A Dynamic Mechanism for Achieving Sustainable Quality Supply

Abstract

This study models a supply chain where a retailer depends on an economically-weaker supplier for high-quality materials. Sustainable supply hinges on adhering to socially and environmentally responsible standards over time. Noncompliance by the supplier due to dynamically
changing, privately observed compliance costs risks future supply capabilities. While the retailer can invest in reducing the cost, the outcome is uncertain. We propose a sustainability
index to gauge the supplier’s compliance and take a system’s perspective to construct a multiperiod index-based agreement to achieve the supply chain’s optimal sustainability index. The
mechanism stipulates the sustainability index and the corresponding payment terms to each
party in each period. The payment structure partly resembles the three-part payment observed
in practice. It reflects current and future states and ensures voluntary participation, truthful
information sharing, and the first-best investment. We illustrate our mechanism and discuss
insights using two examples within the general framework. One example models deteriorating
supplier compliance costs, revealing conditions where the dynamic contract can be implemented
as single-period contracts. The other example highlights the retailer’s investment dynamics and
shows the retailer’s willingness to engage when contract length meets specific thresholds. It
demonstrates how our framework can be used to identify situations where support from nonprofit organizations could prove crucial.

Keywords: supply chain coordination, mechanism design, sustainable supply, investments