Risk intermediation in supply chains

In some supply chains, retailers are relatively small and averse to taking risk. In such a situation, traditional methods of contracting, that typically assume risk neutrality on retailers, might not suffice to maximize the seller's/distributor's expected profit. We present tools for analyzing and solving such a problem from the viewpoint of a (risk-neutral) seller/distributor. We present two types of models that can be used to create contracts, one set in a discrete setting and the other in a continuous setting. In both settings, individual retailers are characterized with different degrees of risk aversion. We first explain in the discrete setting how the varying degrees of risk aversion present hurdle for the design of a uniform contract for all retailers. We then show how to mitigate the problem using ideas from the theory of mechanism design. We offer a simple solution to the contract design problem and show how it can be easily implemented. We next show that in the continuous setting in which the distribution of retailers is continuous, which could be viewed as a limiting case of the discrete setting, the contract design problem actually simplifies. In this continuous setting, we show that it becomes relatively easy to design contracts and establish their optimality from the seller's/distributor's viewpoint. We conclude the chapter with a summary of problems that are still open in this area.