INFORMATION ASYMMETRY, MANUFACTURER–RETAILER CONTRACTS, AND TWO‐SIDED ENTRY

• Published date: 01 November 2018
• Author: Alvin Murphy,Tat Chan,Li Wang
• Date: 01 November 2018
• DOI: http://doi.org/10.1111/iere.12333

INTERNATIONAL ECONOMIC REVIEW

Vol. 59, No. 4, November 2018 DOI: 10.1111/iere.12333

INFORMATION ASYMMETRY, MANUFACTURER–RETAILER CONTRACTS, AND

TWO-SIDED ENTRY∗

BYTAT CHAN,ALVIN MURPHY,AND LIWANG1

Washington University in St. Louis, U.S.A.; Arizona State University, U.S.A.; Shanghai

University of Finance and Economics, China

We investigate the economic determinants of contract structure and entry with transfer contracts, which spec-

ify that manufacturers directly sell their products in retail stores while retailers collect sales revenue and return a

transfer to the manufacturers. Using a unique data set describing entry decisions of clothing manufacturers into

a retail department store, we estimate a two-sided, asymmetric-information entry model. We compare profit

estimates under transfer contracts to counterfactual profit estimates under common alternative contract formats.

Results show that, when adverse selection is present, transfer contracts dominate other contract formats from

the retailer’s perspective; otherwise, the common alternative contract formats dominate.

1. INTRODUCTION

In a typical retail channel, it is required that upstream manufacturers reach a contractual,

rent-sharing agreement with downstream retailers before their products can sell in retail stores.

Three types of contracts are commonly observed in the retail industry: vertical contracts, share

contracts, and transfer contracts. Under vertical contracts, product ownership is transferred from

manufacturers to retailers, who are the residual claimants of the gain or loss from selling to end

consumers, under agreed wholesale prices. This is the traditional type of contract adopted in the

retail sector and has been widely studied in the economics literature. Share contracts, in contrast,

let manufacturers keep the ownership and retailers are paid by a share of sales revenue in return

for selling in their stores.2They have recently become the dominant mechanism adopted by

online retail platforms, such as the Marketplace at Amazon.com and Apple and Android app

stores, to split revenue with third-party sellers or software developers.

This article examines transfer contracts, which have been widely used by department stores

in Asian countries, including China. Under this contract format, manufacturers directly sell

their products in retail stores, while retail stores collect the sales revenue and return a transfer

to the manufacturers. The most important terms in the contract specify the retailer’s targeted

sales revenue and a transfer amount. When sales are less than the target, the difference will

be deducted from the transfer; when sales exceed the target, the manufacturer is paid almost

all of the excess. This essentially guarantees that the retailer’s return is not greatly affected by

demand fluctuations. Although transfer contracts are a recent innovation for rent-sharing in the

retail sector, they are effectively very similar to fixed-rent contracts, which have been typically

used between shopping mall developers and store owners.

Our goal in this article is to investigate the economic determinants of contract-format choice

and to estimate the impacts on both manufacturer and retailer profits from using a transfer

∗Manuscript received May 2016; revised August 2017.

1We would like to thank the editor, Holger Sieg, three anonymous referees, Kelly Bishop, Aviv Nevo, Dan Silverman,

and Matt Wiswall as well as various conference and seminar participants for their helpful comments and suggestions.

We also thank Bin Wang for data support and for providing insights on the Chinese retail market. All remaining errors

are our own. Please address correspondence to: Alvin Murphy, Department of Economics, Arizona State University,

P.O. BOX 879801, Tempe, AZ 85287-9801. E-mail: alvin.murphy@asu.edu.

2Such contracts have a long history in the agricultural sector under the form of “crop-sharing.”

2163

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(2018) by the Economics Department of the University of Pennsylvania and the Osaka University Institute of Social

and Economic Research Association

2164 CHAN,MURPHY,AND WANG

contract in comparison with vertical and share contracts. Our empirical analysis examines

the entry decisions of clothing manufacturers into a major retail store in the Chinese city of

Shanghai. We focus on the information asymmetry between manufacturers and the retail store

and assume that the retail store faces uncertainty regarding some attributes of the manufacturer

that affect sales revenue and manufacture costs; that is, these attributes are private information

for manufacturers. This type of information asymmetry can lead to adverse selection problems

that, through interviews with the store management, we believe to be the major concern of the

store when deciding on contract offers.3

Our main interest is not to propose new contract designs; instead, this article compares the

profit impacts of the transfer, vertical, and share contracts under information asymmetry. Given

that these three types of contracts have been widely adopted in different industries, understand-

ing their impacts is important for both policymakers and for retailers and manufacturers when

choosing between contract formats. Based on the estimation results, we compare the equilib-

rium outcomes under the three types of contracts. We explore different forms of information

asymmetry, in terms of how the two uncertainties on the sales revenue of a brand and the cost

of its manufacturer are correlated with each other, which lead to different degrees of adverse

selection in brand entry. Understanding the impact of adverse selection on profits is informative

about why different contract formats are chosen in different economic environments.

To address these questions, we develop a two-sided model in which the store makes simultane-

ous take-it-or-leave-it offers to all manufacturers and, conditional on the offers, manufacturers

make entry decisions. By specifying and estimating such a two-sided entry model under infor-

mation asymmetry, we are able to study the economic determinants of contract offers and firm

entry that cannot be identified in standard entry models.

To estimate our model, we use a unique data set containing information about manufacturers

in a women’s clothing category who are potential entrants to a major department store in Shang-

hai. Estimation relies on three sources of information: the observed entry and exit decisions

of manufacturers, the actual revenue transfer from the store to manufacturers, and the annual

sales revenue of each contracted manufacturer. The rich nature of our data facilitates clean

identification of model parameters. Brand entry and sales data help identify the sales revenue

function. Data on brand entry and the revenue transfer allow us to separate the manufacturers’

cost function from the “spillover effects” of brand entry on the store’s profit that comes from

categories outside women’s clothing. Another unique feature of our data is that we obtain the

complete list of brand attributes, both objective and subjective, for each potential entrant brand

based on the store’s evaluation. Therefore, we effectively have data on the store’s information

set regarding each potential entrant.

Our results show that the attributes of a manufacturer’s brand have different effects on the

store and manufacturer profits. For example, a better fit between a brand and the majority

of consumers in the store will increase the brand’s sales revenue but will also increase the

manufacturer cost and have a negative spillover effect on the sales of other categories sold in the

store. Other brand attributes also have significant impacts on sales revenue, manufacturer cost,

and spillovers. The standard deviation of the manufacturers’ private information is estimated as

0.44 million RMB,4which is very significant in comparison with the average brand sales revenue

1.5 million RMB.

Our data provide a direct and simple way to validate our structural model—we compare

the expected sales revenue and manufacturer transfers estimated using our model with brand

scores used by the store, which were not used in estimation. We find the measures to be highly

consistent with one another, providing strong evidence for the validity of our model.

To analyze the effects of the interaction of asymmetric information and contract design on

profits, we use our estimation results to conduct counterfactual experiments. We analyze the

3In addition, as discussed in Section 3, various features of our data suggest the existence of both uncertainty and

asymmetric information, which motivates our use of a two-sided, asymmetric-information, entry model.

4Chinese dollar. One RMB is about U.S.$0.16.