Supply Chain Contracting with Moral Hazard

In this paper we consider the problem of designing a contract between a retailer and a supplier in the presence of both adverse selection and moral hazard. We show that in the presence of one, but not both of these problems an appropriately constructed returns policy can lead to first best outcomes being achieved. However, if both moral hazard and adverse selection problems are present then first best outcomes cannot be implemented. Instead we find the optimal contract leads to what we refer to as 1&1/2 best outcomes. This terminology is used because outcomes are inferior to the first best, but are superior to the second best outcomes that would arise in the absence of a returns policy.