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

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