Dynamic Performance-Based Business Share Allocation in a Supply Chain with Substitutable Suppliers

This paper studies a performance-based contract in a supply triad including a manufacturer and two competing suppliers in a dynamic, uncertain, imperfect-information environment. We present a principal-agent model for managing long-term supplier relationships using a unique form of measurement and incentive scheme. We measure a supplier’s overall performance with a rating equivalent to its continuation utility (the expected total discounted utility of its future payoffs), and incentivize supplier effort with larger allocations of future business. We obtain the vector of the two suppliers’ ratings as the state of a Markov decision process. We solve an infinite horizon historydependent contracting problem in which the manufacturer allocates business volume between the two suppliers and updates each supplier’s performance rating in each period based on the current rating and the current period performance outcome. Our contributions are threefold: First, we propose a dynamic principal-agent model with a novel incentive scheme to tackle a common, but challenging incentive problem in a multi-period supply chain setting, including a manufacturer and two competing suppliers. Second, assuming binary effort choices and performance outputs, we characterize the structure of the optimal contract through a novel fixed-point analysis, uncovering dynamics and characteristics that have not been seen in prior literature. Third, we provide a theoretical foundation for the commonly-observed performance-based volume incentive schemes and justify dynamic business-share allocation as an effective incentive tool for motivating critical suppliers.