Provision of Incentives for Information Acquisition: Forecast-Based Contracts vs. Menus of Linear Contracts

In the producer-seller relationship, the seller, besides his role of selling, is often in an ideal position to gather useful market information for the producer’s operations planning. Incentive alignment is critical to motivate both information-acquisition and sales efforts. Two popular contract forms are investigated. One is the forecast-based contract that requires the seller to submit a demand forecast, and he obtains commissions from the realized sales but is also obliged to pay a penalty for any deviation of the sales from the forecast. The other is the menu of linear contracts, from which the seller can choose one that specifies a unique commission rate and a fixed payment. The conventional understanding suggests that the menu of linear contracts is superior, but it is often assumed that information is exogenously endowed. In contrast, we find that with an endogenous information-acquisition effort, the menu of linear contracts may suffer from the conflicted moral hazard effect that creates the friction between motivating the two efforts. The forecast-based contract can however decouple these two tasks and thus dominate the menu of the linear contracts. We further find that when ensuring interim participation is necessary (e.g., renegotiation cannot be prevented after information acquisition), the performance of the forecast-based contract might be affected by the adverse selection effect as it is unable to effectively separate different types, in which the menu of linear contracts excels. We show that when the demand and supply mismatch cost is substantial, the conflicted moral hazard effect dominates the adverse selection effect and the forecast-based contract is more efficient, and it is the converse otherwise. These findings can enrich the understanding of these two contract forms and are useful for sales and operations planning.