Should an Online Retailer Penalize Its Independent Sellers for Stockout?

We consider an online retailer selling a seasonal product provided by an independent third-party seller who has superior information about the demand potential of the product. The online retailer receives customer orders and then sends the orders to the seller for fulfillment, using pre-installed capacity. The supplier privately installs capacity prior to the selling season. The online retailer faces the challenge to accomplish two goals: to incentivize the seller to install the right level of capacity and to extract full surplus from the seller. We show that the commonly used commission contracts in online retailing cannot effectively allow the online retailer to accomplish the two goals to achieve the first-best outcome. We then show that the retailer can effectively accomplish the two goals to achieve the first-best, using a lost-sale penalty contract which has three components: a fixed fee, a commission and a lost-sale penalty which will be charged to the seller if a lost sale occurs.