will appropriate thebenefits arising from better resource coordination.

5. Concluding remarks

We examined a bilateral monopoly with a manufacturer who is not informed about thespecific demand profile and a retailer who is informed about it. Only the realized demandis jointly observable and contractible. The retailer has sufficient bargaining power such thatthe manufacturer can implement the information exchange regime only by setting wholesaleprices such that the retailer is as well-off as he was in the traditional regime where therewas no information exchange (the blocked communication) regime.

We generated insights into (a) the value of the information exchange regime, (b) thefactors that affect the profits of individual players of the value-chain, (c) the resource co-ordination decisions across the two regimes, and (d) the implications for setting resource-based wholesale prices. We showed that the value of information exchange arises froma better coordination of resources. The retailer gets an information rent in the blockedcommunication regime. In the information exchange regime the manufacturer spreads theinformation rent across all the demand profiles. In other words, the wholesale pricingscheme must be determined not only by the resource consumption but also by the infor-mation rent extraction effects. We showed that in cases where the resource consumptionincreases, the expected wholesale revenue decreases when the information rent extractioneffect dominates the resource coordination effect. In particular, when resource costs arehigh, this reversal phenomenon is more likely to occur. We also showed that for the lowand high demand profiles the manufacturer’s incremental expected value from informa-tion may be negative because the information rent effect dominates the resource utilizationeffect.

This study is a first step towards providing insights into value chain relationships andthe effects of information exchange. We used a simple model and a host of assumptionsto highlight the interaction between the demand parameters, costs, demand variability andresource-based pricing. We now discuss relaxing some of the assumptions.


5.1. Linear contracts

For the model we assumed that wholesale prices are linear in the realized demand. Thisassumption allowed the retailer to command information rents in the blocked communi-cation regime and resulted in the information rent effect when moving from the blockedcommunication regime and resulted in the information exchange regime. The assumptionis important because in the simple setting that we examine a piece-wise linear wholesale-price can eliminate the retailer’s information rent.14 However, the linearity assumption issupported by contracts observed in practice (see for example Moorthy, 1987; Chu andDesai, 1995). Also, the piece-wise linear contract could provide arbitrage opportunities forthe retailer. That is, the retailer could obtain units at a lower price and resell them in othermarkets. These arbitrage opportunities have not been modeled specifically and are beyondthe scope of our model. Hence, we have imposed the linear pricing contracts.

5.2. Rationing

The manufacturer could forgo the profit in the low or high demand profile and mitigatethe information rent in the blocked communication regime. This is similar to rationingthe product that enables the manufacturer to coax information on demand by making itunattractive for the retailer to participate in the low or high demand profile (see Antle andEppen, 1985). In this case, the “loss” for the manufacturer in the blocked communicationregime will be spread over the demand profiles in the information exchange regime, therationing effect. That is, moving to the information exchange regime there will be a rationingeffect instead of the information rent effect. The rationing effect will impact pricing andprofitability in a manner qualitatively similar to the information rent effect.

5.3. Risk neutrality

We assumed that the manufacturer and the retailer were risk neutral. The risk neutralityassumption allows us to obtain the first-best efficient solution in the information exchangeregime. A risk-averse retailer would command information rents in blocked communicationregime, even with non-linear wholesale prices. The information exchange regime wouldstill help the manufacturer to more effectively coordinate resource decisions, and thus,both the information rent extraction effect and the resource coordination effect shouldcontinue to exist. The impact of the differences could be smaller or larger depending onthe risk aversion characteristics and the variability of demand (uncertainty). Therefore, inaddition to the factors that were identified, risk aversion characteristics would also affectprofit parking and wholesale pricing decisions. Also, risk neutrality is reasonable when weconsider that manufacturers and retailers carry a portfolio of products.

5.4. Hidden-action interactions

We had assumed that the hidden-action of the retailer did not directly affect the hidden-actiondecisions of the manufacturer, or vice-versa. This assumption allowed the internalization


of hidden-action costs to the isolated part of the value-chain. An interaction between thehidden-actions would lead to a second-best solution in the information exchange regimeeven with risk-neutrality. In the blocked communication regime, both the manufacturer’sand the retailer’s hidden actions would be second best. When moving from the blockedcommunication regime to the information regime, the two main effects, namely, informationrent extraction and resource coordination, should continue to exist. The trade-offs in movingfrom the blocked communication regime to the information exchange regime will depend onwhether the retailer’s and the manufacturer’s hidden-actions are complements or substitutes.

5.5. Expositional assumption

The functional forms (quadratic-linear forms) were chosen so as to obtain a closed formsolution whereby we could study the information rent effect and the resource coordinationeffect more closely. The basic insights generally apply if the expected revenue is concaveand the costs are convex. The equidistant demand profile assumption is also made withoutloss of generality for expositional purposes.

Overall, allowing for risk aversion, non-linear contracts and hidden-action interactionswill allow the possibility of negative value for information exchange similar to the resultsof Baiman and Sivaramakishnan (1993), Christensen (1981), and Penno (1989). We choseto focus on settings where the value of information exchange was positive, in order to betterrepresent the phenomena of the shift to EDI. Thus, in settings similar to these earlier studies,if the value from communication were positive, the tradeoff examined in this paper wouldcontinue to exist.

Future research could be directed towards understanding the nature of value-chain rela-tionships and endogenizing opportunity costs by considering multiple manufacturers andretailers. The interaction between the manufacturer’s and retailer’s efforts could also beexamined further (see Narayanan and Raman, 1996). The information exchange-enablingtechnologies impact profitability, the efficiency of resource consumption and pricing acrossthe value-chain in complex ways. Understanding these effects is essential for developingcosting systems geared to help strategic decisions.

Appendix: Proof of observation and propositions

Proof of Observation 1: We provide the proofs here for the case where there are 3demand profiles. (This can be easily extended to any case where there are N > 2 profiles.The Lagrangian of Program BC is

L(BC) =∑

i

[α + δXi − F(K ) − C(Xi , M) − V (M)]φi +∑

i

λi [G(Xi , K , Si )

− H (Si ) − α − δXi − W ] +∑

i

µri [GS(Xi , K , Si ) − H ′(Si )]

−∑

i

µm[CM (Xi , M) + V ′(M)]φi , i = 1, 2, 3,


where {λi , µri , µ

m} are the Lagrange multipliers on (BC-IRR), (BC-ICR) and (BC-ICM)respectively. Differentiating L(BC) with respect to {Si , M} and setting it equal to zero, wehave −µr

i [2/h] = 0 and µm[2/v] = 0, where we have used GSS(.) = 0, CMM(.) = 0,H ′′(.) = [2/h], V ′′(.) = [2/v]. Using {h, v} > 0 we have that {µr

i , µm) = 0. This

establishes Observation 1.3.The expected profit for the retailer for any given {α, δ, K , M} is given by

T (.|α, δ, K , M, Xi ) = (a + 2K + 2S)Xi − bX2i − [S2/h] − α − δXi .

The service effort satisfies the following condition

∂T (.|α, δ, K , M, Xi )

∂S= 2Xi − 2S/h = 0.

Thus, the optimal Si = h Xi which is first-best. Observation 1.2 follows. Substituting forthe optimal Si the Lagrangian is written as

L =∑

i

φi

[α + δXi − K 2

f− (c − 2M)Xi − M2

v

]+ λi [{a + 2K − (b − h)Xi }

× Xi − α − δXi − W ].

Differentiating with respect to the choice variables α, δ, K , M and equating to zero, we get

∑i

λi = 1;∑

i

λi Xi = µ; K = f µ; and M = vµ.

Substituting back into L , we have

L = ( f + v)µ2 + (a − c)µ − (b − h)∑

i

λi X2i − W .

L is clearly concave in Xi because of our assumption that b > h . . .

We now examine the participation constraint, α+δXi ≤ (a +2 f µ)Xi − (b−h)X2i − W .

Since∑

i λi = 1, all constraints cannot be non-binding. Moreover, from the condition that∑λi Xi = µ, if it is binding at only one point, that point has to be Xi = µ. We now show

that this is not possible.Let us now assume that the participation is binding at X2 , and it is not binding at X1 or

X3. Then,

α + δX2 = (a + 2 f µ)X2 − (b − h)X22 − W, α + δX1 < (a + 2 f µ)X1

− (b − h)X21 − W and α + δX3 < (a + 2 f µ)X3 − (b − h)X2

3 − W.

These three equations imply

(a + 2 f µ) − (b − h)(X2 + X3) > δ > (a + 2 f µ) − (b − h)(X2 + X1),


because b − h > 0, which is a contradiction. Thus the participation constraint is bindingonly for i =1 and 3.

Using these and solving for α, δ we get

α = (b − h)X1 X3 − W = (b − h)(µ2 − η2) − W ;

δ = (a + 2 f µ) − (b − h)(X1 + X3) = [a − 2(b − h − f )µ]

Substituting in the expressions for E(U ) and Ti , we have

E(U ) = (a − c)µ − (b − h)(µ2 + η2) + ( f + v)µ2 − W,

Ti = (b − h)[η2 − (µ − Xi )2] + W.

The total expected retailer profit E(Ti ) is given by

E(Ti ) = (b − h)[η2 − σ 2] + W.

The first term in the above expression is the information rent that is collected by theretailer. (Observation 1.6)

The joint profit for the value chain is

π (·|Xi ) = (a + 2K + 2S)Xi − bX2i − [S2/h] − [K 2/ f ] − [M2/v] − (c − M)Xi

Differentiating π (.|Xi ) with respect to {K , M, S} equating it to zero and solving we havethat the first-best solution satisfies K (Xi ) = f Xi , K (Xi ) = f Xi , and K (Xi ) = f Xi . Itfollows that the first-best {K , M, S} does not obtain in BC.

Proof of Observation 2: We will show that the first-best efficient can be implementedwith {α, δ} specified in Observation 2 and satisfies the constraints in Program IE.

Notation. We will refer to the first indicator as the true state that the retailer observes,and the second indicator as the state that the retailer communicates. Hence, S(i j) indicatesthe service effort choice, when the retailer observes Xi and reports X j . The manufacturerchooses promotional effort K ( j) and manufacturing effort M( j) and provides a contract{α( j), δ( j)} based on the reported X j . Given the contract and the promotional effort, theretailer chooses S(i j). Therefore, S(i i) indicates that the retailer has reported truthfully.

For any report X j ∈ {X} let {S( j j), M( j), K ( j)} satisfy the first-best solution, i.e.,

∂π (.|X j )

∂S= 0, ⇒ S( j j) = h X j

∂π (.|X j )

∂ M= 0, ⇒ M( j) = vX j

∂π (.|X j )

∂K= 0, ⇒ K ( j) = f X j


When the retailer observes Xi and reports X j the expected profit for the retailer is:

T (i j) = [a + 2K ( j) + 2S(i j)]Xi − bX2i − [{S(i j)}2/h} − α( j) − δ( j)Xi ,

and when the retailer observes Xi and reports Xi the expected profit for the retailer is

T (i i) = [a + 2K (i) + 2S(i i)]Xi − bX2i − [{S(i i)}2/h} − α(i) − δ(i)Xi .

For any report X j ∈ {X} the retailer chooses S(i j) to satisfy the following incentive com-patibility constraint with respect to the retailer’s service effort:

∂T (i j)

∂S= 0 ⇒ S(i j) = h Xi .

Substituting for {K ( j), S(i j), α( j), δ( j)} and rearranging we have

T (i j) = −(b − h)(Xi − X j )2 + W (I E), and

T (i i) = W (IE)

It follows that T (i i) − T (i j) > 0 and thus the truth-telling constraints are non-binding.Because T (i i) = W (IE), the participation constraint is satisfied at equality. It follows thatsince j = i is the best-reporting strategy for the retailer the first-best S obtains.

To see that the first-best {K , M} obtain, use the α(i), δ(i) and S(i i) in the expected profitof the manufacturer to get

U (i i) = (a + 2K )Xi − (b − h)X2i − [(K 2) f ] − (c − 2M)Xi − [(M2)/v].

Differentiating U (i i) with respect to {K , M} and equating it to zero it follows that K (i) =f Xi and M(i) = vXi , which is the first-best solution.

Proof of Proposition 1: Using the solution specified in Observations 1 and 2 we have

U (.|Xi , IE) = (a − c)Xi − (b − h − f − v)X2i − (b − h)(η2 − σ 2) − W

U (.|Xi , BC) = (a − c)Xi + (b − h)[X1 X N − {X1 + X N }Xi ]

+ ( f + v)µ(2Xi − µ) − W,

where we have used W (IE) = (b − h)(η2 − σ 2) + W = E[T |BC]. Now,

E[U | IE] = (a − c)E[X ] + (b − h − f − v)E[X2] − (b − h)(η2 − σ 2) − W,

= (a − c)µ − (b − h − f − v)[µ2 + σ 2] − (b − h)(η2 − σ 2) − W

= µ[(a − c) − (b − h − f − v)µ] + ( f + v)σ 2 − (b − h)η2 − W


where we have used E(X ) = µ and E(X2) = µ2 + σ 2.Also,

E[U | BC] = (a − c)E[X ] + (b − h){X1 X N − (X1 + X N )E[X ]}+ ( f + v)µ(2E[X ] − µ) − W

= µ[(a − c) − (b − h − f − v)µ] − (b − h)η2 − W

where we have used E(X ) = µ and X1 = µ − η and X N = µ + η. The expression inthe Proposition 1.1 follows directly from the above. Proposition 1.2 follows directly bydifferentiating VIE with respect to the appropriate variables.

Proof of Proposition 2: Using the above expressions for E[U (.|Xi , IE)], E[U (.|Xi , BC)]and rearranging, we have the expression in Proposition 2.1. Propositions 2.2, 2.3 and 2.4can be directly verified by differentiating DU(Xi ) with respect to the specific variables.

Proof of Proposition 3: Using the optimum K , M from Observations 1 and 2 in the costexpressions we have

V (M | Xi , IE) − V (M | Xi , BC) = vX2i − vµ2 = v(Xi + µ)(Xi − µ)

F(K | Xi , IE) − F(K | Xi , BC) = f X2i − f µ2 = f (Xiµ)(Xi − µ)

C(M | Xi , IE) − C(M | Xi , BC) = (c − Xi )Xi − (c − µ)Xi = Xi (µ − Xi )

and the results follow directly.

Proof of Proposition 4: Using the optimum wholesale prices from Observations 1 and 2we have

R(.|Xi , BC) = (b − h)(µ2 − η2) − W + aXi − 2(b − h − f )µXi .

R(.|Xi , IE) = −(b − h)(X2i + η2 − σ 2) + aXi + 2 f X2

i − W,

where we have used W (IE) = (b − h)(η2 − σ 2) + W = E[T |BC]. Rearranging andsimplifying we have

DR(Xi ) = (b − h)[σ 2 − (µ − Xi )2] − 2 f X i (µ − Xi )

In the above expression, note that E[(µ − Xi )2] = σ 2. Clearly, when Xi = µ, DR ispositive. In the low and high demand profiles, we expect (µ − Xi )2 > E[(µ − Xi )2] = σ 2,and thus Proposition 4 follows directly.


Notes

1. Optimization over the value chain has the potential of higher total profitability if positive externalities existbetween the parts of the value chain. Information exchange is crucial for extracting this incremental value—see for instance Shank and Govindarajan (1993). The term “supply chain” has also been used extensively inthe literature. We do not distinguish in this paper between a value chain and a supply chain.

2. See Spulber (1996), Srinivasan, Kekre and Mukhopadhyay (1994). Also, recently, manufacturers and retailersare joining forces to exchange information on demand forecasts through CFAR, Collaborative Forecastingand Replenishment technologies (see Business Week, October 21, 1996, p. 140).

3. Balakrishnan, Linsmeier and Venkatachalam (1996) provide empirical findings on such phenomena aboutdistribution of profits across the value chain for JIT practices.

4. We assume constant variance across all the demand profiles to keep the analysis simple.5. The pricing function captures competitive services provided by the retailer and the additional quality and

features provided by the manufacturer in the service effort, S and the promotion effort, K.6. The quadratic form of expected revenue is chosen to simplify the exposition. The insights into the inducements

for moving to the information exchange regime are qualitatively similar for more general concave demandfunctions. We discuss relaxing this assumption in the concluding section.

7. We rely on this incompleteness in the contracting arrangement for modeling the friction. This is consistentwith practice where contracts between the retailer and the manufacturer are based on the realized demand.

8. Typically, the manufacturer proposes a unit price and imposes a lower bound on the retailer’s order quantityfor the quarter/year. That is, irrespective of the realized demand the retailer pays for the minimum quantities;above that, the retailer pays the unit price. Thus, in practice, the wholesale prices are linear in realized demand.This assumption has been used in models of the value-chain; for instance, see Moorthy (1987), Chu and Desai(1995) and Gal-Or (1991). In general, linear contracts are sub-optimal in hidden-action and hidden-informationmodels. Studies of hidden-action and hidden-information use the linearity assumption by appealing to thereality of the assumption; for instance, see Feltham and Xie (1994) among various others. We discuss theimplication of relaxing the assumption for our model in the concluding section.

9. The derivation of the observations and the proofs of propositions are in the Appendix.10. The important assumptions that ensure no frictions due to hidden-actions (but only lead to coordination

problems) are CS(.) = 0 and GKS(.) = 0. Relaxing any of these assumptions would result in the incentivecompatibility constraints being binding. To maintain focus on the impact of private information on resourcecoordination and pricing and profitability, hidden-action frictions are suppressed. We discuss relaxing thisassumption in the concluding section.

11. For a similar intuition in auction designs see Cramer and McLean (1998) and McAfee and Reny (1992).Note that risk neutrality is important for achieving the first-best. We discuss relaxing the assumption of riskneutrality in the concluding section. Risk neutrality allows us to focus on the inefficiencies in the BC regimedue to sub-optimal resource coordination and information rents.

12. We have not considered the cost of implementing the IE regime which can make the value of IE negative.Also, the information rent effect and the risk sharing effect could lead to a negative value of information asshown in Baiman and Sivaramakrishnan (1993). Here since we have risk-neutral players, risk sharing effectsdo not come into play.

13. Under the given cost structure, there is no economy of scale and because the two retailers are identical, theyobtain equal profits

14. The proof is available with the authors on request.

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