Long-Term Contracts in a Retailer-Led Supply Chain with Stochastic Demand

Abstract

This paper develops a model to study channel coordination in supply chain. Such chains are characterized by a dominant retailer who aims to coordinate the upstream production quantity. When demand for the final product is stochastic, the supplier has an incentive to keep its capacity relatively low to avoid creating unneeded capacity. The retailer, on the other hand, prefers the supplier's capacity to be high to ensure that the final demand is satisfied. The retailer therefore needs a contract to induce the supplier to increase its production capacity. We investigate a coordinating contract based on a long- term contract with two parameters in which the business relationship is repeated, and the supplier is penalized for too little capacity and compensated for the exceeding part within the order. The results indicate long-term contracts increase the profit potential of the supply chain.