The Impact of Contracts on Upstream Innovation Incentives in a Supply Chain

Abstract

We consider a supply chain with an upstream supplier who invests in innovation and a downstream manufacturer. We study the impact of supply chain contracts with upstream innovation, focusing on three different contract scenarios: (i) a wholesale price contract set by the supplier, (ii) a quality-dependent wholesale price contract set by the manufacturer, and (iii) a revenue sharing contract. We confirm that a revenue sharing contract can coordinate a supply chain including investment in innovation, whereas wholesale price contracts may result in under investment in innovation. However, the downstream manufacturer does not always prefer a revenue sharing contract; the manufacturer’s profit can be higher under a quality-dependent wholesale price than that under a revenue sharing contract, specifically when the innovation cost of the upstream supplier is low. We then extend our model to incorporate upstream competition between suppliers. When the competing suppliers set the wholesale price, by inviting upstream competition, the manufacturer can increase his profit substantially to the level in which he has the right to set the quality-dependent wholesale price in a one-to-one supply chain. Furthermore, under the upstream competition, the revenue sharing contract coordinates the supply chain, and is also an optimal contract form for the manufacturer. We also analyze the case of complementary suppliers, and show that our primary results are robust.