Supply Contracts in Manufacturer-Retailer Interactions with Manufacturer-Quality and Retailer Effort-Induced Demand Haresh Gurnani, 1 Murat Erkoc 2 1 Department of Management, University of Miami, Coral Gables, Florida 33124 2 Department of Industrial Engineering, University of Miami, Coral Gables, Florida 33124 Received 22 September 2005; revised 19 December 2007; accepted 27 December 2007 DOI 10.1002/nav.20277 Published online 14 February 2008 in Wiley InterScience (www.interscience.wiley.com). Abstract: We consider a decentralized distribution channel where demand depends on the manufacturer-chosen quality of the product and the selling effort chosen by the retailer. The cost of selling effort is private information for the retailer. We consider three different types of supply contracts in this article: price-only contract where the manufacturer sets a wholesale price; fixed-fee contract where manufacturer sells at marginal cost but charges a fixed (transfer) fee; and, general franchise contract where manufac- turer sets a wholesale price and charges a fixed fee as well. The fixed-fee and general franchise contracts are referred to as two-part tariff contracts. For each contract type, we study different contract forms including individual, menu, and pooling contracts. In the analysis of the different types and forms of contracts, we show that the price only contract is dominated by the general franchise menu contract. However, the manufacturer may prefer to offer the fixed-fee individual contract as compared to the general franchise contract when the retailer’s reservation utility and degree of information asymmetry in costs are high. © 2008 Wiley Periodicals, Inc. Naval Research Logistics 55: 200–217, 2008 Keywords: supply contracts; information asymmetry; retailer effort 1. INTRODUCTION AND RELATED LITERATURE In decentralized distribution channels, the manufacturer relies on marketing intermediaries (such as retailers) to take the product to the end-user. However, each firm makes deci- sions to maximize their individual profits and hence, the presence of disparate incentives for the firms requires careful consideration in the design of supply contracts. Two basic issues commonly identified in supply contract design are the double marginalization effect [28] and information asymme- try. In this article, we assume that the manufacturer designs the contract but both the manufacturer and retailer engage in activities that influence final demand. We consider the case when the manufacturer invests in the technology used to make the product; a larger invest- ment in technology improves the quality of the product which results in an increased market potential (demand) for the product. However, the technology-investment/quality- improvement costs are directly incurred by the manufacturer only. As such, the manufacturer may charge a higher whole- sale price/transfer fee in order to recuperate these costs. Correspondence to: H. Gurnani (haresh@miami.edu) For instance, in the electricity markets, power generating firms can invest in different dimensions of power quality such as environmentally-friendly green power or premium power for sensitive computing, as opposed to lower quality inter- ruptible power for flexible producers [27]. In the fast food retail business, final demand is not only affected by the retail price and the value added by the retailer, it also depends on the investments made by the franchisor in its brand name [21]. In the automotive industry, Japanese firms made dramatic gains in market share in the 1980s as compared to the US firms by investing in quality-improvement efforts [12]. Similarly, the retailer has the opportunity to influ- ence the final demand by choosing the appropriate sell- ing/promotional efforts. Examples of such activities include breaking bulk, providing shelf spaces, promotional displays, advertising, and other demand enhancing activities [10]. In the automotive industry, final demand depends not only on the quality/brand reputation of the product, but also on the dealer’s selling efforts including after-sales service support. The cost of these promotional efforts is private informa- tion and is directly incurred by the retailer only. In many situations, the manufacturer may not know the retailer’s effec- tiveness (or willingness) to exert effort to influence demand. © 2008 Wiley Periodicals, Inc.