| Abstract: | We analyze the effect of equity‐based incentives in a supply chain with a downstream firm and an upstream supplier. By using the operational decision as a signal to influence external investors’ beliefs, the downstream firm's manager intends to maximize a convex combination of the interim share price and the terminal cash flows. We show that equity‐based incentives create a side effect. Specifically, with a universal buy‐back contract, the deadweight loss of signaling induced by equity‐based incentives could spread throughout the supply chain and cause chain‐wide damages. To mitigate such undesirable consequences, we propose a new mechanism to eliminate the inefficiency. We derive the optimal mechanism that maximizes the downstream firm's profits subject to the constraint that the supply chain efficiency is not undermined. In contrast to the full‐information benchmark, this mechanism gives positive surplus to the supplier. Submitted: January 5, 2011. Revisions received: June 20, 2011; December 11, 2011. Accepted: December 22, 2011.] |
