Effects of Reactive Capacity on Product Quality and Firm Profitability in an Uncertain Market

In many supply chains, the brand-owning retailer designs product quality and decides the retail price but often outsources its production to suppliers. For products with a short selling season, low reactive capacity in the supply chain requires the supplier to carry out production before the selling season;but the uncertain market demand creates risks of stockout or excess inventory. Suppliers' reactive capacity and demand uncertainty can influence brand owners' product pricing and quality decisions. For example, during the COVID-19 pandemic, automakers faced supply shortages for automotive chips because of the upstream suppliers' limited parts inventory and production capacities, which have prompted the automakers to increase the quality (e.g., producing higher trims with more optional upgrade features) and price of their products to target fewer (high-valuation) consumers. This paper studies the impacts of the supplier's reactive capacity and demand uncertainty on product quality and firm profitability under pull contracts in the supply chain. We find that an increase in the supplier's reactive capacity can lead to higher or lower equilibrium product quality, benefiting the retailer but potentially reducing the supplier's profit. Interestingly, both the retailer and the supplier can be worse off with a higher probability for the high market state (with more high-valuation consumers). Further, a higher probability for the high market state can lead to lower product quality.