Bounded Rationality Affecting the Performance of Two-Part Tariff Contracting Mechanism

Abstract

In the behavioural operations management field, bounded rationality has often been revealed as an important factor that can affect human decisions in many fields, including the designing of contract mechanisms. Many previous studies have used utility function models or complex statistical models to reveal the effects of bounded rationality in contract design. However, those models were not easily tractable. Accordingly, we considered the bounded rationality effect ex-ante and artificially pre-restricted some contractual options which could lead to bounded rationality. We started with an overview of bounded rationality that seems both appealing and widely applicable in the contract design process. Our first task was to propose and analyze supply chain participants’ performance when ex-ante constraints were considered with regard to bounded rationality issues based on a specific type of supply chain contract, namely the Two-part Tariff (TPT) contract. Previous research addresses the problem in two ways. One is the identification of contract design biases and the other is the identification of interventions that could help improve contract designs in reality. This study was an attempt to find an alternative that could improve supply chain channel efficiency by incorporating specific contractual parameter constraints. This study also shows that the profit performance and the effectiveness of coordinating contracts can be significantly affected by bounded rationality. The main outcomes of this research are: i. Based on the existing model, we tested certain predictions relating to the effect of bounded rationality on contract performance. ii. We examined the potential effect of artificially restricting bounded rationality contract options when designing TPT contracts to coordinate the parties’ decisions and investigated whether that would leave participants better off or not. iii. We investigated the channel efficiency scenario of conducting experimental treatments when bounded rationality issues have been considered. iv. We used a controlled laboratory setting designed to conform to the assumptions of restricting the supplier’s set of available contractual options to reveal the effect of bounded rationality on TPT contract mechanism. From our study, contract theorists can draw further lessons from our approach to choice sets as a contract design parameter and our reliance on the fundamental assumptions of the choice theory. This study also allows practitioners to improve their contract design process without the requirement to fit this to any existing models.