A Dynamic Mechanism for Achieving Sustainable Quality Supply

Abstract

We model a supply chain where a retailer relies on an economically weaker supplier to supply a high-quality key material. For sustainable supply, the production process must comply with socially and environmentally responsible standards over time. However, compliance costs fluctuate due to an underlying state that is privately observed by the supplier, who may thus fail to comply, risking future supply capabilities. While the retailer can invest in reducing the cost, the outcome remains uncertain. To address these challenges, we introduce a sustainability index to monitor and manage the supplier's compliance within a multi-period, index-based agreement to optimize the supply chain's overall sustainability.  The proposed mechanism modifies the sustainability index and corresponding payment terms for each party in each period, ensuring it reflects current circumstances and the worst-case scenarios, and anticipates future changes. This structure promotes voluntary participation, truthful information sharing, nonnegative payment to the supplier, and the first-best investment. Through two examples within our general framework, we illustrate the payment term dynamics and the importance of continuous investment. The examples also highlight how contract length, investment success probability, and the nature of investments are critical for the success of sustainability programs, pinpointing when external support from non-profit organizations is most effective.

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