1. March 25, 2006Teck Ho Overview of Experiment 2 Markets, A and B Each Market lasts for 6 rounds Each group plays 3 times in Market A and 3 times in Market B Each group is matched with another group only once In each round, role is either Manufacturer or Retailer

2. March 25, 2006Teck Ho Overview of Both B2B Channel Markets Manufacturer’s marginal cost is 20 Manufacturer either chooses a simple wholesale price X (in Market A) or a quantity discount contract: X, Y and Break (integers from 0 to 100) (in Market B) X must be greater than Y (since it is quantity discount contract) in Market B Retailer chooses to Accept or Reject the offer If Retailer Accepts, she chooses the Retail Price Retail Price chosen determines Quantity and payoffs for both players If Retailer Rejects, round ends. Both players earn 0 points

3. March 25, 2006Teck Ho Demand Facing the Retailer In both markets, Retailer sees a simple linear demand Demand = 100 – Retail Price If retail price = 20, demand = 100 – 20 = 80 If retail price = 50 demand = 100 – 50 = 50

4. March 25, 2006Teck Ho Market A: Computation of Payoffs M’s payoffs = [X-20]* QUANTITY R’s payoffs = [PRICE – X]*QUANTITY Total Cost to Retailer QUANTITY Q xQ Quantity Q = 100 – Retail Price

5. March 25, 2006Teck Ho Market A: Sample Linear Price Contract If Price = 80 M’s payoffs = [45 - 20]*20 = 500 R’s payoffs = [80 - 45] *20 = 700 If Price = 55 M’s payoffs = [45 - 20] *45 = 1125 R’s payoffs = [55-45] *45 = 450 Total Cost to Retailer 20 45 QUANTITY X = 45 2000 1000 Price 80 55

6. March 25, 2006Teck Ho Market B: Computation of Payoffs If QUANTITY < = BREAK, M’s payoffs = [X-20] * QUANTITY R’s payoffs = [PRICE-X] * QUANTITY If QUANTITY > BREAK, M’s payoffs = [(X - 20) * BREAK] + [(Y-20) * (QUANTITY – BREAK)] R’s payoffs = [PRICE * QUANTITY] – [X * BREAK + Y * (QUANTITY – BREAK)] Total Cost to Retailer Q 1 Break Q 2 QUANTITY X x Break + Y x (Q2- Break) X x Q 1

7. March 25, 2006Teck Ho Market B: Sample QD Contract 1 Total Cost to Retailer X = 50 Y = 25 BREAK=20 10 20 50 QUANTITY 1750 500 Price 90 50 If QUANTITY = 10 (< = 20), M’s payoffs = [50-20] * 10 = 300 R’s payoffs = [90-50] * 10 = 400 If QUANTITY = 50 (> 20), M’s payoffs = [(50 - 20) * 20] + [(25-20) * (50 – 20)]=750 R’s payoffs = [50 *50] – [50 * 20 + 25 * (50 – 20)] = 750

8. March 25, 2006Teck Ho Market B: Sample QD Contract 2 Total Cost to Retailer X = 45 Y = 20 BREAK=25 20 25 60 QUANTITY 1825 900 Price 80 40 If QUANTITY = 20 (< = 25), M’s payoffs = [45-20] * 20 = 500 R’s payoffs = [80-45] * 20 = 700 If QUANTITY = 60 (> 25), M’s payoffs = [(45 - 20) * 25] + [(20-20) * (60 –25)] = 625 R’s payoffs = [40 *60] – [45 * 25 + 20 * (60 – 25)] = 575

9. March 25, 2006Teck Ho Deciding the Winner Each group’s total earnings is the sum of its earnings either as a manufacturer or a retailer in all six decision rounds The group who has the highest total earnings will win a prize of $40 (Ho & Ho Foundation) + $5 / Group = $100

10. March 25, 2006Teck Ho Simple Rules to Follow In each decision round, manufacturers and retailers will be given 5.5 and 3.5 minutes to make their decisions respectively and --a prompt will appear when the time limit expires Do not click on the BACK button on the browser to return to a previous page--make sure the value you entered in the decision box is correct before clicking on the CONTINUE button. –Clicking on the BACK button to enter a new value will not work and may cause the system to behave erratically

11. March 25, 2006Teck Ho Experiment Starts Here http://128.32.67.154/contractdesign2/

12. March 25, 2006Teck Ho Steps in Designing B2B Contracts Figure out the maximum possible pie Choose a contract structure that makes the maximum pie achievable (linear versus quantity discount (QD)) Pick the right parameters to achieve the maximum pie (Linear: X; QD: X, Break,Y) Pick the right parameters to divide the pie based on relative bargaining power (Linear: X; QD: X, Break, Y) Ensure voluntary and incentive-compatible participation (i.e., retailers will choose the “right way”)

13. March 25, 2006Teck Ho What is the Maximum Pie? Suppose manufacturer and retailer work as a team (marginal cost = 20) Profits are: (Price – 20)*Quantity = (Price – 20) x (100 – Price) Optimal retail price is 60 and quantity = 40 Profits = 1600

14. March 25, 2006Teck Ho Joint Decision: Optimal Retail Price Sales Quantity $60 $20 40 Price $100 Quantity = 100 - Price

15. March 25, 2006Teck Ho Which Contract Form? Linear Wholesale Price Contract Nonlinear Whole Price Contract –Block tariffs

16. March 25, 2006Teck Ho Linear Wholesale Price Contract Suppose Manufacturer offers Retailer a linear wholesale price X. Marginal Cost is 20. Demand is: Quantity = 100 – Price Manufacturer’s profits = (X-20) * (100 – Price(X)) Retailer’s profits = (Price – X)* (100 – Price) Optimal Decisions: –Price(X) = (100 + X )/2 –X=60, Price=80, Quantity = 20 –M’s profits = 800, R’s profits = 400 –Total profits = 1200 Total profits are 75% of the maximum possible profits (1600) Can Quantity Discounts Schemes Increase the Pie?

17. March 25, 2006Teck Ho Independent Channel Members Manufacturer Retailer 20 Price X Quantity=100-Price

18. March 25, 2006Teck Ho Linear Pricing Contract: Optimal Retail Price: Sales Quantity Price (X) = ($100 + X)/2 $X Price $100 Quantity = 100 - Price 100 - Price (X)

19. March 25, 2006Teck Ho How to Achieve Maximum Pie? Marginal cost to the retailer = 20 Optimal retail price = 60

20. March 25, 2006Teck Ho Market B: Optimal Design Total Cost to Retailer Q 1 Break Q 2 QUANTITY X x Break + Y x (Q2- Break) X x Q 1 Choose X and Break to divide the pie Manufacturer makes (X-20)*Break Y=20

21. March 25, 2006Teck Ho Market B: Optimal Design Total Cost to Retailer X = 45 Y = 20 BREAK=32 32 QUANTITY If QUANTITY (< = 32)  Price >= 68, Optimal Price = 72.5 M’s payoffs = [45-20] * 27.5 = 687.5 R’s payoffs = [72.5-45] *27.5 = 756.25 If QUANTITY (> 32)  Price < 68, Optimal Price = 60 M’s payoffs = [(45 - 20) *32] + [(20-20) * (40 –25)] = 800 R’s payoffs = [60 *40] – [45 * 32 + 20 * (40 – 32)] = 800

22. March 25, 2006Teck Ho Market B: 2-Block Tariffs Manufacturer sets Y = 20 to achieve the maximum pie Retailer chooses Price = 60, Quantity = 40 Manufacturer chooses X and Break to divide the pie based on the relative bargaining power Manufacturer earns (X-20)*Break leaving Retailer 1600 – (X-20)*Break A possible optimal contract: –X=45, Y=20, Break = 32 (or X = 60, Y=20, Break=20) –M’s Profits = 800, R’s Profits = 800, Total = 1600

23. March 25, 2006Teck Ho Summary Figure out the maximum possible pie! Choose a contract structure and the right parameters to achieve the maximum pie Divide the pie based on bargaining power Ensure voluntary and incentive-compatible participation (it is the interest of the retailer to choose accordingly)