Short-term vs. Long-term Contracting: Empirical Assessment of the Ratchet Effect in Supply Chain Interaction

Abstract

In laboratory experiments, we compare the performance of short-term and long-term contracts in a two-period supplier–buyer dyad with asymmetric cost information. We find that buyers tend to reject offers if the payoff inequality increases from one period to the next. We coin this dynamic form of inequity aversion as “ratcheting aversion.” We show that under short-term contracting, the buyer's ratcheting aversion limits the supplier's leeway to exploit information revelation in earlier periods because suppliers fear contract rejections in later periods. As a result, the suppliers' empirical benefit of offering long-term contracts over short-term contracts is significantly larger than theory predicts. Furthermore, long-term contracts enable supply chain partners to achieve less volatile supply chain performance than short-term contracts because the buyers' ratcheting aversion leads to more contract rejections under short-term contracting. While normative theory predicts that suppliers should include all future informational rents of the buyers in the first-period offer, thereby creating large payoff differences between periods, we show that it can be behaviorally optimal for the supplier to make offers that lead to more equitable payoffs between periods.