A Dynamic Mechanism for Achieving Sustainable Quality Supply

Abstract

We consider a supply network where a retailer sources from multiple economically weaker suppliers for a high-quality key material. The production of the material needs to comply with social and environmental standards over time. However, such compliance is costly, and the cost varies with privately observed dynamically changing environment (termed as the state), so the suppliers may cut corners, risking losing the ability to supply in the future. While retailer can invest to reduce the compliance cost, the investment outcome is uncertain. Therefore each party faces a trade-off between short-term gains/losses and long-term losses/gains. We present a dynamic model to capture these complexities and explore incentive mechanisms that enable all parties collaborate to achieve sustainable quality supply. We propose a sustainability index that reflects the supplier’s compliance status, and then construct a dynamic mechanism to achieve the first-best index in each period. The payments to the suppliers reflect both current and future states. This mechanism allows suppliers’ voluntary participation and induces truthful information exchange, self-enforcement, as well as first-best retailer investments. We show that the retailer commits and invests in a supplier only if the collaboration is longer than a certain contract length. Thus, we uncover situations where the support from the non-for-profit organizations is particularly valuable. Finally, we discuss additional strategies the retailer may adopt to scale up the program.