OM 1507 Supply Chain Management Indranil Biswas

Lecture Note Session 12

1. Choice of Decision Making

We first analyze single supplier single buyer supply chain (also known as dyadic supply chain) to
understand the impact of decision making (centralized or decentralized) on the profit level of these
supply chain agents (supplier or buyer). In order to facilitate this analysis, we consider the
following stylized model.

Supplier (S) Buyer (B) Finished Goods Market

Marginal Cost of Production = s Marginal Cost of Production = c Market Demand: q = a p

Figure 1: Dyadic Supply Chain

1.1. Model Description

Figure 1 depicts a single supplier single buyer supply chain model. The supplier produces either a
work-in-progress (WIP) or finished goods (FG) and sells it to the buyer. The buyer sells the
finished goods in the market. The buyer can either produce the FG after procuring WIP goods from
the supplier or can act as a retailer. In both scenarios, the buyer faces the final market demand and
the supplier faces a derived demand through the buyer.

In the aforementioned supply chain, the market demand of FG is given by the equation: q
= a p , where q is the demand of FG, p is retail price of FG, and a is the market potential
of the product. The marginal cost of production of the supplier is s and the marginal cost of
production of the buyer is c. In this context, we are going to analyze two types of decision
making: (i) centralized and (ii) decentralized.

1.1.1. Centralized Decision Making

We first analyze centralized decision making in a dyadic supply chain, i.e. when the supplier and
the buyer work as one entity and takes a combined decision about the retail price and the ordering

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OM 1507 Supply Chain Management Indranil Biswas

quantity. Such decision(s) can be taken either through an ex ante agreement or in a vertically
integrated structure. These optimal results for this case are also referred as Benchmark Decisions
for the supply chain. In this case, we assume that the supplier sells her products to the buyer at her
own marginal cost, s, in order to exploit the advantages of a vertically integrated supply chain.1

For the purpose of expositional simplicity, we also assume that the buyer uses 1 unit of
WIP for producing 1 unit of FG. Therefore the derived demand faced by the supplier is given by:
q S q .2

The overall supply chain profit ( SC ) in this case is given by the following expression:

SC p s c q p s c a p

* *
From the first order condition, the optimal retail price ( pSC ) and optimal order quantity ( q SC )
decisions can be computed as follows:

SC
0
p

a p p s c 0

pSC
*

1
a s c
2
*
Using this value of pSC the optimal order quantity is computed. It is shown below.

*
q SC a p SC
*

1
a s c
2

1
We can observe here that due to this decision of the supplier, the entire profit of the supply chain
is realized by the buyer and suppliers individual profit level would become zero. However, the
supplier does not necessarily make zero profit; as the buyer and the supplier are part of the same
entity, they can make an ex ante profit sharing agreement.
2
If the buyer requires n units of WIP to produce 1 unit of FG, then the derived faced by the
supplier would become: q S nq .

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OM 1507 Supply Chain Management Indranil Biswas

The optimal profit level of the supply chain is calculated as follows:

p SC s c q SC a s c 2
1
SC
* * *

4

From the second order condition we observe that the computed optimal retail price maximizes the
2 SC
overall supply chain profit level: 2 0 .
p 2

1.1.2. Decentralized Decision Making

In this section we analyze the decentralized decision making i.e. the supplier and the buyer are
separately trying to maximize their individual profit levels. Therefore the synergy in decision
making (as observed in the previous case of centralized decision making) does not exist any longer.
In this context we assume that the supplier sells her products to the buyer at a per unit wholesale
price w.3

Like the previous case, we also assume that the buyer uses 1 unit of WIP for producing 1
unit of FG, for the purpose of expositional simplicity. Therefore the derived demand faced by the
supplier is given by: q S q .

The profit level of the supplier ( S ) and that of the buyer ( B ) are given by the following
equations:

S w s qS w s q w s a p

B p w cq p w c a p

The analysis of optimal retail price, order quantity and individual profit level employs Stackelberg
Game. Like the Stackelberg model, here the supplier acts as a dominant (leader) firm; she moves
first and picks up her contract term(s) [in our case, contract term is simply the per unit wholesale

3
The supplier can enforce other sophisticated contract types, e.g. Two-part Tariff Contract, Menu
Contract, Quantity Discount Contract etc. for extracting more profit from the buyer. For the
purpose of this course, we are going to stick to simplest of them all, namely Wholesale Price
Contract.

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OM 1507 Supply Chain Management Indranil Biswas

price (w)]. Subsequently the buyer, who acts as a follower firm, observes the decision made by the
supplier and picks her order quantity (and in turn sets the retail price). Supplier acts as a
Stackelberg leader and buyer acts as a Stackelberg follower.

Since the games is a sequential move game with perfect information (i.e. Supplier and
Buyer are assumed to have perfect knowledge about retail price, ordering quantity, and production
methods [i.e. the marginal cost(s) of production] and other relevant information), we can solve it
with Backward Induction.4

The buyer moves first and she decides about her optimal order quantity (for a given
wholesale price level w). From the first order condition we calculate this decision as follows:

B
0
p

a p p w c 0

p * w a w c
1
2

Using this value of p* w the optimal order quantity for the buyer is calculated.

q * w a p * w a w c
1
2

Thus for a given value of w, the buyer sets her retail price and order quantity. Since it is a full
information game, the supplier can anticipate all these aforementioned moves by the buyer. After

4
Backward Induction: It is a method by which we can calculate the sub-game perfect equilibria
(SPE) in the case of sequential games. In this case, we first observe how the buyer (follower)
optimizes her own profit level by choosing her order quantity (the buyer essentially assumes that
the contract parameters chosen by the supplier are exogenous to her). Since this is a full
information game, the supplier can see (or anticipate) how the buyer has moved (or planning to
move) and based on that she makes her choice about contract agreement (i.e. sets the per unit
wholesale price).

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OM 1507 Supply Chain Management Indranil Biswas

observing the move of the buyer, the supplier proceeds and observes that her profit function has
taken the following form:

S w s q S w s q * w w s a w c
1
2

From the first order condition we calculate the optimal wholesale price level of the supplier and it
is given by the following expression:

S w
0
w

w s a w c 0

w*
1
a s c
2

Using this optimal wholesale price ( w* ) decision of the supplier, the buyer can calculate back her
* *
optimal retail price ( pDC ) and ordering quantity ( qDC ); they are given below.

*
p DC
1
2
4

a w* c 3a s c
1

*
q DC
1
2
4

a w* c a s c
1

Based on these optimal parameters, the optimal profit level of the supplier and the buyer can be
calculated.

S*
1
a s c 2 ; B* 1 a s c 2
8 16

Therefore the total profit level attained by the entire supply chain is:

S* B*
1
a s c 2 1 a s c 2 3 a s c 2
8 16 16

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OM 1507 Supply Chain Management Indranil Biswas

We can further observe here (i) the sub-game perfect equilibria of the Stackelberg game is also a
Nash equilibrium, (ii) the sub-game perfect equilibria is unique, and (iii) with perfect information,
the sub-game perfect equilibria of the game is a pure strategy.5

1.1.3. Comparison between Centralized & Decentralized Decision Making

In this section we compare the optimal retail price, order quantity, and profit level(s) between
centralized and decentralized decision making.
*
First we compare decentralized supply chain retail price level ( pDC ) to that of centralized
*
supply chain ( pSC ).

*
p DC p SC
*

1
3a s c 1 a s c 1 a s c 0
4 2 4

The optimal retail price level increases as the supply chain decision making changes from
centralized structure to decentralized structure.
*
Second, we compare the decentralized supply chain ordering quantity ( qDC ) to that of
*
centralized supply chain ( q SC ).

*
q DC q SC
*

1
a s c 1 a s c 1 a s c 0
4 2 4

This change in optimal ordering quantity is also evident from the optimal retail prices; as the
demand function is linear in nature, therefore increase in retail price inevitably leads a reduction
in the ordering quantity. The optimal ordering quantity for centralized supply chain is also known
as the Benchmark Ordering Quantity. The entire literature of supply chain coordination focuses
on designing contractual instruments so that even in the case of decentralized supply chain this
benchmark ordering quantity can be achieved.

Finally, we compare between the overall supply chain profit levels. In the case of
decentralized supply chain the overall supply chain level is summation of the profit levels of
individual supply chain agents, i.e. sum of suppliers and buyers profit levels ( DC
*
S* B* ).

5
The proof of each of these statements are not a part of this course.
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OM 1507 Supply Chain Management Indranil Biswas

In the case of centralized supply chain, the entire profit of the chain is realized by the retailer and
it is expressed by: SC
*
.

DC
*
SC
*
S* B* SC
*

1 2
a s c a s c a s c a s c
2 1 1 2 1 2

8 16 4 16

Here we can observe that the overall supply chain profit has decreased as the supply chain decision
making has been altered from centralized to decentralized. In the context of decentralized supply
chain, as the supplier and the buyer separately try to maximize their individual profit levels, the
synergy in decision making (compared to the case of centralized decision making) does not exist
any longer and it leads to supply chain channel inefficiency. In order to capture this lost profit,
supplier firm often designs sophisticated contract terms.

2. Bargaining in a Supply Chain

In a supply chain, the supplier typically makes the contract offer, rather than the buyer. However,
from the standpoint of theoretical analysis which firm is offering the contract hardly matters
because we seek to identify the contractual agreement that can coordinate the supply chain (i.e.
Benchmark Ordering Quantity should be agreed upon by the supplier as well as the buyer) and
allocates the total profit level of the supply chain among the agents (supplier and buyer). In this
context, it is unlikely in practice that either firm (supplier or buyer) makes a single offer which is
regarded as the final offer. Instead, firms (supplier or buyer) are likely to make many offers and
counter offers before they settle on some agreement. The contract that is actually adopted at the
end of the negotiation process depends on the firms relative bargaining power. The concept of
bargaining power is easy to understand but difficult to quantify.

In the previous discussion (Section 1) we implicitly assumed that both the supplier and the
buyer hold similar bargaining power in the supply chain and thus the leader-follower Stackelberg
game helps us in analyzing the behavior of supplier and the buyer. However, in real life we find
many instances where one of the supply chain agents (supplier or buyer) holds very high
bargaining power over the other (these instances have been discussed in the class). In these
circumstances, the sub-game perfect equilibrium strategies captures the behavior of the supply

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OM 1507 Supply Chain Management Indranil Biswas

chain agents. We are going to analyze the specific case of buyer holding higher bargaining power
in sub-section 2.1.

2.1. Buyer holds bargaining power over Supplier

If the buyer holds higher bargaining power over the supplier, then the Stackelberg bargaining game
takes the following structure:

max B p w c a p
p

s.t. S w s q S

where, S represents the Reservation Profit Level of the supplier. A standard approach to model
bargaining power is to assume one of the firms (in this case supplier) has (an exogenous)
Reservation Profit Level 6, i.e., the firm accepts only a contract that yields that reservation level.
The higher the reservation level, the higher is the firms bargaining power.

In the case of full information game, the buyer firm knows the reservation profit level of
the supplier and can design a contractual agreement in such a way that the supplier makes only her
reservation profit level ( S ). Therefore, in this case the wholesale price can be expressed as

S S
follows: w p s s ; it directly follows from the aforementioned constraint. Using
q a p
this expression for wholesale price, w p , we can calculate the buyers profit level as follows:
B p p s c a p S . Here optimization of buyers level can be done following the
*
method presented in sub-section 1.1.1, and the optimal retail price ( pSG ) is expressed as follows:

*
p SG
1
a s c
2
*
The optimal retail price is equal to that of centralized supply chain: p SG p SC
*
. Therefore the
optimal ordering quantity in this case is equal to the benchmark ordering quantity:

6
Typically, any firm (supplier or buyer) has an outside opportunity for earning (for instance: (i)
the supplier can trade with another buyer, (ii) the buyer can earn by allocating the shelf space of
her store to another suppliers product) and this provides the firm with an idea about her own
reservation profit level. If the offered contractual agreement is not sufficiently attractive, either of
the supply chain agents will refuse to trade.
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OM 1507 Supply Chain Management Indranil Biswas

*
qSG a p SG
*
a p SC
*
q SC
*
. Algebraic simplification further yields the optimal profit level of

the buyer is: B* SC

*
S , and that of the supplier is: S* S . Thus the buyer is able to
coordinate the entire supply chain when she holds sufficiently higher bargaining power than the
supplier and she is able to extract the entire profit of the supply chain after providing the supplier
with her reservation profit level only.

Bibliography

1. Cachon, G. P. (2003). Supply chain coordination with contracts. Handbooks in operations

research and management science, 11, 227-339.
2. Corbett, C. J., Zhou, D., & Tang, C. S. (2004). Designing supply contracts: Contract type
and information asymmetry. Management Science, 50(4), 550-559.
3. Mas-Colell, A., Whinston, M. D., & Green, J. R. (1995). Microeconomic theory (Vol. 1).
New York: Oxford university press.
4. Osborne, M. J., & Rubinstein, A. (1994). A course in game theory. MIT press.
5. Ertogral, K., & Wu, S. D. (2001). A bargaining game for supply chain contracting. Pre-print.