Incentives to Enhance Production Reliability against Disruption: Cost-Sharing vs. Penalty

Two kinds of incentive strategies, cost-sharing and penalty, are examined in dealing with production disruption, with consideration of production process reliability as an endogenous factor for a two-echelon supply chain. Based on the Stackelberg game framework, we derive the optimal decisions of supply chain partners and compare their expected profits with different strategies. Considering the uncertain demand and the retailer’s preference against the risk, we further analyze how the partners’ decisions and the retailer’s expected profit are influenced by the feature of loss aversion. From theoretical analysis and numerical experiments, we find that: (1) overall, a penalty strategy dominates that of cost-sharing for the retailer, whereas the reverse applies with respect to the manufacturer; (2) a penalty strategy may outperform a cost-sharing strategy for the whole supply chain, depending on demand; and (3) a reasonable aversion against risk can help the retailer to achieve a more robust result when a penalty strategy is adopted under volatile and unpredictable demand.