A dominant retailer's optimal pricing strategy to stimulate upstream innovation

Consider a basic two-echelon retailer-Stackelberg supply chain in which the supplier sells a product to a retailer, who in turns retails it to the consumers. The supplier has the opportunity to invest in process innovation to reduce his marginal production cost. However, due to the existence of the classical “double marginalization” and “hold-up” problems, the supplier will tend to invest less than what would be optimal from the perspective of the whole supply chain. The question we pose is: how to stimulate the supplier's innovation via appropriately designed contract format from the dominant retailer's perspective. We examined the performance of two contract formats (namely, markup-only commitment contract, and markup commitment with lump-sum payment contract) and our results show that, markup commitment with lump-sum payment contract always dominants the markup-only commitment contract, not only because it can effectively stimulate the supplier's innovation investment, but also it can full coordinate the supply chain.