Supply Chain Contracting with Quality Choice

We analyze a firm designing and selling a seasonal product with demand uncertainty and a single ordering opportunity. Prior to the start of the selling season, product quality and inventory must be jointly determined; a higher quality product results in a greater selling price but also greater marginal production cost. We consider both a centralized supply chain, in which a single firm determines quality and inventory, and a decentralized supply chain, in which a manufacturer determines product quality and a retailer determines inventory. In a centralized supply chain, we provide a simple characterization of the optimal inventory and quality, and demonstrate that at the optimal inventory-quality pair the sales function elasticity is equal to the reciprocal of the cost function elasticity. In a decentralized supply chain, we demonstrate that standard wholesale price contracts cannot coordinate the supply chain in inventory or quality, and discuss the impact of these contracts on quality and inventory levels; interestingly, we show that quality is often higher under wholesale price contracts than in a centralized system due to substitutability with inventory, despite the fact that double marginalization reduces manufacturer incentives to invest in quality, all else being equal. We also show that, surprisingly, standard revenue sharing contracts can coordinate the supply chain in quality choice in some cases; however, this requires truthful sharing of the manufacturer’s cost structure, which we demonstrate is not in the manufacturer’s interests to reveal. We conclude that simultaneously coordinating product design and inventory in decentralized supply chains, while feasible, is likely to be challenging in practice, perhaps helping to explain the value of the recent surge of “direct-to-consumer” distribution that avoids coordination problems by having the same firm design and sell seasonal goods.