Strategic Commitment To Price To Stimulate

European Journal of Operational Research 150 (2003) 617–639
www.elsevier.com/locate/dsw
Production, Manufacturing and Logistics
Strategic commitment to price to stimulate

downstream innovation in a supply chain
a,* b
Stephen M. Gilbert , Viswanath Cvsa
a
Management Department, The University of Texas at Austin, CBA 4.202, Austin, TX 78712, USA
b
McKinsey & Co., Inc., 1301 East 9th Street, Cleveland, OH 44114, USA
Received 13 November 2000; accepted 3 July 2002
Abstract
It is generally in a firmÕs interest for its supply chain partners to invest in innovations. To the extent that these
innovations either reduce the partnersÕ variable costs or stimulate demand for the end product, they will tend to lead to
higher levels of output for all of the firms in the chain. However, in response to the innovations of its partners, a firm
may have an incentive to opportunistically increase its own prices. The possibility of such opportunistic behavior
creates a hold-up problem that leads supply chain partners to underinvest in innovation. Clearly, this hold-up problem
could be eliminated by a pre-commitment to price. However, by making an advance commitment to price, a firm
sacrifices an important means of responding to demand uncertainty. In this paper we examine the trade-off that is faced
when a firmÕs channel partner has opportunities to invest in either cost reduction or quality improvement, i.e. demand
enhancement. Should it commit to a price in order to encourage innovation, or should it remain flexible in order to
respond to demand uncertainty. We discuss several simple wholesale pricing mechanisms with respect to this trade-off.
Ó 2002 Published by Elsevier B.V.
Keywords: Channel coordination; Channels of distribution; Industrial organization; Cost reducing R&D
1. Introduction
In many industrial environments, the innovations that are performed by one firm provide benefits for the
entire supply chain. Consider, for example, the partnership between Toshiba and Sony in which Toshiba
provides customized integrated circuits for the Playstation 2 product. Clearly both firms benefit from one
anotherÕs innovations. Such interdependency also characterizes the relationship among Intel, Microsoft,
and the producers of personal computers. The marketÕs willingness to purchase PCs containing the most
recent generation of IntelÕs integrated circuits depends on the extent to which Microsoft innovates to create
software that customers perceive as useful. The demand for IntelÕs products may also depend upon in-
novations from the personal computer manufacturers that either make their systems more appealing to the
market (e.g. Dell investing in infrastructure to provide customer support services), or that lead to less
*
Corresponding author. Tel.: +1-512-471-9456; fax: +1-512-471-3937.
E-mail addresses: steve.gilbert@bus.utexas.edu (S.M. Gilbert), vishy_cvsa@mckinsey.com (V. Cvsa).
0377-2217/03/$ - see front matter Ó 2002 Published by Elsevier B.V.

doi:10.1016/S0377-2217(02)00590-8
618 S.M. Gilbert, V. Cvsa / European Journal of Operational Research 150 (2003) 617–639
expensive assembly, better inventory management, or otherwise decrease marginal costs and tend to lead to
lower personal computer prices.
Recently, Intel announced a $ 100M investment in developing a lab that will assist OEMs in the de-
velopment of e-business applications using Intel architecture-based servers. This announcement not only
suggests that Intel has a strong interest in stimulating innovation among its downstream supply chain
partners, it also suggests that these other firms tend to underinvest in innovation relative to what would be
optimal from the perspective of Intel.
In general, innovation can be characterized as either cost reducing or as demand enhancing. When in-
novation allows a firm to reduce its marginal costs, then that firm tends to set prices lower and produce
higher quantities of output, benefiting its customers and suppliers respectively. Innovation that increases
the perceived value of the final product can be characterized as demand enhancing because it tends to
increase the number of customers willing to purchase at a given price.
For both of these types of innovation, there are two main forces that can cause a firm to underinvest
relative to what would be most beneficial to either their partners or to the supply chain as a whole. First,
since a portion of the benefits from either a demand enhancing or a cost reducing innovation would
spillover to its supply chain partners, its investment decision is affected by a benefit externality, and it ig-
nores the portion of benefits that spillover. This effect is very similar to the well-known double-marginal-
ization effect that arises in supply chain pricing decisions. As with the double-marginalization effect, this
benefit externality cannot be eliminated with linear, i.e. single-part, pricing mechanisms which are extremely
common in practice.
The second force that causes a firm to underinvest is the fear of supplier opportunism among its supply
chain partners. For example, suppose that, in preparation for the next generation of PC, Dell invests in
developing a design that is less expensive to assemble. After observing DellÕs innovative design, Intel or
other suppliers could have an incentive to respond by setting prices higher than they otherwise would. In
other words, by investing in innovation, a firm subjects itself to the possibility of being held-up by its
partner(s). As discussed in Fine (1998), the potential for this sort of hold-up issue is greatest in supply
chains that involve modular product designs and where a firm depends upon its partner(s) for both
knowledge and capacity. This description seems very appropriate for supply chains in the computer in-
dustry where the components of a computer system: integrated circuits, monitors and peripherals, oper-
ating systems, etc., are typically provided by independent firms that depend upon one another for both
knowledge and capacity.
In the absence of market uncertainty, a firm could costlessly eliminate this latter reason for its supply
chain partner to underinvest by making a commitment to price before the investment decision is made. (Intel
could do this either by committing to a forward contract or, given the strength of its reputation, it could
effectively make such a commitment simply by publicly announcing the anticipated prices of its next gen-
eration of integrated circuits.) However, when demand uncertainty is significant, such commitment is not
without cost: Investments in innovation often have long lead times, and decisions to undertake such projects
often must be made when there is a great deal of uncertainty about demand, whereas pricing and quantity
decisions can often be delayed until there is at least better information about demand. Thus, if a firm is going
to make a commitment to price in order to encourage investment, it must sacrifice the flexibility to respond to
this improved information. However, as has been noted by VanMieghem and Dada (1999), wholesale pricing
flexibility can often serve as an important buffer against market uncertainty. Thus, we have the following
trade-off: By maintaining wholesale price flexibility, a firm can buffer itself against uncertain demand, but
by doing so it may also discourage its supply chain partners from investing in innovation.
In this paper we consider the issue by studying the relationship between a supplier and a downstream
buyer who has an opportunity to invest in either cost-reducing or demand-enhancing innovation. This is a
reasonable representation of how a firmÕs advance commitment to price affects its downstream channel
partnersÕ investment in innovation. To focus attention on the trade-off between encouraging innovation and
S.M. Gilbert, V. Cvsa / European Journal of Operational Research 150 (2003) 617–639 619
maintaining flexibility, we model the interaction as a bilateral monopoly, leaving the effects of competition
in either the upstream or downstream markets to future research.
We use our model to examine three variations of a linear contract: One in which the supplier retains
pricing flexibility until after the buyerÕs innovation has come to fruition and demand uncertainty has been
resolved; one in which the supplier makes a full commitment to a wholesale price in advance of both cost
reduction and resolution of demand; and one in which the supplier guarantees that the wholesale price will
be no higher than a specified ceiling, but may be lower if the market response is poor. In practice, any
contract in which the supplier commits to a price but the buyer retains quantity flexibility can be interpreted
as a ceiling contract since the supplier can always lower her price in response to demand information if it is
in her interest to do so. The key features of our paper are that it identifies this trade-off between pricing
flexibility and strategic commitment to induce downstream innovation, and that it provides insight into
how simple contracts that are commonly used in practice can be used to manage it.
The remainder of our paper is organized as follows. In Section 2, we review the relevant literature. In
Section 3 we develop and analyze investment in innovation for both fully flexible and fully committed
wholesale prices. We draw upon these results in Section 4 where we analyze a ceiling contract that allows
partial flexibility to decrease the wholesale price. In Section 5, we provide a numerical example, and in
Section 6 we summarize the managerial implications of our results.
2. Literature review
There is a significant literature devoted to identifying ways in which innovation during the design of a
product can help reduce the variable cost of production. For example, Daetz (1987) describes ways in which
the number of parts in a product can be reduced, and claims that assembly cost is roughly proportional to
the number of parts. Whitney (1988) provides examples of how Volkswagen and Nippondenso, among
others, have reduced assembly costs by innovative part number reductions and claims that 70–80% of
manufacturing cost is determined in the design stage.
A number of other authors have considered the way in which innovative product design can reduce the
costs of logistics. Specifically, Lee et al. (1993) identified this issue in their discussion of the modular design
of the desk-jet printer at Hewlett–Packard that allowed product differentiation to occur at decentralized
locations. They identify several ways in which a modular design can result in lower shipping and inventory
costs, and they also suggest that such a design may require significant investments in engineering resources
as well as in technology to perform the differentiation de-centrally. A number of other papers, including Lee
(1996), Lee and Tang (1997), Lee and Tang (1998), Lee and Billington (1994), Gupta and Krishnan (1998)
and Swaminathan and Tayur (1999), discuss issues related to how innovation during design can facilitate
lower logistical and inventory costs.
Although the above research provides a solid theory for how production and logistical costs should be
considered during the design of a product, it has little to say about the interactions among firms in a supply
chain. Until recently, such interactions were primarily studied in the economics/industrial organization
literature. A good general overview of this literature as it relates to contractual vertical relationships is
provided by Katz (1989). In a paper that is more specifically related to the trade-off that we are studying,
Klein et al. (1978) provide an excellent discussion of how and when relationship-specific investments can
create the possibility of opportunistic behavior among vertically related firms. However, their paper tends
to focus on understanding when vertical integration is preferred to de-centralization.
In contrast to this, the primary focus of our research is to understand how practical contractual forms
affect the incentive structure of the firms in the supply chain. This approach is common to much of the
literature on supply chain contracting, and thorough reviews can be found in Lariviere (1998) and Tsay
et al. (1998). However, the existing work in this area has focused almost exclusively on how contracts affect
decisions regarding either capacity or inventory. A noteworthy exception to this is the recent paper by
Corbett and DeCroix (2001), that analyzes how a contract can encourage a supplier of indirect production
materials to participate in reducing the amount of its product that is consumed.
A portion of the supply chain contracting literature does consider contracts that require firms to sacrifice
some dimension of operational flexibility. For example, Li and Kouvelis (1999) develop a model that values
supply contracts that afford a buyer different types and amounts of flexibility to exploit changes in the price
of a commodity prior to an anticipated requirement for it. Bassok and Anupindi (1997) and Tsay et al.
(1998) examine contracts that require the buyer to consume at least some minimum threshold quantity.
Tsay and Lovejoy (1999) consider a related contractual form in which the buyer is restricted in the amount
by which he can update his forecasted order quantities.
A common assumption in nearly all of the supply chain contracting literature is that both demand and
variable costs are assumed to be exogenous. However, in practice decisions relating to demand enhance-
ment and cost reduction can have a significant impact on the performance of a supply chain. For example,
Dewan et al. (2000) describe the interactions among Internet service providers, proprietary content pro-
viders (PCPs), and Telecommunications firms as being ‘‘simultaneously competitive and cooperative’’.
They demonstrate that PCPs clearly benefit when telecommunications or internet access fees decrease, but
they do not address the issue of how or what these PCPs can or should do to influence these fees.
We are aware of very few papers that look specifically at how a firm can influence either the costs or the
demand in another industry. Maksimovic (1990) demonstrates how bank loan commitments can increase
the equilibrium output in a duopoly by effectively decreasing the marginal cost of production. Two other
papers, examine the ways in which a vertical contract affects innovation. Gupta and Loulou (1998) dem-
onstrate that a franchising arrangement, which allows a manufacturer to capture retail level profits through
a lump sum payment, can discourage the manufacturer from reducing its costs. Harhoff (1996) analyzes the
effect of subsidizing R&D in a downstream industry, and shows that, although R&D subsidies tend to
stimulate competition by increasing entry, a larger number of firms tends to depress the within-industry
R&D investment per firm.
One of the key features of our paper is that it considers the trade-off that the upstream firm faces between
pricing flexibility and strategic commitment. As shown by VanMieghem and Dada (1999), if a firm has
flexibility to adjust its price in response to demand, then its capacity investment and production quantity
decisions are relatively insensitive to uncertainty. Although VanMieghem and Dada (1999) extend their
analysis to competitive settings, they do not consider the trade-off between strategic commitment and
flexibility that can be faced by an individual firm. However, both Appelbaum and Lim (1985) and Spencer
and Brander (1992) do address such a trade-off within the context of a single level (industry) of a supply
chain. Both of these papers examine how market uncertainty affects a firmÕs willingness to make a strategic
quantity commitment in a contestable market. This contrasts with our paper in which we look at how a
strategic commitment to price by one firm affects actions taken by channel partner.
3. The model
To gain insight into the trade-off that a firm faces between maintaining price flexibility and encouraging
its supply chain partners to innovate, we consider a bilateral monopoly in which the downstream firm has
an opportunity to invest in innovation that will either enhance demand for its product or reduce its
marginal production costs. Throughout the paper, we adopt the convention of using the pronouns she and
he to refer to the supplier and the buyer respectively.
We assume that both firms have access to the same information, and although we assume that the
supplier can observe the results of the buyerÕs investment in innovation, we do not consider contracts that
are explicitly contingent upon these results. For example, a supplier may be able to estimate a buyerÕs
variable costs from observations of product or process designs, but formal measures of such costs are
notoriously imprecise, and enforcing a contract that is explicitly contingent upon such costs would be
extremely difficult. As discussed previously, our interest is in understanding how the incentive structure is
affected by simple contracts that are easily implemented and observed in practice. Thus, we restrict our
attention to single-part pricing mechanisms, mainly due to their prevalence in practice.
In practice, investments that have the most significant impact on a productÕs appeal or variable pro-
duction cost typically happen during design. (According to Whitney (1988), 70–80% of manufacturing cost
is determined during design.) We model this by assuming that the downstream firm must decide how much
to invest before demand uncertainty is resolved. Under this assumption, we examine the way in which the
supplierÕs ex ante commitment to wholesale price affects the buyerÕs investment and various measures of
supply chain performance.
To model the base-case demand in the market that is served by the buyer, let us assume that the inverse
demand function is linear in the quantity produced. In particular, let q be the quantity, and define the
market clearing price as follows:
pðqÞ ¼ a þ q
where a is a positive constant and is an additive error term, with density f ðÞ, mean of 0, standard de-
viation of r, and positive support in the range ðmin ; max Þ. In order to examine the trade-off between
strategic commitment and flexibility, it is important that we be able to represent the fact that it may be
possible for a firm to postpone decisions regarding quantity and (or) price until improved information is
available about demand. For ease of exposition, we represent this state of improved information as the state
of perfect information, i.e. postponed decisions are made after observing the realization of .
The supplierÕs variable production cost is Cs , and the buyerÕs variable cost, prior to any investment is Cb .
For the sake of simplicity, we assume a þ min > Cs þ Cb . This assumption, which is similar to the ones
made by Spencer and Brander (1992) and by Appelbaum and Lim (1985), implies that for every realization
of demand, there exists a non-zero quantity of output for which the market clearing price is greater than the
marginal cost of production. By allowing us to avoid consideration of situations in which the buyer op-
timally responds to low realizations of demand by selling nothing, this assumption simplifies the presen-
tation of our results. However, it does not alter the basic trade-offs that we identify.
To model the buyerÕs investment in innovation, let r be the maximum amount of cost reduction (demand
stimulation) that can be attained via the buyerÕs innovation. Define fraction h to be the fraction of this
maximum that results from an investment of Ih2 , where I is some positive constant. Thus, by investing Ih2
the buyer can reduce his marginal costs (shift demand) by hr. Note that the quadratic form of the in-
vestment function represents diminishing returns.
For cases in which our model represents investment in cost reducing innovations, we assume that r 6 Cb .
This allows us to consider situations where the buyerÕs cost consists of several components, not all of which
are controllable. For example, although the buyer might be able to eliminate some assembly costs by re-
ducing the number of parts (as suggested by Daetz (1987) among others), all costs are not avoidable. The
gap between r and Cb represents these unavoidable costs.
For cases in which our model represents investment in demand stimulating innovations, the buyerÕs
investment can be interpreted as increasing the margin, mðq; w; hÞ, that the buyer earns for a given quantity
(q) and wholesale price (w) by an amount rh, i.e.
mðq; w; hÞ ¼ pðqÞ w Cb þ rh
where r represents an upper limit on the amount by which the buyer can stimulate demand, e.g. through
advertising or developing a product that is perceived as more valuable. As before, an investment of Ih2 is
required to achieve fraction h of the maximum stimulation. Note that for demand enhancing investments,
we no longer require the restriction that r 6 Cb .
To guarantee that the profit functions be concave in the amount invested, we require that it not be too
cheap to reduce costs or stimulate demand. Specifically we require that 3I > r2 . However, it is worth noting
that, as described by Gupta and Loulou (1998) in their analysis of how innovation is influenced by channel
structure, this relationship is typically satisfied easily by practical investment opportunities.
In what follows, we investigate several levels of flexibility in the wholesale pricing between the supplier
and the buyer. Throughout our analysis, we assume that the buyer must make his investment before de-
mand uncertainty is resolved. This is based on the observation that product and process design issues
typically have to be resolved before the time at which production quantities must be determined. At the
time that these production quantities must be determined, improved information about demand may or
may not be available.
First, we consider the case of complete wholesale pricing flexibility where the wholesale price is deter-
mined only after the buyer has determined how much to invest and the demand uncertainty has been re-
solved. We then consider the case of complete wholesale price commitment, where the supplier commits to
a wholesale price prior to both the buyerÕs cost reduction and the realization of demand. To assess the effect
of the buyerÕs operational flexibility, we consider as a sub-case the situation where he cannot postpone his
quantity decision until after demand uncertainty is resolved. This sub-case is particularly important since
requiring the buyer to make an early quantity commitment is one way in which the supplier can make her
own commitment to price credible. Finally, we analyze what we refer to as a ceiling wholesale price, in
which the supplier makes advance commitment to only an upper bound on the wholesale price, reserving
the option to charge lower wholesale prices once demand uncertainty is resolved.
3.1. Fully flexible wholesale price
In this section we consider what happens when the supplier remains fully flexible by delaying the an-
nouncement of wholesale price until after demand information is revealed. Thus, the buyer must determine
how much to invest with no guarantee regarding the wholesale price that will be offered by the supplier. This
analysis implicitly assumes that lead times for innovation are long relative to production lead times. Spe-
cifically, the buyer must make advance commitment to the level of innovation, but he can postpone his
production quantity decision. For example, when a PC manufacturer prepares to introduce the next gen-
eration of machine, it has to determine the amount of engineering resources to devote to reducing the number
of parts, developing a modular design, etc. prior to when it commits to specific production quantities. When
it does commit to production quantities, it can do so with the benefit of improved market information.
This situation can be modeled as the following leader–follower game: The buyer moves first by deter-
mining the fraction (h) of the maximum cost reduction (demand enhancement) in which to invest. After
demand is observed, the supplier reacts to both demand and the effect (rh) of the buyerÕs innovation by
announcing a wholesale price (w). Finally, the buyer responds by choosing a quantity (q). Note that this
model presumes that the supplier can observe the result of the buyerÕs innovation prior to announcing her
wholesale price. This implies that the supplier can observe product and process designs as well as interpret
their effects on either production costs and or market response. In practice, the supplierÕs ability to do this is
likely to be imperfect. Our assumptions should be viewed as an analytically tractable representation of a
situation in which the supplier has significantly better, though perhaps imperfect, information about the
buyerÕs costs and or market response immediately prior to launch.
The above game can be analyzed using backward induction. At the final stage of this game, the buyer
takes as given: the realization of demand uncertainty (), the wholesale price (w), and the amount (hr) by
which he has reduced his own costs (shifted demand), and determines an order quantity (q) that maximizes
the following profit function:
pb ð; h; w; qÞ ¼ qða þ q w Cb þ hrÞ Ih2 : ð1Þ
It is easy to see that pb ð; h; w; qÞ is concave in q. From first-order conditions, we can see that the buyerÕs
optimal order quantity satisfies

qð; h; wÞ ¼ Max 0; 12ða þ w Cb þ hrÞ : ð2Þ
Thus, when the supplier reacts to the realization of demand and sets a wholesale price, she does so with
anticipation that the buyer will react as shown above. Thus, the supplier sets the wholesale price to
maximize the following profit function:
ps ð; h; wÞ ¼ ðw Cs Þqð; h; wÞ:
It is easy to see that the above function is concave for w < a þ Cb þ hr, and that the supplierÕs optimal
wholesale price response to the realization of demand and the buyerÕs innovation is
wð; hÞ ¼ 12ða þ þ Cs Cb þ hrÞ: ð3Þ
Note that the assumption that a þ min > Cs þ Cb guarantees that the wholesale price and quantity will
be positive for all realizations of demand. We have now established how the game will be resolved once
demand information is revealed. At the time that the buyer makes his investment, he anticipates these
responses for every realization of demand, and seeks to maximize his expected profits. By substituting (2)
and (3) into (1) and integrating over , these expected profits can be expressed as the following function of
the buyerÕs decision, h, the fraction of total available costs to eliminate:
2
ða Cs Cb þ hrÞ r2
pFF
b ðhÞ ¼ þ Ih2
16 16
where the two superscripts on the buyerÕs profit refer to the level of flexibility of the supplier and buyer
respectively. The first F refers to the supplierÕs flexibility to postpone her wholesale pricing decision until
after observing demand, and the second F refers to the buyerÕs flexibility to postpone his quantity decision
until after observing demand.
2 2
It can be confirmed that pFF b ðhÞ is concave so long as r 6 16I. Recall, that, by assumption r 6 3I, so it
follows that first-order conditions are sufficient to characterize the optimal amount of innovation for the
buyer:
r
hFF ¼ ða Cs Cb Þ: ð4Þ
16I r2
Note that the buyerÕs investment depends only on the first moment of the demand distribution, and is
insensitive to demand variance. This observation is similar to the result that was obtained by VanMieghem
and Dada (1999) for a single firmÕs capacity investment decision. In both their model and ours, the in-
vestment decision is independent of demand variance only so long as the quantity response function is
linear in the realization of demand. In our model, the linearity of the response function is assured by the
assumption of unconstrained capacity, and the assumption that a þ min > Cs þ Cb , which insures that there
will be a non-zero quantity of output for even the lowest demand realization. Although these assumptions
are somewhat restrictive, it would not be possible to obtain a closed form expression for hFF without them.
Moreover, we do not believe that relaxing these assumptions would significantly enhance the managerial
insights that our model allows.
By substituting (4) back into (2) and (3), and integrating over , we can see that the expected flexible
wholesale price and quantity, E½w and E½q for case FF are shown in the first column of Table 1. From
these expressions, it can be observed that the expected wholesale price and quantity are increasing in the
parameter (r) which represents the maximum potential for cost reduction (demand enhancement). The
higher wholesale price is the result of the fact that the supplierÕs optimal ex post wholesale price is in-
creasing in the amount by which costs are reduced or demand is shifted upward. Once the buyer invests,
the supplier has an incentive to increase the price. The larger quantity occurs in spite of the higher
Table 1
Comparison of wholesale pricing flexibility
Case FF (flexible wholesale price Case CF (committed wholesale Case CC (committed wholesale
flexible quantity) price flexible quantity) price flexible quantity)
r r r
h ða Cs Cb Þ ða Cs Cb Þ ða Cs Cb Þ
16I r2 2ð4I r2 Þ 2ð4I r2 Þ
8I 1 1
E½w ða Cs Cb Þ þ Cs ða þ Cs Cb Þ ða þ Cs Cb Þ
16I r2 2 2
4I I I
E½q ða Cs Cb Þ ða Cs Cb Þ ða Cs Cb Þ
16I r2 4I r2 4I r2
32I 2 r2 I I ða Cs Cb Þ2
E½ps ða Cs Cb Þ2 þ ða Cs Cb Þ2
ð16I r 2 Þ2 8 2ð4I r2 Þ 4I r 2 2
I r2 I r2 I
E½pb ða Cs Cb Þ2 þ ða Cs Cb Þ2 þ ða Cs Cb Þ2
16I r 2 16 2
4ð4I r Þ 4 4ð4I r2 Þ
48I r2 3r2 3I r2 3I
E½pc Iða Cs Cb Þ2 þ ða Cs Cb Þ2 þ ða Cs Cb Þ2
ð16I r 2 Þ2 16 2
4ð4I r Þ 4 4ð4I r2 Þ
wholesale price because the effect (hr) of the investment in innovation dominates the effect of the increased
price.
Finally, the expected profits of the supplier, the buyer, and the channel, denoted by E½pFF FF
s , E½pb ,
FF
E½pc respectively, can be computed. The results of these computations are presented in the first col-
umn of Table 1, along with the buyerÕs amount of innovation and expected wholesale price and
quantity. In the table, it can be observed that the expected profits for the supplier, the buyer, and the
supply chain are increasing in the variance of demand. This is consistent with the comparisons that are
often made between operational flexibility and financial options. However, it is worth pointing out that
this result is based on the assumption that, under the flexible wholesale price, no advance commitment
must be made to quantity so that all production decisions are made after the realization of demand is
observed.
3.2. Full commitment to wholesale price with postponed quantity
In this section, we investigate the situation in which the supplier commits to a wholesale price in advance
of the buyerÕs investment and the realization of demand. For now, we continue with the assumption that
although the buyer invests prior to the realization of demand, he can postpone his quantity decision. This is
intended to represent situations in which the buyer has the benefit of improved information when he makes
his production quantity decision than he had when he made product design decisions.
We model this as the following leader–follower game: While demand uncertainty remains unresolved,
the supplier acts as a leader by committing to a wholesale price that is not contingent upon either demand
or the investment of the downstream firm, and the buyer responds by determining h, the fraction of the
maximum cost reduction (demand enhancement), in which to invest. Finally, after demand information is
revealed, the buyer makes a quantity decision.
As before, this game can be analyzed using backward induction. In the final stage, the buyerÕs profit and
optimal order quantity are as shown in (1) and (2). When the buyer makes his investment decision, he now
faces uncertainty about demand, but the supplierÕs wholesale price is no longer contingent upon the re-
alization of demand. Thus, when the buyer invests, he takes the wholesale price as given and seeks to
maximize the following profit function with respect to his investment decision, h:
Z max
E½pCF
b ða; w; hÞ ¼ ðqð; h; wÞða þ qð; h; wÞ w Cb þ hrÞ Ih2 Þf ðÞ d
min
2
ða w Cb þ hrÞ þ r2
¼ Ih2 : ð5Þ
4
Recall that the two superscripts on the buyerÕs profit refer to the level of flexibility of the supplier and
buyer respectively. The C refers to the supplierÕs ex ante commitment to wholesale price, and the F refers to
the buyerÕs flexibility to postpone his quantity decision.
From first order conditions, we can see how the buyerÕs optimal amount of innovation depends upon the
supplierÕs commitment to wholesale price:
r
hCF ðwÞ ¼ ða w Cb Þ: ð6Þ
4I r2
Note that the buyerÕs cost reduction is decreasing in w. A lower wholesale price means that for a given
mark-up, the buyer will have higher volumes, and at higher volumes, a given amount of cost reduction
(demand enhancement) puts more money in the buyerÕs pocket. Note also that, as was true for case FF , the
buyerÕs investment depends upon the demand distribution only through its first moment.
We can now consider the supplierÕs problem of determining the price to which to commit. When she
commits to a wholesale price, she does so anticipating the buyerÕs ex ante amount of innovation, hCF ðwÞ,
and the quantity, qð; hCF ðwÞ; wÞ, with which he would respond to any realization of demand. Thus, using
(2) and (6), it can be shown that the supplierÕs expected profits are the following function of her committed
wholesale price w:
2I
E½pCF
s ðwÞ ¼ ðw Cs Þða w Cb Þ: ð7Þ
4I r2
From first order conditions, it can be seen that the optimal wholesale price to which the supplier will
commit is
a þ Cs Cb
wCF ¼ :
2
By substituting back into (6) and (2), we can see how the buyerÕs amount of innovation and order
quantity (for any given realization of demand) depends upon the original parameters. The expected amount
of buyer innovation, E½hCF , order quantity, E½qCF , and the expected profits of the supplier, buyer and the
supply chain as a whole are listed in column 2 of Table 1.
By comparing the first two columns of Table 1, there are several observations that can be made about the
effects of the supplierÕs pricing flexibility when the buyer can postpone his quantity decision:
(1) The amounts of innovation (h) are presented in the first row of Table 1. By comparing cases FF and CF
in this row, it can be seen that hCF > hFF , i.e. the supplierÕs commitment to wholesale price results
in more innovation by the buyer.
(2) The expected wholesale prices are given in the second row of Table 1. (Note that under committed
wholesale prices, we refer to the price to which the supplier commits as the expected wholesale price.)
It is interesting to observe that the price to which the supplier would commit is lower than the expected
price that she would offer if she remained flexible. This is in spite of the facts that a committed wholesale
price results in more downstream innovation and that wholesale prices are typically increasing when
either downstream costs are lower or demand is larger. The intuition for this is as follows: Under flex-
ible pricing, the only effect of lowering the wholesale price is the stimulation of demand. Under com-
mitted prices, the supplier has stronger incentive to decrease her price due to the additional effect of
stimulating the buyerÕs investment in innovation.
(3) The expected output quantities are given in the third row of Table 1. It can be seen that, as a result of
the increased investment and lower expected wholesale price, E½qCF > E½qFF , i.e. the expected amount
sold increases when the supplier commits to wholesale price.
It is also of interest to understand how demand variance affects the supplierÕs preference between
commitment and flexibility as well as how it affects supply chain performance. The following proposition
characterizes the role of demand variance:
Proposition 1. (a) For a given amount of expected demand ðaÞ, there exists a threshold of variance, K0 , such
that for r2 < K0 , the supplier prefers commitment to wholesale price, while for r2 > K0 , she prefers to remain
flexible. (b) Regardless of the level of demand variance, the buyer’s expected profits are always larger if the
supplier commits in advance to a wholesale price than if he remains flexible. (c) Regardless of the level of
demand variance, the supply chain profits are always larger when the supplier commits in advance to a
wholesale price.
This result, which explicitly accounts for the role of strategic commitment, contrasts with the traditional
view that a (monopolist) firm would always be better off if it could postpone its pricing decision until
demand uncertainty is revealed. It is interesting to compare this result with that of Appelbaum and Lim
(1985) who considered the trade-off between strategic commitment and flexibility in a duopoly, and showed
that an incumbent firm will prefer to remain flexible over making a strategic commitment beyond a
threshold amount of demand uncertainty. Although part (a) of the above proposition is consistent with
this, parts (b) and (c) indicate that the buyer and the supply chain as a whole are always better off when the
supplier makes a strategic commitment. This occurs because of the fact that the supplierÕs price commit-
ment eliminates the possibility that she will later exploit the buyerÕs investment with higher wholesale prices.
Thus, price commitment tends to stimulate innovation by making investment more attractive to the buyer.
Moreover, because the buyer retains pricing flexibility, the chain as a whole is able to respond to demand
uncertainty in spite of the supplierÕs wholesale price commitment.
3.3. Full commitment to wholesale price with early quantity response
In this section we consider the case where the buyer lacks the operational flexibility to delay his quantity
decision until more information is available about demand. This inflexibility may be exogenously imposed,
e.g. by other suppliers that are not explicitly represented in our model. Alternatively, it could be imposed by
the supplier in our model in order to lend credibility to her own commitment to price. Note that without
requiring the buyer to make an early commitment to quantity, it may be difficult for the supplier to make a
credible commitment to price since there would be nothing to prevent her from decreasing the price in
response to demand if it were in her own interest to do so. In this section, we analyze how the buyerÕs
inflexibility affects the performance of the chain when the supplier makes an advance commitment to price.
As before, this situation can be modeled as a leader follower game, but in this case, all of the decisions
are made (and all of the costs are incurred) prior to the realization of demand. We assume that the supplier
makes the first move by offering a wholesale price, and that the buyer reacts by simultaneously investing in
cost reduction (demand enhancement) and determining his quantity. The solution to this game, including
the wholesale price, level of investment, expected order quantity, as well as the expected profit levels can be
determined using the same backward induction approach that we have used previously. The solution to this
game, denoted CC (for Committed price and Committed quantity), is shown in the third column of Table 1.
It is interesting to compare how the behavior of the supply chain depends upon whether the buyer has
quantity flexibility when the supplier commits to wholesale price. The following observations can be made
from comparing the second and third columns in Table 1:
(1) By comparing the first row of these two columns, it can be seen that, as long as the supplier makes an
early commitment to price, the buyerÕs amount of innovation (h) is the same, regardless of whether he
has quantity flexibility. As in the previous cases, the amount of innovation depends on the distribution
of demand only through its first moment.
(2) The supplierÕs optimal committed wholesale price does not depend upon whether the buyer has to make
an advance commitment to quantity.
(3) Because the buyerÕs flexible quantity is linear in the realized demand parameter, his expected quantity
when he has quantity flexibility is identical to the quantity to which he would commit if he lacked flex-
ibility.
(4) By comparing the supplierÕs profits we see that E½pCF CC
s ¼ E½ps . The expected profit of the supplier is
the same regardless of whether the buyer can postpone his quantity decision. Thus, in our model, the
only strategic justification for the supplier to demand that the buyer make a quantity commitment is to
lend credibility to her own commitment to price.
(5) By comparing the buyerÕs profits, we see that E½pCF CC
b P E½pb . The buyer loses the ability to benefit
from demand variability when the buyer has to make an advance commitment to quantity. This also
reduces the combined profits, i.e. E½pCF CC
c P E½pc .
4. Ceiling wholesale price with quantity flexibility
In the previous section, we demonstrated the role that a supplierÕs commitment to a price can play in
encouraging innovation by eliminating the buyerÕs fear of being held-up. However, in environments that are
characterized by large amounts of demand uncertainty, we showed that the supplierÕs profits are higher if
she retains pricing flexibility than if she sacrifices it to provide a stronger incentive for the buyer to innovate.
Much of the reason for this is that, without pricing flexibility, the supplier cannot respond to poor market
conditions by dropping her price; both she and the buyer are burdened with the commitment that she has
made.
We have previously alluded to the idea that as long as the buyer has quantity flexibility, it may be
difficult for the supplier to make a credible commitment to price since there is nothing to prevent her from
reducing her price below the announced commitment if it is in her interest to do so. In this section, we
explicitly allow for such an ex post price reduction in what we refer to as a ceiling contract. In a ceiling
contract, the supplierÕs commitment is partial in the sense that she commits to only an upper limit, which we
denote by Wc , on the price. The buyer responds to this price ceiling by investing in cost reduction (demand
enhancement). Let hPF ðWc Þ be the buyerÕs innovative response to wholesale price ceiling Wc . Note that the
first superscript P refers to the supplierÕs partial commitment to wholesale price, while the second super-
script F refers to the buyerÕs flexibility that allows him to postpone his quantity decision until after ob-
serving demand. (Since it is reasonable to assume that the wholesale pricing decision must preceed the
quantity decision, wholesale price flexibility is only possible when the buyer has quantity flexibility.)
After the supplier observes demand realization () and the effect (h) of the buyerÕs investment in inno-
vation, she announces a price, zð; Wc ; hÞ that is no larger than the specified ceiling (Wc ). Finally, the buyer
responds to a given wholesale price (z) with a quantity decision, qð; z; hÞ.
Because the actual wholesale price ðzð; Wc ; hPF ðWc ÞÞÞ at which goods are transferred is the minimum of a
demand-realization-specific profit maximizing wholesale price and the ceiling Wc , it is not possible to obtain
closed form results for the general version of this model. However, we can obtain significant insights from
analyzing the special case in which demand follows a discrete distribution such that
a
D 1a w:p: 1 a;
¼ ð8Þ
D w:p: a;
where D P 0, and a 2 ð0; 1Þ. Note that the expected value of this distribution is zero. As before, we assume
that a þ min ¼ a D > Cs þ Cb .
From the perspective of the buyer, there are three possibilities regarding her investment. To represent
these possibilities, let us define three sets into which h can fall:
R1 ðWc ; DÞ ¼ fh : h P 0 and h 6 h12 ðWc ; DÞg;
R2 ðWc ; DÞ ¼ fh : h P 0 and h12 ðWc ; DÞ 6 h 6 h23 ðWc ; DÞg;
R3 ðWc ; DÞ ¼ fh : h P 0 and h P h23 ðWc ; DÞg;
where h12 ðWc ; DÞ and h23 ðWc ; DÞ are defined as follows:
1 a
h12 ðWc ; DÞ ¼ 2Wc a D Cs þ Cb ;
r 1a
1
h23 ðWc ; DÞ ¼ ð2Wc a þ D Cs þ Cb Þ:
r
Note that at least one of these sets must be non-empty. The sets have the following interpretation: For
h 2 R1 ðWc ; DÞ, the investment is small enough relative to Wc and D that for both realizations () of demand,
zð; Wc ; hÞ < Wc . Thus, h 2 R1 ðWc ; DÞ results in the announced ceiling price being an effectively fully flexible
price.
For h 2 R2 ðWc ; DÞ, we have zðDða=1 aÞ; Wc ; hÞ ¼ Wc , and zðD; Wc ; hÞ < Wc . Thus, h 2 R2 ðWc ; DÞ results
in the announced ceiling price being an effective ceiling price.
Finally, for h 2 R3 ðWc ; DÞ, the investment is large enough relative to Wc and D that the supplierÕs optimal
response to both realizations of demand is to set the wholesale price equal to the ceiling price, i.e.
zðDða=1 aÞ; Wc ; hÞ ¼ zðD; Wc ; hÞ ¼ Wc . Thus, h 2 R3 ðWc ; DÞ results in the announced ceiling price being an
effectively committed price. The buyerÕs expected profit can be expressed as follows:
8 PF
< pb1 ðWc ; h; DÞ for h 2 R1 ðWc ; DÞ;
pPF
b ðW c ; h; DÞ ¼ pPF ðWc ; h; DÞ for h 2 R2 ðWc ; DÞ; ð9Þ
: b2
pPF
b3 ðWc ; h; DÞ for h 2 R 3 ðW c ; DÞ;
where
1 a a 2 a 2
pPF
b1 ðWc ; h; DÞ ¼ aþD Cs Cb þ hr þ ða D Cs Cb þ hrÞ Ih2 ;
16 1a 16
1 a a 2 a
pPF
b2 ðWc ; h; DÞ ¼ a þ D Wc Cb þ hr þ ða D Cs Cb þ hrÞ2 Ih2 ;
4 1a 16
1a a 2 a 2
pPF
b3 ðWc ; h; DÞ ¼ aþD Wc Cb þ hr þ ða D Wc Cb þ hrÞ Ih2 :
4 1a 4
Let us introduce the notation dxi ½ to represent the ith derivative with respect to x, where i ¼ 1 if the
superscript is omitted. It is easy to confirm that pPF b ðWc ; h; DÞ is concave in h within each of the three sets
that have been identified since dh2 ½pPF b ðW c ; h; DÞ < 0 within each set. Moreover, dh ½pPF b ðWc ; h; DÞ is linear
and decreasing within each Ri ðWc ; DÞ for i ¼ 1; 2; 3. However, pPF b ðWc ; h; DÞ is not concave at the points
h ¼ h12 ðWc ; DÞ and h ¼ h23 ðWc ; DÞ. Specifically, at these points, we have: dh ½pPF b ðWc ; h; DÞ 6
dhþ ½pPF
b ðWc ; h; DÞ where the superscripts and þ denote derivatives from the left and right respectively
(see Fig. 1).
Let hPF ðWc ; DÞ be the buyerÕs optimal level of investment corresponding to an announced wholesale price
Wc , and volatility parameter D.
Fig. 1. The buyerÕs marginal profit as a function of h: a ¼ 60, Cs ¼ 0, Cb ¼ 12, r ¼ 10, I ¼ 100, a ¼ 0:25, D ¼ 2.
Proposition 2
(a) There exist thresholds T1 ðDÞ 6 T2 ðDÞ such that the buyer’s optimal investment response satisfies
8
< h3 ðWc ; DÞ 2 R3 ðWc ; DÞ for Wc 6 T1 ðDÞ;
hPF ðWc ; DÞ ¼ h2 ðWc ; DÞ 2 R2 ðWc ; DÞ for T1 ðDÞ 6 Wc 6 T2 ðDÞ; ð10Þ
:
h1 ðWc ; DÞ 2 R1 ðWc ; DÞ for T2 ðDÞ 6 Wc ;
where
rða Cb Cs Þ
h1 ðWc ; DÞ ¼ ;
16I r2
rð4ða Cb Wc Þ þ að3a þ 3D þ 4Wc þ 3Cb Cs ÞÞ
h2 ðWc ; DÞ ¼ ;
16I r2 ð4 3aÞ
and
rða Cb Wc Þ
h3 ðWc ; DÞ ¼ :
4I r2
(b) hPF ðWc ; DÞ is non-increasing in Wc .
(c) T2 ðDÞ is non-decreasing in D and there exists D P 0 such that T1 ðDÞ ¼ T2 ðDÞ for D 6 D and T1 ðDÞ is non-
increasing for D > D .
The above results can be used to show how the supplierÕs pricing policy will be affected by the amount of
uncertainty regarding demand. For our binary discrete distribution of demand, the supplierÕs expected
profits can be expressed as the following function of the announced ceiling price:
8 PF
< ps3 ðWc ; DÞ for Wc 6 T1 ðDÞ;
pPF
s ðWc ; DÞ ¼ pPF ðWc ; DÞ for T1 ðDÞ 6 Wc 6 T2 ðDÞ; ð11Þ
: s2
pPF
s1 ðWc ; DÞ for T2 ðDÞ 6 Wc ;
where
Wc Cs
pPF
s3 ðWc ; DÞ ¼ ða Wc Cb þ rh3 ðWc ; DÞÞ;
2
1a a a
pPF
s2 ðWc ; DÞ ¼ ðWc Cs Þ a þ D Wc Cb þ rh2 ðWc ; DÞ þ ða D Cs Cb þ rh2 ðWc ; DÞÞ2 ;
2 1a 8
1 a a 2 a
2
pPF
s1 ðWc ; DÞ ¼ aþD Cs Cb þ rh1 ðWc ; DÞ þ ða D Cs Cb þ rh1 ðWc ; DÞÞ ;
8 1a 8
where T1 ðDÞ, T2 ðDÞ, and hPF ðWc ; DÞ are as defined in Proposition 2. Note that the first subscript (s) indicates
the supplier’s profits, while the second i ¼ 1, 2, 3 indicates the index of the set ðRi ðWc ; DÞÞ into which the
buyerÕs investment response will lie. For example, pPF s3 ðWc ; DÞ represents the supplierÕs profits when the
announced ceiling price induces an investment that is in R3 ðWc ; DÞ so that Wc is an effectively committed
price. By substituting (10) into (11) and differentiating twice with respect to Wc , it can be shown that, within
each of the three ranges, pPF s ðWc ; DÞÞ is concave. However, it is not concave at the breakpoints T1 ðDÞ and
T2 ðDÞ.
Observe that the wholesale price announcement can be described as follows: price announcement,
Wc 6 T1 ðDÞ, is an effectively committed price; price announcement, Wc 2 ðT1 ðDÞ; T2 ðDÞÞ, is an effective ceiling
price; and price announcement, Wc P T2 ðDÞ is an effectively flexible price.
Before we introduce the following proposition, note that for the distribution of the demand error term
that is defined in (8) there is a one-to-one correspondence between the parameter D ¼ min and demand
variance:
a
r2 ¼ Var½ ¼ ðDÞ2 : ð12Þ
1a
Proposition 3. For a given value of a, there exists a threshold Ka such that the supplier’s optimal ceiling price
will be

PF MinT1 ðDÞ; W3uc ðDÞ for D 6 Ka ;
Wc ðDÞ ¼
Min T2 ðDÞ; W2uc ðDÞ for D P Ka ;
where Wi uc ðDÞ is the unconstrained maximizer of the function pPF si ðWc ; DÞ for i ¼ 1; . . . ; 3. Thus, if D 6 Ka , the
ceiling price is effectively a committed price, and for D > Ka , the ceiling price is effectively a ceiling in the sense
that for the low realization of demand, the supplier will set his wholesale price to something less than WcPF ðDÞ.
The above result confirms that, for sufficiently low amounts of demand uncertainty, the supplier will
announce a price that induces sufficiently large investment from the buyer, that the actual wholesale price
will not be reduced below the announced price regardless of the realization of demand. As demand un-
certainty increases, the supplier may, at first, reduce his announced wholesale price to encourage the larger
amount of downstream investment that occurs in the effectively committed price region. However, as de-
mand uncertainty continues to increase, the supplier will eventually announce larger prices, preferring to
exploit the best demand realizations over encouraging investment.
5. Numerical study
In this section we perform a numerical study to gain further insight into how the supplierÕs commitment
to price affects the downstream investment in innovation, and subsequently the profitability of the supply
chain. For the purposes of the numerical study we use the Bernoulli distribution defined in (8). There are
several interesting features in this distribution which make it convenient for a numerical study. Note that
mean demand, E½a þ ¼ a, and as a increases to 1, the upper realization of demand increases rapidly and
the lower realization remains constant at a D. Thus, we can increase the variance, r2 ¼ aD2 =ð1 aÞ, as
large as we desire by increasing a towards 1 while both preserving the mean at a and avoiding negative
realizations of demand.
In order to investigate the interaction between the supplierÕs preference between full commitment and
full flexibility with respect to price, let us arbitrarily take the parameters of the problem to be as follows:
a ¼ 40, Cs ¼ 0, Cb ¼ 16, r ¼ 10, I ¼ 200, a ¼ 0:75. Let us also assume that the buyer can postpone his
quantity decision until after demand information is available. Recall from Proposition 1 that above a
certain threshold of demand uncertainty, K0 , the supplier will switch her preference from strategically
commitment to flexibility. In Fig. 2a, it can be observed that, for this particular set of parameters, K0 45.
The effects of the reversal of preference upon the buyer can be seen in Fig. 2b. As r2 increases beyond
K0 45 and the supplier switches to a flexible pricing policy. Since this exposes the buyer to being held-up,
his level of investment drops off sharply which adversely affects the profits of the buyer and the supply chain
as a whole. This is particularly interesting since under either a flexible pricing policy or a pre-committed
price, the profits of the supplier, the buyer, and the supply chain are monotonic and convex in a. However,
when we consider the supplierÕs switch in preference between these two policies, the profits of the buyer and
the supply chain are neither monotone nor convex.
In Fig. 3a–d, we investigate how the supplier will implement a ceiling price under varying levels of
demand variance (r2 ). In Fig. 3a, demand variance, r2 ¼ 75, is relatively large, and at the optimal an-
nounced ceiling price (wc 19) the supplierÕs expected profits are larger than what she could earn under
either full commitment or full flexibility.
Fig. 2. (a) The supplierÕs optimal profit when she must either fully commit or remain fully flexible: a ¼ 40, Cs ¼ 0, Cb ¼ 16, r ¼ 10,
I ¼ 200, a ¼ 0:75. (b) The buyerÕs profit when the supplier chooses between full commitment and full flexibility: a ¼ 40, Cs ¼ 0,
Cb ¼ 16, r ¼ 10, I ¼ 200, a ¼ 0:75.
Fig. 3. (a) SupplierÕs profit when a ceiling price is announced under very large demand variance: a ¼ 40, Cs ¼ 0, Cb ¼ 16, r ¼ 10,
I ¼ 200, a ¼ 0:75, D ¼ 5 (r2 ¼ 75). (b) SupplierÕs profit when a ceiling price is announced under moderately large demand variance:
a ¼ 40, Cs ¼ 0, Cb ¼ 16, r ¼ 10, I ¼ 200, a ¼ 0:75, D ¼ 3:65 (r2 ¼ 40). (c) SupplierÕs profit when a ceiling price is announced under
moderately small demand variance: a ¼ 40, Cs ¼ 0, Cb ¼ 16, r ¼ 10, I ¼ 200, a ¼ 0:75, D ¼ 2:58 (r2 ¼ 20). (d) SupplierÕs profit when a
ceiling price is announced under small demand variance: a ¼ 40, Cs ¼ 0, Cb ¼ 16, r ¼ 10, I ¼ 200, a ¼ 0:75, D ¼ 0:5 (r2 ¼ 0:75).
In Fig. 3b, the demand variance, r2 ¼ 40, is only moderately high. Observe that, at this more moderate
level of uncertainty, r2 ¼ 40 < K0 45, i.e. the buyerÕs preference between full commitment and full
flexibility has reversed so that she now prefers full commitment. Nevertheless, at the optimal announced
ceiling price (wc 17), the buyerÕs expected profits are still higher than with either full commitment or full
flexibility.
In Fig. 3c, the demand variance, r2 ¼ 20, is moderately small. In this case, the optimal announced ceiling
price wc 11:5 is an effectively committed price in the sense that the actual wholesale price will be wc for
either realization of demand. It is interesting to observe that in this case wc is less than the optimal
committed price, wCF ¼ ða þ Cs Cb Þ=2 ¼ 12. Moreover, the supplierÕs expected profits are higher under
the optimal committed price than under the optimal ceiling price. Obviously, the supplier would prefer to
make a commitment to price instead of announcing a price that she could later decrease in response to low
realizations of demand. Unfortunately, as long as the buyer retains flexibility to postpone his quantity
decision, it can be difficult for the supplier to make such a commitment credible. (After observing a low
realization of demand, it would be in the supplierÕs best interest to reduce the price below the committed
price wCF , and the buyer would have no reason to enforce the committed price.) On the other hand, one way
in which the supplier might be able to make her commitment to price credible would be to require that the
buyer make a reciprocal commitment to quantity. Recall from Section 3.3 that E½pCF CC
b ¼ E½ps , i.e. given
that the supplier commits to price, she is indifferent as to whether the buyer commits to quantity. This
suggests that for moderately low demand variance, a supplier could benefit from having lead times that are
long enough to force buyers to commit to orders before information is available about demand.
Finally, in Fig. 3d, the demand variance is so small, r2 ¼ 0:75, that wc ¼ wCF ¼ 12. In this case, the
demand variance is so small that even if the optimal committed price is announced as a ceiling price, the
supplier will have no reason to reduce it in response to the lowest realization of demand.
6. Discussion
In this paper, we have explored the way in which commonly implemented variations on linear wholesale
pricing policies affect the incentives for supply chain partners to invest in innovation. This is a dimension of
supply chain behavior that has not been adequately addressed in the operations literature.
The key trade-off that we have identified is the one faced by a supplier when she must balance the need
for flexibility to respond to demand uncertainty against the need to insure the buyer against exploitation by
committing in advance to a price. We have shown that from the perspective of either the buyer or the
supply chain, commitment to wholesale price is always preferred. However, from the perspective of the
supplier, full commitment dominates full flexibility for low amounts of uncertainty, while the opposite is
true above a certain threshold amount of uncertainty. In our numerical study, we have also demonstrated
that, for sufficiently large demand variance, the supplier earns larger profits under an optimal ceiling
contract than under either full flexibility or full commitment to wholesale price. What is even more in-
triguing is that, for moderately low demand variance, the supplier may prefer to make a full commitment to
price over retaining flexibility to decrease price in response to a low realization of demand. This suggests
that suppliers who face moderately low demand could benefit from requiring their customers to enter
contracts that require both parties to commit in advance to price and quantity for the sole purpose of
lending credibility to the supplierÕs commitment to price.
Perhaps the most restrictive of our assumptions is that of linear demand. As discussed in Lee and Staelin
(1997), linear demand curves result in the supplier and buyer being vertical strategic substitutes (VSS), i.e.
an increase in one firmÕs margin tends to decrease the margin of the other. (Alternatively, if an increase in
one firmÕs margin tends to increase the margin of the other, then the two firms are said to be vertical
strategic complements (VSC).) Recall that the main reason that the supplierÕs commitment to price en-
courages the buyer to innovate is that the supplierÕs price is increasing in the amount of the buyerÕs in-
novation. Thus, it is reasonable to expect that we would find results that are qualitatively similar to ours in
supply chains in which the demand function results in VSS, but it is not obvious that such results would
hold when the demand function results in VSC. We leave this as a topic for future research.
Beyond the linear demand assumption, we have made assumptions that imply that the buyerÕs quantity
response is linear in the realization of demand. Specifically, for every realization of demand, the buyerÕs
optimal quantity response is non-zero, and the supplierÕs capacity is sufficient to fill the buyerÕs order. This
additional assumption facilitates the analysis, but a similar trade-off would exist without them. However, it
would be of interest to investigate how the trade-off would be affected when either very low demand re-
alizations or binding capacity constraints were significant issues.
To highlight the trade-off that the supplier faces between her own pricing flexibility and the need to
encourage downstream innovation, we have intentionally restricted ourselves to a simple bilateral mo-
nopoly. Although we believe that this basic trade-off would also exist in the presence of competition in
either industry, it is certainly of interest to investigate how its dynamics would be affected by more com-
plicated competitive settings. It would also be of interest to investigate how a commitment to price (or
quantity) would affect firms that produce highly complementary products. For example, Microsoft and
Intel do not buy and sell directly to one another, but each of their profits depends heavily upon the
innovations of the other.
Yet another interesting avenue to pursue would be to investigate a more elaborate model of the inno-
vation process that accounts for the uncertainty of the outcome. Given the ability of the firms to respond to
the outcome of the innovation process, we might expect that, as with financial options, the value of the
opportunity to innovate would increase in its variance. On the other hand, the uncertainty of the inno-
vation process would certainly have an impact on the willingness of either firm to make prior commitments
to price and quantity.
We hope that our paper can serve as a building block for further research into how supply chain in-
teractions affect operational decisions other than the price and quantity decisions that have received much
of the attention until now.
Appendix A
Proof of Proposition 1. (a) In Table 1, it can be seen that E½pCF FF

s is independent of variance, while E½ps is
linearly increasing in the variance. Thus, commitment eliminates the supplierÕs ability to benefit from de-
mand variance. Obviously, for sufficiently large values of r2 , E½pFF CF 2
s > E½ps . On the other hand, for r ¼ 0,
we have
!
2
I 32I
E½pCF FF
s E½ps ¼ ða Cs Cb Þ2
2ð4I r2 Þ ð16I r2 Þ2
!
Ið32Ir2 þ r4 Þ 2
¼ 2
ða Cs Cb Þ > 0: ðA:1Þ
2ð4I r2 Þð16I r2 Þ
(b) In Table 1 it can be seen that both E½pCF FF
b and E½pb are linearly increasing in the demand variance,
CF
but that E½pb increases at a faster rate. The claim follows from the fact that the term that is independent
of demand variance is also larger in E½pCF FF
b than it is in E½pb .
CF FF
(c) In Table 1 it can be seen that both E½pc and E½pc are linearly increasing in the demand variance,
but that E½pCFc increases at a faster rate. The claim follows from the fact that the term that is independent
2
of demand variance is also larger in E½pCF FF
c than it is in E½pc since, for r ¼ 0, we have
!
3I ð48I r2 ÞI 2
E½pCF FF
c E½pc ¼ ða Cs Cb Þ
4ð4I r2 Þ ð16I r2 Þ2
!
Ir2 ð112I r2 Þ 2
¼ 2
ða Cs Cb Þ > 0: ðA:2Þ
2
4ð4I r Þð16I r Þ 2
Proof of Proposition 2. For the first two parts of the proposition, it suffices to demonstrate them for an
arbitrarily chosen value of D. Therefore, for notational convenience, we will omit reference to D in all
functions for which it is an argument in the proof of parts (a) and (b).
(a) Although the buyerÕs profit function, pPF b ðWc ; hÞ is concave in h within each of the three ranges, it is not
concave at h12 ðWc Þ and h23 ðWc Þ. As shown in Fig. 1, dh ½pPF b ðWc ; hÞ is a decreasing and linear function within
þ PF
each of the three ranges, and dh ½pPFb ðWc ; hÞ > 0 at h ¼ 0. Also note that dh ½pPF b ðWc ; hÞ 6 dh ½pb ðWc ; hÞ at the
points h ¼ h12 ðWc Þ, and h ¼ h23 ðWc Þ. Therefore, there must be at least one, and not more than three sta-
tionary points, and the optimal solution must be at one of them. From first order conditions, it can be
confirmed that hi ðWc Þ is the unique stationary point of function pPF bi ðWc ; hÞ for i ¼ 1; 2; 3.
We will first show that hPF ðWc Þ ¼ h1 ðWc Þ 2 R1 ðWc Þ if and only if Wc exceeds a threshold. It is easy to see
that as Wc becomes arbitrarily large, we must have hPF ðWc Þ ¼ h1 ðWc Þ since for sufficiently large Wc , we have
neither h2 ðWc Þ 2 R2 ðWc Þ nor h3 ðWc Þ 2 R3 ðWc Þ. (Observe that the lower boundaries, h12 ðWc Þ and h23 ðWc Þ
of R2 ðWc Þ and R3 ðWc Þ are increasing in Wc while h2 ðWc Þ and h3 ðWc Þ are decreasing in Wc .)
Suppose that for some announced ceiling price, T , an optimal investment response is hPF ðT Þ ¼ h1 ðT Þ 2
R1 ðT Þ. By the definition of an optimal response, we must have that pPF PF
b ðT ; h1 ðT ÞÞ P pb ðT ; hÞ for any other
h. Now, since h12 ðWc Þ, the upper boundary of R1 ðWc Þ, is increasing in Wc , we will continue to have
h1 ðWc Þ 2 R1 ðWc Þ for all Wc P T . By taking derivatives of the appropriate
S pPF
b ðWc ; hÞ function with respect to
Wc , it can be seen that dWc ½pb ðWc ; hÞ 6 0 for any h 2 fR2 ðWc Þ R3 ðWc Þg. Since, dWc ½pPF
PF
b ðWc ; hÞ ¼ 0 for
h 2 R1 ðWc Þ, it follows that hPF ðWc Þ ¼ h1 ðWc Þ for any Wc P T .
We will now show that hPF ðWc Þ ¼ h3 ðWc Þ 2 R3 ðWc Þ if and only if Wc falls at or below a threshold. When
Wc is a sufficiently small positive value, h12 ðWc Þ 6 h23 ðWc Þ 6 0 so that R1 ðWc Þ ¼ R2 ðWc Þ ¼ f;g, and the op-
timal investment response must be at h3 ðWc Þ 2 R3 ðWc Þ. Suppose that for some ceiling price T , an optimal
PF PF PF
investment Sresponse S is h ¼ h3 ðT Þ 2 R3 ðT Þ. Thus, we must have pb ðT ; h3 ðT ÞÞ P pb ðT ; hÞ for all
h 2 fR1 ðT Þ R2 ðT Þ R3 ðT Þg. Since h23 ðWc Þ is increasing in Wc , and h3 ðWc Þ is decreasing, we must have that
h3 ðWc Þ 2 R3 ðWc Þ for all Wc 6 T . To see that h 6¼ h3 ðWc Þ cannot dominate h3 ðWc Þ for any Wc 6 T , we can
consider the marginal effect of the ceiling price upon the buyerÕs profits. First, when the investment response
to an announced price W is h3 ðW Þ 2 R3 ðW Þ, the marginal effect of W upon the buyerÕs profit is
dpPF
b ðW ; h3 ðW ÞÞ dpPF ðW ; h3 ðW ÞÞ dh3 ðW Þ a W Cb þ h3 ðW Þr
dW ½pPF
b ðW ; h3 ðW Þ ¼ þ b ¼ <0
dW dh dW 2
ðA:3Þ
where dpPF
b ðW ; h3 ðW ÞÞ=dh ¼ 0 by the definition of h3 ðW Þ as a stationary point. It is easy to confirm from
0 0 0
(A.3) that, dW ½pPF PF
b ðW ; h3 ðW Þ < dW ½pb ðW ; h for any h 2 R3 ðW Þ such that h < h3 ðW Þ. Similarly, if
0
h 2 R2 ðW Þ, we have
0 ð1 aÞ a
dW ½pPF
b ðW ; h Þ ¼ aþD W Cb þ h0 r < 0: ðA:4Þ
2 1a
Subtracting (A.3) from (A.4), it is easy to see that
!
PF 0 PF ð1 aÞ 0 a
dW ½pb ðW ; h Þ dW ½pb ðW ; h3 ðW ÞÞ ¼ rðh3 ðW ; DÞ h Þ þ a D W Cb þ h3 ðW Þr > 0:
2 2
ðA:5Þ
0
Note that the first term in the above expression is non-negative by the assumption that h 2 R2 ðW Þ and
h3 ðW Þ 2 R3 ðW Þ, while the latter term is positive since h3 ðW Þ 2 R3 ðW Þ. Finally, for h0 2 R1 ðW Þ, it is easy to
0 0 0
see that dWc ½pPF b1 ðWc ; h Þ ¼ 0. Thus, we can conclude that for any h < h3 ðW Þ, we have that dW ½pb ðW ; h Þ
PF
PF
dW ½pb ðW ; h3 ðW ÞÞ > 0. S
Let us now consider Wc < T , and suppose that hPF ðWc Þ < h23 ðWc Þ, i.e. hPF ðWc Þ 2 fR1 ðWc Þ R2 ðWc Þg. Since
h23 ðWc Þ is increasing in Wc , if follows that hPF ðWc Þ < h23 ðT Þ 6 h3 ðT Þ. We have
Z T
PF
PF
PF
pPF
b ðW c ; h 3 ðW c ÞÞ pPF
b W c ; h ðWc Þ ¼ pPF
b ðT ; h 3 ðT ÞÞ pPF
b T ; h ðWc Þ þ dW pb ðW ; hPF ðWc ÞÞ
Wc
PF
dW pb ðW ; h3 ðW ÞÞ dW > 0: ðA:6Þ
Note that the assumption that hPF ðT Þ ¼ h3 ðT Þ implies that the first term in the right-hand-side of the above
expression is positive. The second term is also positive since we have established the fact that for any
h0 < h3 ðW Þ, we have PF 0 PF
S dW ½pb ðW ; h Þ dW ½pb ðW ; h3 ðW ÞÞ > 0. Note that (18) contradicts the optimality of
PF
h ðWc Þ 2 fR1 ðWc Þ R2 ðWc Þg.
We have now established that there must be thresholds, T1 6 T2 , such that hPF ðWc Þ ¼ h3 ðWc Þ 2 R3 ðWc Þ if
and only if Wc 6 T1 , while hPF ðWc Þ ¼ h1 ðWc Þ 2 R1 ðWc Þ if and only if Wc P T2 . As previously shown, the op-
timal response, hPF ðWc Þ, must be at one of the three potential stationary points. Therefore, for Wc 2 ðT1 ; T2 Þ
we must have hPF ðWc Þ ¼ h2 ðWc Þ.
(b) For notational convenience we continue to omit reference to D in functions for which it is an ar-
gument. To see that hPF ðWc Þ is non-increasing in Wc , recall from part a that hPF ðWc Þ must occur at either
h1 ðWc Þ, h2 ðWc Þ, or h3 ðWc Þ, all three of which are continuous and non-increasing in Wc . At threshold T1 , the
optimal response is h3 ðT1 Þ P h23 ðT1 Þ, where the inequality follows from the definition of R3 ðWc Þ. Assuming
that T1 < T2 , then for sufficiently small d > 0: the optimal response to announced ceiling price Wc ¼ T1 þ d is
h2 ðWc Þ 2 R2 ðWc Þ. By continuity of h23 ðW Þ, which is the boundary separating R2 ðW Þ from R3 ðW Þ, it follows
that hPF ðWc Þ is non-increasing at the point Wc ¼ T1 . A similar argument can be applied to the threshold T2
or to the case in which T1 ¼ T2 .
(c) Since this part of the claim does involve different values of D, we reintroduce this parameter as an
argument to the buyerÕs profit function. To see that T2 ðDÞ is non-decreasing, let us consider the marginal effect
of D on the buyerÕs profits. For h 2 R1 ðW ; DÞ it is easy to show that: dD ½pPF b1 ðWc ; h; DÞ ¼ Da=8ð1 aÞ. Simi-
larly, for h 2 R3 ðW ; DÞ, we have dD ½pPF b3 ðWc ; h; DÞ ¼ Da=2ð1 aÞ. We now observe that, for h 2 R2 ðWc ; DÞ,
a a a
dD pPF
b2 ðWc ; h; DÞ ¼ aþD Wc Cb þ hr ða D Cs Cb þ hrÞ
2 1a 8
a a a
P aþD Cs Cb þ hr ða D Cs Cb þ hrÞ
4 1a 8
a Dað1 þ aÞ Da h i
¼ ða Cs Cb þ hrÞ þ P ¼ dD pPF
b1 ðW c ; h; DÞ : ðA:7Þ
8 8ð1 aÞ 8ð1 aÞ
From theS above, we can conclude that dD ½pPF ðWc ; h1 ðWc ; DÞ; DÞ 6 dD ½pPF ðWc ; h; DÞ for any h 2
fR2 ðWc ; DÞ R3 ðWc ; DÞg. Since h12 ðWc ; DÞ is decreasing in D, we have that h1 ðT ; Do Þ 2 R1 ðT ; Do Þ for all
Do 6 D. It follows that if h1 ðT ; DÞ 2 R1 ðT ; DÞ is the optimal investment response for some announced ceiling
price T and D, then h1 ðT ; Do Þ 2 R1 ðWc ; Do Þ must be an optimal investment response to ceiling price T and
Do 6 D. Thus, T2 ðDÞ is non-decreasing.
It remains to be shown that there exists a threshold D , such that T1 ðDÞ ¼ T2 ðDÞ for D 6 D , while T1 ðDÞ is
non-increasing for D > D . We first note that when D ¼ 0, we must have T1 ð0Þ ¼ T2 ð0Þ since R2 ðWc ; 0Þ ¼ f;g
for all Wc . To prove the claim, it suffices to show that if the optimal investment response to some announced
ceiling price T and uncertainty parameter D0 is h3 ðT ; D0 Þ 2 R3 ðT ; D0 Þ, then for any Do 6 D0 the optimal re-
sponse cannot be h2 ðT ; Do Þ 2 R2 ðT ; Do Þ.
In order to demonstrate this, let us first define g13 ðWc ; DÞ and g23 ðWc ; DÞ as follows:
g13 ðWc ; DÞ ¼ pPF PF
b ðWc ; h1 ðWc ; DÞ; DÞ pb ðWc ; h3 ðWc ; DÞ; DÞ; ðA:8Þ
g23 ðWc ; DÞ ¼ pPF PF

b ðWc ; h2 ðWc ; DÞ; DÞ pb ðWc ; h3 ðWc ; DÞ; DÞ: ðA:9Þ
By taking first and second derivatives, it can be confirmed that both g13 ðWc ; DÞ and g23 ðWc ; DÞ are concave in
D, and that g13 ðWc ; DÞ is decreasing in D. Let us now make the following observations: (1) If
h2 ðT ; DÞ 62 R2 ðh2 ðT ; DÞ then h2 ðT ; Do Þ 62 R2 ðh2 ðT ; Do Þ for any Do 6 D. (2) If h2 ðT ; DÞ 2 R2 ðh2 ðT ; DÞ then
h2 ðT ; D Þ 2 R2 ðh2 ðT ; D Þ for any D P D. These observations follow from the fact that h12 ðWc ; DÞ is de-
creasing in D while
3ar 3a 1
dD ½h2 ðWc ; DÞ ¼ 2
6 < ¼ dD ½h23 ðWc ; DÞ
16I r ð4 3aÞ rð4=3 þ 3aÞ r
where the first inequality results from the assumption that 3I > r2 . We are now ready to demonstrate the
claim. If h2 ðT ; D0 Þ 62 R2 ðT ; D0 Þ, then it follows from observations 1 and 2 above that h2 ðT ; Do Þ 62 R2 ðT ; Do Þ.
Thus, h2 ðT ; Do Þ cannot be an optimal investment response for any Do 6 D0 . Now suppose that
h2 ðT ; D0 Þ 2 R2 ðT ; D0 Þ. By the assumption that h3 ðT ; D0 Þ 2 R3 ðT ; D0 Þ is an optimal investment response to
announced price T and uncertainty parameter D0 , we must have that
g23 ðT ; D0 Þ ¼ pPF 0 0 PF 0 0
b ðT ; h2 ðT ; D Þ; D Þ pb ðT ; h3 ðT ; D Þ; D Þ 6 0: ðA:10Þ
Define Dmax ðT Þ to be the value of D that satisfies
h3 ðT ; DÞ ¼ h23 ðWc ; DÞ:
Specifically, Dmax ðT Þ > D0 is the largest value of D for which h3 ðT ; DÞ 2 R3 ðT ; DÞ. Note that we can express
g23 ðT ; Dmax ðT ÞÞ as follows:
Z h23 ðT ;Dmax ðT Þ

g23 ðT ; Dmax ðT ÞÞ ¼ dh pPF
b ðT ; h; Dmax ðT ÞÞ dh > 0 ðA:11Þ
h2 ðT ;Dmax ðT ÞÞ
where the inequality follows from the fact that h2 ðT ; Dmax ðT ÞÞ is a stationary point, which implies that
dh ½pPF
b ðT ; h; Dmax ðT ÞÞ 6 0 for h 2 ½h2 ðT ; Dmax ðT ÞÞ; h23 ðT ; Dmax ðT Þ. By combining (22) and (23) with the fact
that g23 ðWc ; DÞ is concave in D, it follows that g23 ðT ; Do Þ < 0 for all Do 6 D0 .
Proof of Proposition 3. By totally differentiating (11), twice with respect to Wc , it is easy to see that
pPF
s ðWc ; DÞ is concave within each of the three ranges, but it is not concave at the breakpoints. To determine
the optimal price announcement, we must compare the best prices within each region.
We first observe that dWc ½pPF s ðWc ; DÞ ¼ 0 for all Wc > T2 ðDÞ. Hence there is no marginal benefit to the
supplier from increasing his announced ceiling price above T2 ðDÞ, the point above which the buyerÕs in-
vestment drops off to the point that the supplierÕs price is effectively fully flexible. (Note that at the an-
nounced prices of T1 ðDÞ and T2 ðDÞ, the buyer is indifferent between two different levels of investment.
However, the supplier is not indifferent, and strongly prefers the larger level of investment. To facilitate the
analysis, we arbitrarily assume that in these cases of buyer indifference, he chooses the larger level of in-
vestment.)
Let us define W3 ðDÞ to be the ceiling price that maximizes the supplierÕs profits within the set of prices
that are effectively committed. Specifically, let W3 ðDÞ be the solution to the following optimization problem:

Max pPF s3 ðWc ; DÞ subject to: Wc < T1 ðDÞ : ðA:12Þ

Since pPF
s3 ðWc ; DÞ is concave in Wc , it is easy to see that W3 ðDÞ ¼ Min T1 ðDÞ; W3
uc
.
Similarly, let us define W2 ðDÞ to be the ceiling price that that maximizes the supplierÕs profits within the
set of prices that are effective ceiling prices. Specifically, let W2 ðDÞ be the solution to the following opti-
mization problem:

Max pPF s2 ðWc ; DÞ subject to: T1 ðDÞ < Wc 6 T2 ðDÞ : ðA:13Þ
Since pPF
s2 ðWc ; DÞ is concave for Wc , the optimal solution to (A.13) must lie at either the unconstrained
maximizer, or at one of the boundaries of the feasible region. It follows that
W2 ðDÞ ¼ MinfMaxfT1 ðDÞ; W2uc ðDÞg; T2 ðDÞg:
Note that if W2uc ðDÞ 6 T1 ðDÞ, then W2 ðDÞ ¼ T1 ðDÞ, and it will be dominated by W3 ðDÞ since
pPF PF PF
s3 ðW3 ðDÞ; DÞ P ps3 ðT1 ðDÞÞ P ps2 ðT1 ðDÞÞ
where the first inequality results from the definition of W3 ðDÞ as the optimal effectively committed price and
the latter inequality results from the fact that h3 ðWc ; DÞ P h2 ðWc ; DÞ.
For D ¼ 0, i.e. the deterministic case, it is obvious that R2 ðWc ; 0Þ ¼ f;g for all Wc and that the supplierÕs
optimal price is W3 ð0Þ ¼ ða þ Cs Cb Þ=2. Suppose that for some volatility, Do , the supplierÕs optimal price
announcement is WcPF ðDo Þ ¼ W2 ðDo Þ. We must show that, for any D0 P Do , the supplierÕs optimal price
announcement will be WcPF ðD0 Þ ¼ W2 ðD0 Þ.
From the previous discussion, if W2 ðDo Þ dominates W3 ðDo Þ, then we must have T1 ðDo Þ < W2 ðDo Þ 6 T2 ðDo Þ.
Recall from Proposition 2, that T1 ðDÞ is non-increasing for D P Do . Therefore, increasing the volatility
parameter serves to tighten the constraint in the optimization problem (A.12) that defines the optimal
profits that can be earned from an effective commitment price. Hence for any D0 P Do , we have that
o o 0 0
pPF PF
s ðW3 ðD Þ; D Þ P ps ðW3 ðD Þ; D Þ: ðA:14Þ
o o
From the supposition that W2 ðD Þ is the optimal price announcement for volatility D , we have
o o o o
pPF PF
s ðW2 ðD Þ; D Þ P ps ðW3 ðD Þ; D Þ: ðA:15Þ
We now observe that, because T1 ðDÞ and T2 ðDÞ are respectively non-increasing and non-decreasing in D, an
announced price of W2 ðDo Þ will be an effective ceiling price for any D0 P Do . By the definition of W2 ðD0 Þ as an
optimal effective ceiling price for volatility D0 , we have
0 0 o 0
pPF PF
s2 ðW2 ðD Þ; D Þ P ps2 ðW2 ðD Þ; D Þ: ðA:16Þ
Let us now examine the marginal effect of volatility on a supplierÕs profit for a given effective ceiling price
W 2 ðT1 ðDÞ; T2 ðDÞÞ. For this fixed price announcement, the marginal effect of volatility upon the supplierÕs
profits is
1a a
dD ½pPF
s2 ðW ; DÞ ¼ ðW Cs Þ þ rdD ½h2 ðW ; DÞ
2 1a
a
þ ða D Cs Cb þ rh2 ðW ; DÞÞð1 þ rdD ½h2 ðW ; DÞÞ: ðA:17Þ
4
By substituting dD ½h2 ðW ; DÞ ¼ 3ra=ð16I r2 ð4 3aÞÞ, into (A.17) and re-arranging, we have that

PF ðW Cs Þð16I r2 Þ a D Cs Cb þ rh2 ðW ; DÞ 2
dD ½ps2 ðW ; DÞ ¼ a ð16I 4r Þ
2ð16I r2 ð4 3aÞÞ 4ð16I r2 ð4 3aÞÞ
3r2 aða D Cs Cb þ rh2 ðW ; DÞÞ
P > 0:
4ð16I r2 ð4 3aÞÞ
Where the first inequality results from the fact that W P 12 ða D þ Cs Cb þ rh2 ðW ; DÞÞ. Thus, as the
volatility increases, the supplierÕs profits increase for a fixed effective ceiling price. It follows that if the
supplier adjusts its effective ceiling price to the new, higher level of volatility, its profits will increase even
more. Because dD ½pPFs2 ðW ; DÞ > 0, for any W 2 ðT1 ðDÞ; T2 ðDÞÞ, we must have that
o 0 o o
pPF PF
s2 ðW2 ðD Þ; D Þ P ps2 ðW2 ðD Þ; D Þ: ðA:18Þ
Combining (A.14), (A.15), (A.16), and (A.18), it follows that if it is optimal for the supplier to announce an
effective ceiling price for some volatility Do , then it will also be optimal for the supplier to announce effective
ceiling prices for all D P Do .
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Strategic Commitment To Price To Stimulate

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European Journal of Operational Research 150 (2003) 617–639

Production, Manufacturing and Logistics

Strategic commitment to price to stimulate

0377-2217/03/$ - see front matter Ó 2002 Published by Elsevier B.V.

3.1. Fully ﬂexible wholesale price

3.2. Full commitment to wholesale price with postponed quantity

3.3. Full commitment to wholesale price with early quantity response

4. Ceiling wholesale price with quantity ﬂexibility

Proof of Proposition 1. (a) In Table 1, it can be seen that E½pCF FF

g23 ðWc ; DÞ ¼ pPF PF

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