Strategic Supply Chain Contracting to Stimulate Downstream Process Innovation.pdf

Strategic Supply Chain Contracting to Stimulate Downstream Process Innovation Stephen M. Gilbert¤and Viswanath Cvsay June 29, 2000 Abstract In a supply chain, investments that a ˉrm makes in reducing its own variable costs provide an obvious beneˉt to its suppliers: All else being equal, lower marginal costs cause the ˉrm to increase its own output, hence increasing consumption of suppliers outputs. Without pre-commitment to wholesale prices from its supplier(s), a ˉrm will tend to underinvest in cost reduction because of fear of being held-up. Clearly, a supplier to such a ˉrm can eliminate this hold-up problem by pre-committing, instead of remaining °exible with respect to wholesale price. However, by making an advance commitment to wholesale price, it gives up an important means of responding to demand uncertainty. In this paper we examine the trade-o? that is faced by a ˉrm when its downstream channel partner has opportunities to invest in making relationship speciˉc marginal cost reductions. Should it commit to a price in order to encourage downstream investment in cost reduction, or should it remain °exible with respect to wholesale price in order to respond to demand uncertainty. We discuss several simple wholesale pricing mechanisms with respect to this trade-o?. (Channel Coordination, Channels of Distribution, Industrial Organization, Cost Reducing RD) ¤(Corresponding Author)The University of Texas at Austin, Management Department, CBA 4.202, Austin, TX 78712, steve.gilbert@bus.utexas.edu yCase Western Reserve University, Department of OR and OM, 10900 Euclid Ave., Cleveland, OH 44106 vxc10@po.cwru.edu. 1 Introduction When one ˉrm in a supply chain invests in process innovation aimed at reducing its own variable production costs, collateral beneˉts often acrue to its supply chain partners. All else equal, lower marginal costs tend to result in lower prices and higher quantities of output from a ˉrm, beneˉtting its customers and suppliers respectively. Howev