The Incentive Virtues of Performance‐Based Trade Allowances and Loss Leading

ABSTRACT A retailer can boost demand for a manufacturer's product through non‐verifiable activities. Performance‐based trade allowances—rebates conditional on the retailer's successful sales efforts—help mitigate this moral hazard problem. In equilibrium, the wholesale contract includes a retail price set below cost, complemented by a rebate for incremental units purchased when efforts successfully increase sales. Loss leading thus emerges as an incentive mechanism, rather than a practice driven by anti‐competitive or exploitative intent. A ban on below‐cost pricing leads to higher retail prices and reduced promotional efforts.