Int. j. econ. manag. soc. sci., Vol(3), No (12), December, 2014. pp.

854-859

TI Journals

International Journal of Economy, Management and Social Sciences

www.tijournals.com

ISSN:
2306-7276

Copyright 2014. All rights reserved for TI Journals.

Reward-or-Penalty Inter-temporal Pricing of a Decentralized Channel

Supply Chain under Asymmetric Information Condition
Weiping Liu *
Department of Business Administration, Eastern Connecticut State University, USA.
*Corresponding author: liuw@easternct.edu

Keywords

Abstract

Decentralized channel supply chain

Asymmetric information
Intertemporal pricing
Coordination mechanism
Reward-or-penalty, sales efforts

In a decentralized channel supply chain, manufacturer often wants retailer to exert more sales efforts to
increase the sale quantity. However, sales efforts are usually private information. Therefore, asymmetric
information regularly exists between manufacturers and retailers. To improve the financial efficiency of the
whole channel supply chain, reward-or-penalty inter-temporal pricing can be resorted to as a coordination
mechanism. This mechanism allows manufacturer to take actions such as sharing costs of the retailers sale
efforts, subsidize retailers markdown and passing the savings of production cost to the retailer to reward
retailers who exert more sales efforts while penalizing those who do not. In return, manufacturer also benefit
from the inter-temporal pricing.

1.

Introduction

A supply chain between a manufacturer and retailers is often known as channel supply chain. From the financial point of view, channel financing
is an important form of supply chain finance. In a channel supply chain where a manufacturer sells to multiple retailers, retailers sale efforts are
important in influencing market demand. Retailers can exert their sale efforts and boost the end consumers demand of the product by various
marketing techniques or by offering better services to end customers. From the manufacturers point of view, when sales volume increases,
manufacturers profit is also likely to increase.
Therefore, manufacturer should encourage retailers to exert more sales efforts. One of the most important tools manufacturer can use in channel
financing is pricing. Wholesale price of products from a manufacturer, such as consumer products, must be set and dynamically adjusted from
time to time at its own best interest. Retailers must also decide periodically how to set prices for those goods to extract the most profit from the
potential market for this product.
Pricing in a decentralized channel supply chain has several challenging problems. First, in a decentralized channel supply chain, despite the fact
that supply chain partners are supposed to cooperate with each other, each partner wants to maximize its own benefits by making individualistic
decision. Both manufacturer and retailers use their private information to optimize their private objective functions and maximize their own net
profit, i.e. the asymmetric information exists between the manufacturers and retailers. The local optima may not lead to globally optimal.
Second, a major source of uncertainties in supply chain networks originates from the fact that decisions of supply chain partners are made over
long period of time. The topic of decentralized supply chain modeling and analysis has attracted a lot of research interest recently. Most of those
studies have focused on designing mechanisms to synchronize the interests of these individualist decisions makers for a single period of time so
that the decision outcome will be in the best interest of the whole supply chain. However, the integration of supply chain over time, also called
hierarchical integration, is also important. The interests of partners of a supply chain should be synchronized to improve the financial efficiency
of the whole system not only for a single period of time but also across different time period.
Thirdly, pricing decisions are not only made over time but also interactively. Both manufacturer and retailers want to extract as much profit as
possible. Both will react with best response to the decisions made by other party. In addition, in making pricing decisions, both manufacturers
and retailers have to incorporate the demands of the end users in the market into their consideration.
To address these problems, we propose that reward-or-penalty inter-temporal pricing is used as a coordination mechanism to improve the
financial efficiency of the whole system. This mechanism allows manufacturer to take actions, such as sharing costs of the retailers sale efforts,
subsidize retailers markdown and passing the savings of production cost to the retailer, to reward retailers who exert more sales efforts while
penalizing those who do not. In return, manufacturer also benefit from the inter-temporal pricing.
The rest of the paper is organized in the following way. Section 2 is a literature review of related research on inter-temporal pricing under
different conditions and for different supply chains. Section 3 discusses the key role played by retailers sales efforts in channel supply chain.
Section 4 studies the manufacturers decision model under asymmetric information condition. Section 5 presents the reward-or-penalty intertemporal pricing model for a decentralized channel supply chain. Section 6 is a discussion of the manufacturers strategic control position in the
channel supply chain. Section 7 contains the concluding remarks.

2.

Literature Review

The effect of asymmetric information on economic decisions has attracted a lot of research attention in the last several decades. Myers and
Majluf [1] hypothesize that when the management has unfavorable inside information, the firm will always issue new stocks to take advantage of
the information asymmetry. Dierkens [2] also finds that information asymmetry is a significant variable for equity issues. The asymmetric
information theory has been applied to several financial problems, such as new equity issues by Liu [3] and stock repurchase by Liu [4]. Corbett
[5] shows that when asymmetric information and incentive conflicts are simultaneously considered in the absence of a central planner, it

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Reward-or-Penalty Inter-temporal Pricing of a Decentralized Channel Supply Chain under Asymmetric Information Condition
International Journal of Economy, Management and Social Sciences Vol(3), No (12), December, 2014.

generally does lead to inefficient supply chain performance. Chen et al [6] study a distribution channel where a supplier distributes a single
product to retailers, who in turn sell the product to consumers. They assumed that supply chain partners typically optimize their own
performance based on locally available information. The overall performance of the supply chain can be improved by employing mechanisms to
coordinate decisions.
The inter-organizational integration of supply chain has been the subject of discussion for a long time. Narayanan and Raman [7] point out that
each of the partners in supply chain has its own priorities and goals, therefore a supply chain can stay tight only if every company in the chain
has reasons to pull in the same direction to ensure that supply chains deliver goods and services quickly and cost-effectively. Schneeweiss and
Zimmer [8] analyze a supply chain between a producer and a supplier within a supply chain. They propose to use hierarchical planning as
mechanism to improve the coordination between suppliers and producers.
Researchers have studied different types of supply chain and suggested different solutions to improve the financial efficiency of these systems.
Weng [9] studies a channel supply chain and finds that the effective coordination that maximizes the joint profit of the supplier and buyer can be
achieved by employing both quantity discounts and franchise fees simultaneously. Taylor [10] proposes to use channel rebates, which is a
payment from a manufacturer to a retailor based on retailer sales to end consumers, as supply chain coordination. Bernstein and Federgruen [11]
study a coordination mechanism to determine the wholesale and retail prices to maximize the profits of the whole supply chain in which several
competing retailers served by a common supplier. Chiang [12] extends the single-period vertical price interaction in a channel supply chain into
a multi-period setting and finds that both supply-chain entities are better off in the long run when they ignore the impact of current prices on
future demand and focus on immediate-term profits. Krishnan et al [13] study a channel supply chain and find that if the wholesale price exceeds
marginal production cost, then the retailer orders fewer than the joint profit-maximizing inventories. The manufacturer can coordinate inventory
by using a returns policy, but returns dull the retailers incentives to work hard when demand is low. When sales effort costs are verifiable, the
model shows that the manufacturer can share the retailers promotion costs.

3.

The Key Role of Retailers Sale Efforts

3.1. Environment
Consider a supply chain in which a manufacturer distributes a non-perishable consumer product through retailers over an infinite time horizon.
The product, for which there are no substitutes or complements, is available to a population of consumers who are price takers and whose
product valuations are heterogeneous. In the following explanation, the retailer is the one that manufacturer picks up as the target partner and the
index is omitted. Both manufacturer and retailer are assumed to be risk neutral and the risk-free discount rate is zero. In addition, they are
concerned with the mean rather than the variance of their profits. It is assumed that the product inventory within this supply chain network is
stored at the manufacturers warehouses so that the manufacturer will have sufficient inventory in the current time period and the manufacturers
production ability is compatible with the retailers orders quantity. It is also assumed that the total costs of the manufacturer has to bear are
production cost, inventory cost and transportation cost.
The retailers are directly associated with the market demand and responsible for purchasing costs and marketing costs. All the cost functions for
the manufacturers and retailers are continuous, convex, and nonlinear function. The demand function of the product by the end consumers is
assumed to be a decreasing function of the retail price. This assumption is more realistic than the constant demand function.
It is also assumed that there are two periods: period 1 and period 2. At period 1, manufacturer and retailer have same information and the
manufacturer and the retailer in turn set wholesale and retail prices, respectively. Customers with valuation above the retail price adopt the
product at a constant rate. The wholesale price of the product set by the manufacturer in the first period is denoted by
and the retail price set
by the retailer in the first period is . At period 2, manufacturer and retailers have asymmetric information.
3.2. Retailers Sale Efforts
In a channel supply chain where a manufacture sells to multiple retailers, retailers sales promotion efforts could boost market demand. Retailers
can exert their sale efforts and increase the demand by various marketing techniques. The relationship between the sales volume by a retailer
and retailers sale efforts S can be expressed by Cobb-Douglas Production function:
(

)=

(1)

where = the production level or sales volume of the retailer,

S=sale efforts of the retailer,
M= manufacturers efforts of production,
A= total factor productivity,
and are the production elasticity of S and M.
Both and are positive fraction. These values are constants determined by available technology.
If the production function is denoted by

( , ), then the partial derivative

is the rate at which production changes with respect to the

retailers sales efforts, also known as marginal production with respect to the retailers sales efforts or marginal productivity of the retailers
sales efforts.
If marginal productivity of the retailers sales efforts is assumed to be proportional to the amount of production per unit of the retailers sales

efforts, then

for some constant

differential equation:

. If we keep M constant (M=M0), then this partial differential equation becomes an ordinary

This separable differential equation can be solved by rearranging the terms and integrating both sides:

Weiping Liu *

856

International Journal of Economy, Management and Social Sciences Vol(3), No (12), December, 2014.

ln( ) = ln ( )
ln( ) = ln (
)
(
, )= ( )
(

where

(2)

) is the constant of integration and it is a function of

since it could depend on the value of

Now we can consider the production level (equivalently the sales volume of the retailer decision) for any given level of retailers sale effort. It is
easy to verify that we can restrict our attention to strictly positive effort. From this equation, since is a positive number, we can see that the
retailers optimal sales volume is a positive function of S. When a retailer exerts more efforts in selling, the sales volume Q* will increase.
Retailers can use a variety of measures, such as advertising, direct mail, display, free goods and better services to promote the sale of the
product. Usually these actions will incur extra costs. Frequently these extra costs are private information of retailers and will not reveal to
manufacturer. From the manufacturers point of view, when Q* increases, the manufacturers profit will also be likely to increase. Therefore,
manufacturer should encourage retailers to exert more sales efforts. However, the manufacturer is facing a problem: since the manufacturer may
not be able to see what sales efforts the retailer does, how should the manufacturer make their decisions when confronting with this asymmetric
information?

4.

Manufacturers Decision Model under Asymmetrical Information Condition

For simplicity and without losing generality, the prediction model of the manufacturer is assumed to be a binary model. The sales efforts of the
retailer can be classified into two groups: upstate and downstate. Let us assume that the probability densities of upstate and downstate are ( )
and ( ) respectively. When a particular sales efforts behavior of the retailer X is observed, a decision regarding which group this X comes
from should be made based on a classification rule. Let us denote such classification rule by (x). (x) =U if X is assigned to the upstate class
and (x) = D if X is assigned to the down-state class.
Obviously, the manufacturer wants to minimize the loss of wrong decisions. Let L(U, D) be the loss incurred by classifying X into class D
when actually X is from class U. Thus L(U, U) = L(D,D) =0, L(U,D)= CD , L(D, U)= C U, where C D is the cost of classifying X into down-state
when actually X is from upstate and CU is the cost of classifying X into upstate when actually X is from the downstate. Thus L(i, (x) ) is simply
the cost incurred when
classifying X from class i .
The total loss incurred when using (x) for X is from upstate group is:
, ( )

( )

The total loss incurred when using (x) for X is from downstate group is:
, ( )

( )

Let U and D be the probability that the next X comes from the upstate and the downstate respectively. In binary prediction models, U =1 D .
Thus U and D , called prior probabilities, represent an opinion summary. Let () be the total loss when using the classification rule (x).
Then
( )=
( ) +
( )
, ( )
, ( )
(3)

where () is the Bayes risk of (x) with respect to the prior probabilities U and D . It summarizes the quality of a classification rule (x)
into a single number. Each rule (x) corresponds to a Bayes risk. The classification rule (x), which minimizes the Bayes risk, is called the
Bayes rule. If P U (X ) and P D (X) , U and D , C U and C D are known, the minimum Bayes risk can be achieved as follows:
( )<
( ), set (x) =U, i.e., classify X into upstate, and if
Given an observation X, if
( ), set (x) =D, i.e., classify X into downstate.

( )>

Note that the Bayes rule corresponds to the smallest integral of () . If both classes of outcomes are normally distributed, the optimal decision
rule can be easily obtained as follows:
Let outcomes of upstate have a normal distribution with mean U and variance , and outcomes of downstate have a normal distribution with
mean D and variance , then
( )=

and
( )=

1
2

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Reward-or-Penalty Inter-temporal Pricing of a Decentralized Channel Supply Chain under Asymmetric Information Condition
International Journal of Economy, Management and Social Sciences Vol(3), No (12), December, 2014.

We assume that in the binary prediction models, U > D. By the Bayes rule, (x)=U if
(

<
Simplifying the above gives:

When the two variances are equal, i.e.,

<

ln

ln (
=

)<0

, the solution to the inequality is straightforward:

(4)

Hence, when X satisfies the above inequality, (x) =U should be used, i.e., classify X into upstate group. The rule established this way is the
Bayes rule.1 Notice that in this inequality, variances and means are constant. In practice, for the manufacturers when they make pricing
decisions, the difference between C U and CD can be neglected. Thus the critical variable in this Bayes rule is the ratio: .
Therefore, for the manufacturer, it is straightforward to solve the problem of asymmetric information. Even though the manufacturer rarely has
complete information about the retailers sales efforts to promote the products, the manufacturer can track the results of the efforts, the sales
volume of the retailer. A retailers increased sales volume shows that the retailers sales efforts are satisfactory, i.e. U > D, then accordingly the
retailer should be rewarded or favorably treated by a lower wholesale price, denoted by
( ). Otherwise, the retailer is penalized by higher
wholesale price, denoted by
( ). ( ( )< ( )).

5.

Reward and Penalty

If we denote the net profit of the manufacturer in the first period by

and sales volume by the retailer by Q1 , then
=
. Similarly, the
net profit for the retailer in the first period is
= (
).
Consider the following numerical example: in the first period, the manufacturer sells 100 units of a good to the retailer (Q1 =100) at the wholesale
price of $4 apiece (
= $4). The retailer can sell the good in the market for $10 apiece ( = $10) and the cost of sale is $2 apiece ( =
$2). Therefore both manufacturer and retailer have a net profit of $400,
=
= $400.
In the second period, the retailer can exert more sale efforts, and let us label this as Scenario U. In this period, the retailer can take the following
two actions separately or simultaneously. First, the retailer can intensify its sales efforts and the sales cost increases to
( )( ( ) > .
Intensified sales efforts can increase the sales volume to the end customers, i.e., the retailer will increase the quantity ordered from the
manufacturer. Second, the retailer can decrease the retail price to ( )( ( ) < ). Because in this study, we assume the demand function
of end consumers is a decreasing function of retail price, i.e.,

< 0, retail price reduction can also increase the sales volume (the order

quantity of the retailer from the manufacturer). Lets denote the sales volume by the retailer in the second period by Q2 (U) (Q2(U)>Q1). The
increased sales volume is a signal to the manufacturer that
> , the manufacturer should reward the retailer by reducing the wholesale price
( )( ( ) <
to
). In this scenario, the profit functions for the manufacturer and retailer are respectively:
( )=
( )=

( )
( )[

( )
( )

( )

( )]

(5)
(6)

Obviously, when
increases, net profit for both manufacturer and retailer will increase.
The following is a numerical simulation of this scenario. Sales cost increases to $4, ( ) = $4. Also the retailer decreases the retail price to $9
apiece ( ( ) = $9). These sales efforts and retail price reduction increase the sales volume to 120 units, (Q 2(U)=120). The increased volume
is a signal to the manufacturer that
> , the manufacturer should reward the retailer by reducing the wholesale price to $2.5 ( ( ) =
$2.5). Thus, net profit for manufacturer and the retailer can be $300 ( ( ) = ( ) = $300) respectively.
If the manufacturer does not reward the retailers sales efforts and wholesale price remains as
, the retailers net profit ( )will be reduced.
The sales volume (quantity that retailer orders) ( ) will drop. The net profit for the manufacturer will also be reduced. Let us name this as
Scenario C. In Scenario C, the manufacturer is actually taking advantage of the retailer. The action taken by manufacturer is not an optimal
response to the retailers sales efforts. Nash equilibrium is a profile of strategies such that each players strategy is an optimal response to the
other players strategy (Fudenberg and Tirole, [14]). Therefore, Scenario C is not a Nash Equilibrium. As a consequence, the cooperation is not
likely to continue. In this scenario, the profit functions for the manufacturer and retailer are respectively:
( )=
( )=

( )
( )[

( )
( )
( )]

(7)
(8)

( )( ( ) < ) and sales volume will be reduced to

If the retailer does not increase its sales efforts, retail costs will be reduced to
( )
( ) < ( ) . The reduced sales volume is a signal to the manufacturer that
< . The manufacturer will penalize the retailer by
maintaining a high wholesale price. The net profit of both manufacturer and retailer will be lower. Let us call that Scenario D. In this scenario,
the profit functions for the manufacturer and retailer are respectively:
1

. This rule when the variances of the two groups can also be established. For the simplicity of analyses, the rule when the variances of the two groups are different is ignored here.

Weiping Liu *

858

International Journal of Economy, Management and Social Sciences Vol(3), No (12), December, 2014.

( )=

( )

( )

(9)

( )=

( )[

( )

(10)

( )

( )]

Period 2

It can be seen that Scenario U is a Nash Equilibrium. Even though in Scenario D, both manufacturer and retailer have lower net profit, Scenario
D is also a Nash Equilibrium.
When the net profits of the manufacturer and the retailer for the first period and the second period for the Scenario U are combined, the
combined net profit of the manufacturer and retailer is
+
( ) and
+ ( ) respectively. When the net profits of the manufacturer
and the retailer for the first period and the second period for the Scenario D are combined, the combined net profit of the manufacturer and
retailer is
+
( ) and
+ ( ) respectively.
Obviously,
+
( )>
+
( ) and
+ ( ) > + ( ) '+ ( ). Therefore, the manufacturer can use Scenario U to reward
the retailer for its sales efforts and Scenario D as a penalty. The general lesson is that if stage game has more than one Nash Equilibrium in the
future, then one can be used as reward and the other as punishment to induce the desired behavior from other party.
The above three scenarios are summarized with the following table:

6.

PM

YM

PR

CR

YR

Period 1

100

400

10

400

Scenario U
Scenario C
Scenario D

120
0
25

2.5
4
4

300
0
100

9
8
8

4
4
0

300
0
100

Manufacturers Strategic Control Position

From the above analysis, we can see that the profit function of the manufacturer and the retailer can be expressed by:
=
=

(11)

(12)

As analyzed above,

)]

is a positive function of S. Equation (11) indicates that when retailers exert more sales efforts and increase the sales

volume, the manufacturer also benefits when sales volume increases. Equation (11) can also be rewritten as

. Holding

constant,

when increases,
decreases. This implies that the manufacturer can lower the wholesale price without hurting too much of its net profit.
We can also see that
is a function of S.
We can get a few important insights from Equation (12). First, in Equation (12), when
decreases, because
is a negative function of ,
will increase. Actually the decrease of
itself is an effort of S.
Second, in Equation (12),
+
is the cost function of a retailer. When a retailer exerts more sales efforts,
increases. The increase of
has two conflicting effects: on the one hand, the increased cost will have a negative effect on the sales of the retailer (hence the quantity ordered
by the retailer ) and retailers profit
; on the other hand, the intensified sales efforts can boost the demand of end customers. However, if
the manufacturer can reduce
, that will cancel part of the increase of
. Therefore,
+
can be taken as having a joint effect on .
In Scenario U, the reduction of wholesale price by the manufacturer plays three important roles: First, essentially, the manufacturer is sharing the
cost of a retailers sales efforts. Second, the reduced wholesale price also gives the retailer flexibility to mark down the retail price to induce
bigger demand in the market. Third, reduced wholesale price can also originate from the savings of production cost. Manufacturer can
voluntarily pass the savings to the retailer to improve supply chain performance.
Thirdly, even though Equation (12) is the profit function of the retailer, the manufacturers wholesale price
plays a critical role in this
equation. It shows that in channel supply chain, the manufacturer has a strategic control position. As a dominant provider to many retailers, the
manufacturer has a magic weapon to reward or penalize the retailer so that a sustainable relationship can be established in the channel supply
chain. Thus when reward-or-penalty inter-temporal pricing is used as a coordinator between the manufacturer and retailer, actually the
manufacturer serves as a quasi-centralized strategic planner for the channel supply chain as a whole.
The reward-or-penalty inter-temporal pricing is not only a good stimulant to retailers but also a good tool for manufacturers, particularly
consumer products companies, to effectively control their own commercial and financial destiny. Reward-or-penalty inter-temporal pricing, if
properly used, allows the manufacturers to reward trade partners, who exert more efforts in promotion and boost the demand of the product in
the market and increase the sale, which in turn increases the profit of the manufacturer and improves the manufacturers own long-term financial
health.

7.

Concluding Remarks

This research proposes to use reward-or-penalty inter-temporal pricing as a coordination mechanism to improve the financial efficiency of a
channel supply chain. This model is examined under the conditions that there are two periods. However, the model developed can be easily
extended to infinite time periods. A distinguished advantage of this model is that the penalty can be easily reversed and cooperation can be
restored between the manufacturer and retailers. This is fundamentally different from the so-called Grim Trigger, which terminates the
cooperation forever.

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Reward-or-Penalty Inter-temporal Pricing of a Decentralized Channel Supply Chain under Asymmetric Information Condition
International Journal of Economy, Management and Social Sciences Vol(3), No (12), December, 2014.

On the other hand, though this is a two-period model, the reward-or-penalty intertemporal pricing proposed in this study can be used as a
coordination mechanism today. The promise of rewards and the threat of punishment in the future of a relationship can provide incentives for
good behavior at present. Despite the fact that reward and penalty will occur in the second period, manufacturer can make pricing decision in the
first period.
Another important advantage of this model is that this model is very practical. Because of the fierce competition in consumers product market
and volatility in financial markets, many companies are facing downward pressure for the demand of their products. Trade pricing is one of the
most important tools employed by many forwarding thinking companies to boost their sales or productions.
Even though reward-or-penalty inter-temporal pricing could be a powerful coordination mechanism to improve the financial efficiency of a
channel supply chain, the manufacturer still should be very careful in using the tool. Notice in the previous several sections, we choose to use the
word sales volume of the retailer rather than order quantity of the retailer. There is a subtle but important difference between these two
phrases. When manufacturer gives lower wholesale price to the retailers, retailers can take advantage of the low price and buy more than they
can sell. Narayanan and Raman [7] give an example that in the late 1980s, Campbell Soup offered distributors discounts several times every
year. Distributors bought more units than they sold, so Campbells sales fluctuated wildly. Therefore, manufacturers should provide incentives to
retailers on the increased sales but not just on the purchase quantities and prevent retailers from forward-buying large quantity.
The rationale behind the reward and penalty system is simple: there is a trade-off between the price and volume for the manufacturer. When the
manufacturer rewards the retailer with a lower wholesale price, its aim is to encourage the retailer to exert more sales efforts so that the sales
volume can increase. This should be a long-term behavior not a short-term speculation. Only when the long-term volume increases, both
manufacturer and retailer can have higher total net profit. If retailers abuse the opportunities of the lower wholesale price and overstock the
products, the total sale does not increase. The interests of the supply chain can be misaligned and the supply chain can fall apart.
In this study, one of the assumptions is that the risk-free discount rate is zero. If this assumption is relaxed and the effect of time value of money
is incorporated, the deduction of wholesale price can also be in the form of extended payment terms so that retailers can match their inventory
cycle to their sales cycle better. The extended payment can not only have the same effect of wholesale price reduction but also provide retailers a
significant working capital enhancement which will often result in sales increase.

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