Equity-Based Incentives and Supply Chain Buy-Back Contracts

Acknowledgement: We thank the Chief Editor (Professor Asoo J. Vakharia), the Senior Editor, the Associate Editor, and two referees for their invaluable suggestions that helped improve the clarity and quality of this paper. The order of authorship is alphabetical, and the authors contributed equally to the manuscript. ABSTRACT We analyse the effect of equity-based incentives in a supply chain with a downstream firm and an upstream supplier. By using the operational decision as a signal to influence external investors' beliefs, the downstream firm's manager intends to maximize a convex combination of the interim share price and the terminal cash flows. We show that equity-based incentives create a side-effect. Specifically, with a universal buy-back contract, the deadweight loss of signalling induced by equity-based incentives could spread throughout the supply chain and cause chain-wide damages. To mitigate such undesirable consequences, we propose a new mechanism to eliminate the inefficiency. We derive the optimal mechanism that maximizes the downstream firm's profits subject to the constraint that the supply chain efficiency is not undermined. In contrast to the full-information benchmark, this mechanism gives positive surplus to the supplier. Supply chain management.