Formula Pricing and Profit Sharing in Inter‐Firm Contracts

Abstract

Ronald Coase viewed transaction cost minimization as a central goal of contracting and organizational decisions. We discuss how a solution to the traditional successive monopoly problem that has not been discussed in the literature can economize on such costs. Specifically, we show that when we allow for profit sharing between upstream and downstream firms, a simple formula pricing contract can be used to generate the vertically integrated level of profits. This simple contract, empirically, would take the form of the standard linear wholesale price contracts that are ubiquitous in vertical contexts, even those where we might expect successive monopoly to be an issue. We discuss the advantages of the proposed contract from a transaction cost perspective. We also discuss some of its limitations, in particular the likelihood of misrepresentation of costs, and ways in which such misrepresentation might be addressed in the contract.

Information and profit sharing between a buyer and a supplier: Theory and practice

“…Another paper with which some of our results agree is that of Blair and Lafontaine (). Methodologically, both papers also use theoretical models without quantitative data to arrive at conclusions.…”

“…Blair and Lafontaine (), Dyer and Chu () and to some extent the present paper used TCE as a theoretical framework. Dyer and Chu (), using data from different countries, found evidence that perceived trustworthiness reduces transaction costs and leads to greater information sharing in supplier–retailer relationships.…”

“…How feasible and effective is a profit‐sharing contract in coordinating supply chains when information is uncertain? Blair and Lafontaine (), in their discussion of profit sharing in inter‐firm contracts, proposed formula pricing to make wholesale price decisions. There are, however, differences and improvements between the present paper and theirs.…”

“…His key question, after all, related to the make or buy, hierarchy or market, vertical integration or inter‐firm purchase decision; the differences in the specialized competences of a supermarket and a fresh food processor are so substantial as to obviate the possibility—or at least substantially reduce the likelihood—of vertical integration between the two firms. However, as Blair and Lafontaine (), among many others have shown, there is a variety of means of organizing production and distribution that involve neither independent entities interacting in a completely arm's length fashion (market) nor internalization or corporate integration (hierarchy). Issues of trust and cooperation make transaction costs relevant.…”

“…They can, for example, adopt decentralized decision making if it offers higher profit. Blair and Lafontaine (2015) argued that formula pricing can reduce transaction cost because the franchisor and franchisee only need to reach one agreement on a sharing parameter, α. Whereas accepting their findings that profit sharing can reduce transaction cost by reducing negotiation processes, our application is to a more generic buyer-supplier relationship in a supply chain; information is asymmetric and information concealing serves as a benchmark.…”