Optimal Retail Contracts With Return Policies

A central problem in vertical relationships is to minimize the mismatch between supply and demand. This paper studies a problem of contracting between a manufacturer and a retailer who privately observes the retail demand materialized after the contracting stage. Cash payments are bounded above by the retailer’s revenue, while the return of unsold inventories is bounded above by the order quantity net of the actual quantity sold. While the majority of the papers in the literature takes the contractual forms as given and investigates the consequences that these contracts may lead to in various contexts, without assuming any functional form of contracts, we show that the optimal contract can be implemented by a buy-back contract: the manufacturer requests an upfront payment from the retailer and buys back the unsold inventories at the retailer’s salvage value. The optimality of buy-back contracts is robust to several scenarios including competition between retailers.