Cost-sharing contracts and efficiency in a two-stage supply chain

This paper proposes an efficiency-enhancing contract mechanism in a two-stage supply chain. The model includes a buyer (the Original Equipment Manufacturer or OEM) who relies on a seller (the supplier) for key components. The self-interested supplier creates a level of capacity before demand is realised, but this level may not be optimal for the supply chain. Furthermore, the self-interested OEM may choose a suboptimal output price. The firms thus create a contract stipulating three factors: the OEM's output price, a fraction of the supplier's capacity costs to be paid by the OEM, and a fixed rebate paid from the supplier to the OEM. These factors can be chosen so that the efficient level of capacity is created, and both the supplier's and OEM's profits increase. Sensitivity analysis is then conducted to indicate the industry characteristics that make this type of contract most effective.