Foundations of Buy-Back Contracts

This paper characterizes the optimal supply-chain contract from the perspective of incentive theory. Most of the supply-chain literature takes the contractual form as given and investigates its implications and uses in various contexts. We show that when the retailer faces limited liability and privately observes demand, the optimal arrangement can be implemented by the familiar buy-back contract. Under this contract, the retailer makes an upfront payment and sells unsold inventory back to the supplier at a price equal to the retailer's salvage value. The returns therefore serve as a screening tool that differentiates different types of retailers ex post