Bounded Rationality in Supply Chain Contracts

Abstract

Bounded rationality affects human decisions in a variety of contexts including supply chain contracts. However, predictive models of contracting that account for bounded rationality are scarce, in a sharp contrast with ubiquity of descriptive models used in the data analyses. One apparent reason of such scarcity is that commonly used specifications (e.g. logit) are well-suited for statistical analyses but make analytical models intractable in many aspects. As a result, it is not surprising that the extant theory provides very little guidance. This study makes three contributions. First, it introduces a framework that describes different contracts in a unified way as choice sets in the contracting space. The key advantage of this approach is analytical tractability. It is completely avoids the main cause of intractability, non-existence of a closed form characterization of a quantal response equilibrium, by making it possible to characterize the relative performance of different contracts directly, without characterizing their absolute performance. Second, contrary to a current stance of the literature that bounded rationality cannot explain the performance differences of different contractual forms, our analysis reveals how bounded rationality brings into play certain structural differences between contractual forms and predicts their performance implications. Finally, we characterize the supplier’s optimal contract.