Incentives for Information Revelation in a Supply Chain and the Bullwhip Effect

Getting downstream firms in a supply chain to share private information about consumer demand with their suppliers is generally considered a prerequisite to dampening the bullwhip effect, that is, the amplification of demand shocks as they pass upstream in a supply chain. If downstream firms are reluctant to share their demand information, how can they best be incentivized to do so, and what does the optimal incentive scheme imply for the bullwhip effect and supply chain efficiency? We examine these questions by developing a supply chain model with asymmetric information, and show that the supplier should optimally follow a two-pronged strategy. One prong consists of the optimal incentive contract to induce information revelation. Information revelation requires a distortion in the downstream firm’s orders that makes them more responsive to demand shocks, which tends to strengthen the bullwhip effect. The other prong helps to reduce this distortion and dampen the bullwhip effect. It consists of getting the downstream firm to increase its initial order and stock up on inventory before it learns about demand. A larger initial order is sufficient to eliminate the bullwhip effect if demand shocks are not too persistent. Our results hold if the marginal production cost does not increase too quickly with output and the inventory holding cost is not too high.