Int. J. Applied Management Science, Vol. 2, No.

1, 2010

Pricing and effort investment decisions of a supply chain considering customer satisfaction Tiaojun Xiao*, Xiulian Cai and Jiao Jin
School of Management Science and Engineering, Nanjing University, Nanjing 210093, China Fax: (86) 25-83597501 E-mail: xiaotj@nju.edu.cn E-mail: cai.little@gmail.com E-mail: jinjiao.zero@163.com *Corresponding author
Abstract: This paper develops a two-period game model of a supply chain consisting of one manufacturer and one retailer to investigate the pricing and effort investment decisions when customer satisfaction is considered. We assume that both players are risk averse and divide the retailers effort into short-term selling effort and customer-satisfying (CS) effort, where short-term selling effort only influences current demand and CS effort only influences future demand in the next period. We find that the pricing and effort investment decisions and the certainty equivalents of the random present profits largely depend on risk sensitivity, demand uncertainty, correlation coefficient between the errors of the market scales in two periods, discount factor and subsidy rate. When the patience/discount factor or the CS effort sensitivity of the retailer increases, the retailer will increase CS effort investment. The retail price and effort investments of the retailer and the unit wholesale price of the manufacturer are decreasing in correlation coefficient due to a higher risk cost. Keywords: supply chain management; customer satisfaction; risk aversion; effort investment; game theory. Reference to this paper should be made as follows: Xiao, T., Cai, X. and Jin, J. (2010) Pricing and effort investment decisions of a supply chain considering customer satisfaction, Int. J. Applied Management Science, Vol. 2, No. 1, pp.119. Biographical notes: Tiaojun Xiao is currently an Associate Professor in the School of Management Science and Engineering, Nanjing University, in China. He received his PhD in Management Science and Engineering at Southeast University and MS in Mathematics at Central South University of Technology, in China. His research interests include applied game theory, evolutionary management theory, supply chain disruption and risk management, and supply chain coordination management. He has published in several journals, including Decision Sciences, Omega, International Journal of Production Economics, Annals of Operations Research, European Journal of Operational Research, Production Planning & Control, International Journal of Information Technology & Decision Making, Kybernetes, etc. Xiulian Cai received her MS in Management Science and Engineering at Nanjing University, in China. Her research interests including supply chain management and customer behaviour. She is one of the participants of NSFC under Grant 70671055.

Copyright 2010 Inderscience Enterprises Ltd.

T. Xiao et al.
Jiao Jin is an MS candidate at the School of Management Science and Engineering, Nanjing University, in China. Her research interest is logistics and supply chain management. She is one of the participants of NSFC under Grants 70671055 and 70731002. Her main work is taking on the model simulation and researching the adaptive negotiation mechanism for supply chain coordination.

Introduction

Nowadays, customer satisfaction is an important business strategy for a firm. The firm focuses not only on current demand and profit, but also on future demand and profit. For example, FedEx pays important attention to customer satisfaction. FedEx has been measuring customer satisfaction since the day that the company was founded. FedEx has stringent customer-service standards: each package must be delivered on time, calls must be answered in four rings or a maximum of 20 seconds. In addition, the company pays important attention to customer complaints and finds the root cause of service failure through analysing complaints, which helps FedEx obtain a high market share (Management Development Review, 1997). Why is customer satisfaction important? Customer satisfaction is the customers responses to the expectation of performance of the products and their interaction with the salesperson and is usually considered as future profitability (Oliver and Swan, 1989; Rust and Zahorik, 1993; Kalra et al., 2003). Empirical evidence shows a positive relationship between customer satisfaction and economic performance (Anderson et al., 1994; Gmez et al., 2004). For example, in the supermarket sector, customer satisfaction management is especially important due to increased competition, low switching costs of customers, and frequent and intense customer traffic (Gmez et al., 2004). Much of the literature on customer satisfaction focused on customers satisfying/dissatisfying beliefs and the ways of measuring customer satisfaction. However, how to successfully manage and motivate the retailers/salesperson that directly delivers service to customers to achieve customer satisfaction has not been studied sufficiently. In reality, employees usually are more myopic than firms and retailers often discount future profit more than manufacturers, which is one of the reasons explaining why they need incentives (Sannikov, 2008). This paper develops a two-period game model of a supply chain consisting of one manufacturer and one retailer to investigate the retail price and effort investment decisions of the retailer and the unit wholesale price decision of the manufacturer when customer satisfaction is considered and subsidy rule is given. We differentiate the retailers effort into short-term selling (SS) effort and customer-satisfying (CS) effort according to their effects on the demand. We assume that the retailer is more myopic than the manufacturer, i.e., the retailer has a lower discount factor. Thus, the manufacturer may induce the retailer to invest more in CS effort by paying a CS effort subsidy to the retailer. Stiglitz (2002) points out that when facing information asymmetry, incentive mechanism design firms tend to act risk averse. Dikolli (2001) assumes that the agent who determines short-term and long-term effort investments is risk averse, but the principal is risk neutral. We assume that the manufacturer and the retailer are risk averse and focus on the effect of the risk sensitivity on the equilibrium outcome. We find that when the patience (discount factor) of the retailer or the CS sensitivity of demand increases, the optimal CS effort investment will increase. The retail price and effort

Pricing and effort investment decisions of a supply chain

investments of the retailer and the unit wholesale price of the manufacturer are decreasing in the correlation coefficient between the errors of the market scales in two periods due to a higher risk cost. When the risk sensitivity of the manufacturer increases, the retailer will increase the effort investments and decrease the retail price to stimulate demand due to a lower wholesale price. When the risk sensitivity of the retailer increases, the retailer will decrease the effort investments and retail price, while the manufacturer will raise the unit wholesale price. The remainder of the paper is organised as follows. The related literature is reviewed in Section 2 and the basic model is presented in Section 3. Section 4 studies the equilibrium decisions, in particular, gives the equilibrium outcome when both players are risk neutral. Section 5 investigates the effects of the risk sensitivity and some main parameters on the equilibrium decisions and certainty equivalents (CEs) of players by using a numerical example. Section 6 summarises the results of this paper and points out directions for future research.

Literature review

This paper is closely related to effort and customer satisfaction and risk management. The degree of customer satisfaction can be defined as customers perception of the disparity between their prior expectations and the actual performance of the product (Howard and Sheth, 1969; Tse and Wilton, 1988). The relationship between market share and the degree of customer satisfaction is studied in Fornell (1992) and Anderson et al. (1994). Customer satisfaction online for the rapid growth of online transaction in service industries is also an important topic (Shankar et al., 2003). Empirical studies have proved the positive correlation between customer satisfaction and firm performance (Anderson et al., 1994). Hauser et al. (1994) suggest that the effort of salesperson can raise customer satisfaction, which in turn results in a greater future demand. According to Bellou (2007), firms benefit from satisfied customers due to: 1 2 3 repeat business reducing cost of acquiring new customers greater and better word of mouth.

Satisfied customers have fewer tendencies to terminate the purchasing relationship with the firm and thus resulting in repeat purchasing behaviour (Abdul-Muhmin, 2005). Customer satisfaction also provides positive word of mouth (Casal et al., 2008; Molinari et al., 2008). Kalra et al. (2003) assume that customer satisfaction is normally distributed and conditional on both selling effort and level of overselling and investigate customer satisfaction in a certain product category. Homburg et al. (2005) conduct two experimental studies and reveal the willingness of satisfied customers to pay higher prices. The literature above considers customer satisfaction from the firms marketing perspective. Few publications consider customer satisfaction from the supply chain operational perspective. Retailers (dealers or franchisees) play an important role in raising customer satisfaction (Finkelman and Goland, 1990). Chu and Desai (1995) study the coordination of a supply chain consisting of one manufacturer and one retailer, where the manufacturer uses either customer satisfaction assistance or customer satisfaction

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index bonus to motivate the retailer to provide higher customer satisfaction. Chu and Desai (1995) find that if the risk-neutral retailer has a short-term orientation, customer satisfaction index bonus is a more effective coordination mechanism. In Jammernegg and Kischka (2005), the supplier performs regular customer satisfaction survey and the information attained from the survey is used to improve dynamic coordination of the supply chain. In this paper, we will consider the effects of customer satisfaction on the marketing and operations of a supply chain, where the retailer determines effort investment to raise the customer satisfaction that influences the market scale in the next period. Why should the effort related to customer satisfaction be motivated? Different discount rates commonly exist in a principal-agent relationship, and usually, an agent is more myopic than a principal. Employees usually are more myopic than a firm under economic conditions of a strong labour market, retirement plans, electronic job listings and an active recruiter industry (Dikolli, 2001). Schotter and Weigelt (1992) develop a long-term scheme that alters the managers subjective discount rate and thus managers are willing to give greater consideration to the long-term output. Long-term bonus scheme that ties compensation to long-term (usually three to four years) organisational performance has widely been used in top companies to mitigate the adverse effect of agents myopia (Sloan, 1993). Hauser et al. (1994) employ customer satisfaction to induce employee group to allocate long-term and short-term effort levels in the best interest of the firm. In our model, the retailer determines its long-term and short-term effort investments rather than effort levels and the manufacturer only provides compensation to the long-term effort investment. The risk management plays an important role in the decisions of firms (Agrawal and Seshadri, 2000; Gan et al., 2004; Lee, 2008). Agrawal and Seshadri (2000) show that a risk averse retailer will charge a higher price and order less compared with a risk-neutral retailer. However, we find that the risk averse retailer will offer a lower price (see Figure 6). Usually, the literature on risk describes principal as risk neutral and agent as risk averse (Hauser et al., 1994; Dikolli, 2001; Kalra et al., 2003; Gan et al., 2004). Few publications have considered the situation with risk averse principal. Nevertheless, principals risk aversion may be a reasonable assumption. Leyden and Link (1993) point out that the firms who are small or whose business mainly consists of governmental contracts may be risk averse. Lewis and Sappington (1995) argue that risk averse principal is common in the procurement setting where the principal (procurer) cannot diversify all project-specific risks. Lau and Lau (1999) suggest that a larger and more diversified firm should be (and often is) less risk averse. In the study of manufacturer return policy for channel parties to share risk, Tsay (2002) generates several new insights about the effect of manufacturer risk aversion. Differing from theirs, we assume that the manufacturer designs the subsidy rate mechanism that induces the retailer to invest more in CS effort to access higher customer satisfaction and all players are risk averse. This paper complements the literature by investigating the pricing and two types of effort investment decisions of a supply chain, rather than a firm when both the manufacturer and the retailer are risk averse and they incorporate customer satisfaction in the objectives. We consider the effort investments, rather than the effort levels. We focus on how to make a trade-off between short-term benefit and long-term benefit, and the effects of the subsidy rate of CS effort investment, effort sensitivity of demand, risk sensitivity, uncertainty and correlation coefficient on the equilibrium decisions (especially, effort investments), and CEs of the random present profits.

Pricing and effort investment decisions of a supply chain

The basic model

Consider a supply chain consisting of one manufacturer (M) and one retailer (R), where both players are risk averse. The manufacturer sells its product through the retailer who incorporates customer satisfaction into its objective. The customer satisfaction influences future demand and profitability of the supply chain. Specifically, higher customer satisfaction increases future demand, which in turn increases the future profitability of the manufacturer and the retailer. However, the retailer who often is more myopic than the manufacturer must pay an effort investment to raise customer satisfaction. The manufacturer may have an incentive to induce the retailer to raise customer satisfaction by paying an effort subsidy. The retailer undertakes two types of efforts, SS effort and CS effort. The SS effort only increases current demand and the CS effort only increases future demand by adding customer satisfaction and retailers reputation for quality (Hauser et al., 1994; Chu and Desai, 1995). The decision time window is divided into two periods. Period 1 is the period where customer satisfaction and retailer efforts are taken into consideration, i.e., the retailer determines two types of efforts in the first period. In reality, tomorrow will be like today and the retailer will make both types of efforts. To focus on the short-term versus long-term trade-offs, we take Period 2 as an ending period without effort (Hauser et al., 1994; Chu and Desai, 1995; Kalra et al., 2003). We have the following notation (i = 1, 2): c a I1 unit production cost of the manufacturer market scale corresponding to zero retail price and effort levels, a > c SS effort investment of the retailer, referring to as SS effort investment and the SS effort level is I1 CS effort investment of the retailer, referring to as CS effort investment and the CS effort level is I 2 the subsidy rate that the manufacturer pays the retailer for CS effort investment, 0t1 the error of the market scale in Period 1, with zero mean and variance 12
2 the error of the market scale in Period 2, with zero mean and variance 2

I2

1 2 1 2
wi pi
%i q

the correlation coefficient between the errors in two periods, 1 1 the effort sensitivity of demand to the SS effort level, referring to as SS effort sensitivity, 1 > 0 the effort sensitivity of demand to the CS effort level, referring to as CS effort sensitivity, 2 > 0 the unit wholesale price announced by the manufacturer in period i, wi c the retail price announced by the retailer in period i the random demand for the retailer in period i

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% Ri the random profit of the retailer in period i, the mean is denoted by E % Ri % Mi the random profit of the manufacturer in period i, the mean is denoted by E % Mi

j j

the discount factor of player j, reflecting the patience of player j, 0 j 1, j = M, R the risk sensitivity of player j, j 0, j = M, R.

Similar to Hauser et al. (1994) and Chen and Xiao (2009), we assume that the demand function of the retailer in Period 1 is
%1 = a + 1 I1 p1 + 1 q

(1)

and the demand function of the retailer in Period 2 is

%2 = a + 2 I 2 p2 + 2 q

(2)

Differing from Hauser et al. (1994), we assume that the error vector (1, 2) is binormally 2 , ) (Holmstrm distributed and the errors are correlative, i.e., (1 , 2 ) ~ N (0, 0, 12 , 2 and Milgrom, 1987). In reality, the errors may be incurred by the change of the common market environment. Sometimes, an occasional event increases the market scale in Period 1, but decreases the market scale in Period 2. Thus, the errors may be correlative. Equations (1) and (2) mean that improving demand scale has a diminishing return on effort/service expenditure. The larger the SS (CS) effort sensitivity, the higher the efficiency of the SS (CS) effort will be. We will consider the effects of the changes of effort efficiency and correlation coefficient. The random profits of the retailer in two periods respectively are
% R1 = (a + 1 I1 p1 + 1 )( p1 w1 ) I1 (1 t ) I 2 % R 2 = (a + 2 I 2 p2 + 2 )( p2 w2 )

(3) (4)

% R1 + R %R2 . The present profit of the retailer during two periods is We assume that the manufacturer always meets the order of the retailer. Thus, the random profits of the manufacturer in two periods respectively are % M 1 = ( w1 c)(a + 1 I1 p1 + 1 ) tI 2 % M 2 = ( w2 c)(a + 2 I 2 p2 + 2 )

(5) (6)

Equations (3) and (5) mean that the manufacturer subsidises the retailer tI2 for the CS effort investment, which stimulates the market demand in Period 2 through improving customer satisfaction. The present profit of the manufacturer in two periods is %M 1 + M % M 2 . In reality, the manufacturer often has higher patience than the retailer because the purchase cost of the retailer is higher than the production cost of the manufacturer and the retailer directly faces the market demand uncertainty, i.e., M > R (Chu and Desai, 1995). In particular, for some seasonal goods, the retailer has lower patience and wants a quick turnover of capital. Thus, the retailer will lower the CS effort

Pricing and effort investment decisions of a supply chain

investment, which harms the benefit of the manufacturer in Period 2. To stimulate the CS effort investment of the retailer, the manufacturer has to pay a CS effort subsidy. Similar to Kalra et al. (2003) and Gibbons (2005), we assume that the utility function % ji = 1 exp[ j % ji ]. Thus, maximising the expected (present) of player j in period i is u utility is equivalent to maximising its CE. In this paper, we assume that the subsidy rate t is exogenous to simplify the analysis. We will investigate how the subsidy rate influences the equilibrium decisions and utilities of the players. The time sequence of this game is as follows: 1 2 3 4 at the beginning of Period 1, the manufacturer determines the unit wholesale price w1 during Period 1, the retailer jointly determines retail price p1, SS effort investment I1 and CS effort investment I2 at the beginning of Period 2, the manufacturer determines the unit wholesale price w2 during Period 2, the retailer determines retail price p2.

By using backward induction technique, we can solve the dynamic game.

The equilibrium decisions

4.1 The equilibrium decisions in Period 2

Similar to Kalra et al. (2003) and Holmstrm and Milgrom (1987), for the retailer, maximising the expected utility ER2 is equivalent to maximising its CE
2 CER 2 = (a + 2 I 2 p2 )( p2 w2 ) 1 ( p2 w2 ) 2 2 , 2 R

(7)

which is a concave function of p2. The second term is the risk cost of the retailer in Period 2. Similarly, we can give the CE, CEM2, of the manufacturer in Period 2. Furthermore, we derive the following. Proposition 1 Given the CS effort investment I2, the equilibrium decisions in Period 2 are
2 p2 ( I 2 ) = c + (a c + 2 I 2 ) A2 / [ A1 (2 + R 2 )] and 2 w2 ( I 2 ) = c + (1 + R 2 )(a c + 2 I 2 ) / A1 ,
2 4 where A1 = 2 + 2(R + M ) 2 + R M 2 and 2 2 4 2 2 A2 = 3 + 4R 2 + R 2 + M 2 (2 + R 2 ).

Proposition 1 implies that the unit wholesale price and retail price are increasing in market scale a, CS effort sensitivity 2 and CS effort investment I2. That is, when the potential demand increases, the retailer will raise retail price to access a higher unit profit and the manufacturer will raise the unit wholesale price to share a part of the increased benefit. When the manufacturer becomes more conservative (higher M), the

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manufacturer would like to lower the wholesale price to induce a higher order quantity. Differentiating w2(I2) with respect to R, we have
4 w2 ( I 2 ) / R = M 2 (a c + 2 I 2 ) / A12 ,

which is positive following from a > c. Similarly, we can show that the retail price p2(I2) is a decreasing function of R and M. Specifically, when the retailer becomes more conservative, the retailer will lower the retail price to attract the customers, while the manufacturer prefers raising the wholesale price to access a higher unit profit, which results in a lower unit profit and risk cost for the retailer. When the manufacturer becomes more conservative, the retailer will lower the retail price to attract customers due to a lower unit wholesale price. Given the CS effort investment, the equilibrium CE of the retailer in Period 2 is
CER 2 ( I 2 ) =
2 2 (a c + 2 I 2 ) 2 ( A1 1 R 2 ) 2 2 A12 (2 + R 2 )

which is a decreasing function of R and an increasing function of M. The equilibrium CE of the manufacturer in Period 2 is
CEM 2 ( I 2 ) =
2 2 (a c + 2 I 2 ) 2 (1 + R 2 ) 2 2 A1 (2 + R 2 )

which is an increasing function of R and a decreasing function of M. Thus, when the risk sensitivity of one player increases, the player will obtain a lower CE due to a higher risk cost, while the other player will obtain a higher CE due to a higher expected profit. In addition, in Period 2, both players benefit from the CS effort investment of the retailer in Period 1. Thus, the manufacturer has an incentive to share a part of the CS effort cost with the retailer.

4.2 The equilibrium decisions in Period 1

Since the CS effort investment of the retailer in Period 1 influences the utility of each player in Period 2, each player will maximise its expected utility in two periods, equivalently, maximising the CE of its present profit. Similar to equation (7), the CE of the retailers present profit is

% R1 + R (a + 2 I 2 p2 ( I 2 ))( p2 ( I 2 ) w2 ( I 2 )) 1 PCER = E [( p1 w1 ) 2 12 2 R
2 2 + 2 R 1 2 ( p1 w1 )( p2 ( I 2 ) w2 ( I 2 )) + R 2 ( p2 ( I 2 ) w2 ( I 2 )) 2 ]

(8)

The final term is the risk cost incurred by the error of the random present profit of the retailer. Let the optimal retail price, SS and CS effort investments of the retailer in Period 1 be p1(w1), I1(w1) and I2(w1), respectively. We assume that the SS effort
2 sensitivity satisfies 1 < 4 + 2R 1 to assure that the equilibrium decisions are positive.

Solving the first-order condition PCER / I1 = 0 for I1, we have

I1 ( w1 ) = 1 2 ( p1 ( w1 ) w1 ) 2 . 4 1

Pricing and effort investment decisions of a supply chain

Inserting I1(w1) into the first-order condition PCER / p1 = 0, and then solving it for p1, we have
a + w1 (1 + R 12 12 / 2)
2 2 12 / 2 + R 1 2 2 4 R R 1 2 (2 A2 + 3R 2 + R 2 ) (a c + 2 I 2 ) 2 2 A1 (2 12 / 2 + R 1 )(2 + R 2 )

p1 ( w1 , I 2 ) =

Inserting p1(w1, I2) into the first-order condition PCER / I 2 = 0, and then solving it for I2, we can obtain the unique solution I2(w1), omitting it due to the complexity of the expression. Furthermore, we have p1 ( w1 ) = p1 ( w1 , I 2 ( w1 )). The CE of the manufacturers present profit in two periods is
% M 1 + M ( w2 ( I 2 ) c)(a + 2 I 2 p2 ( I 2 )) 1 PCEM ( p1 , I1 , I 2 , w1 ) = E 2 M [( w1 c) 2 12 + 2 M 1 2 ( w1 c)( w2 ( I 2 ) c)
2 2 +M 2 ( w2 ( I 2 ) c) 2 ]

(9)

Expecting the reaction of the retailer, the manufacturer determines w1 to maximise PCEM (p1(w1), I1(w1), I2(w1),w1). Owing to the complexity of the equilibrium expressions, we omit them and will study the effects of some factors on them by using numerical examples. From equations (8) and (9), we derive the following. Proposition 2 Assume that both manufacturer and retailer are risk neutral ( R = M = 0 ) and 1 < 2. The equilibrium decisions are
p1 =

4a + (a + c)(2 12 ) 2(4 12 )

, I1 =

12 (a c) 2 , 4(4 12 ) 2

I , if t < t I2 and w1 (a + c), = 2 =1 2 I , otherwise 2 where I 2 =

2 2 2 2 R 2 (a c) 2 M 2 (a c) 2 , I = and 2 2 2 2 2 (16 16t R 2 ) (8t M 2 )

2 t = 1 R 2 / 16.

Proposition 2 implies that, when both the manufacturer and retailer are risk neutral, in Period 1, only CS effort investment depends on the subsidy rate t. The CS effort investment I 2 is an increasing function of t for all t < t. Differentiating I 2 with respect to R, we have
2 I 2 32(a c) 2 (1 t ) R 2 = , 2 3 R (16 16t R 2 )

which is positive following from t < t. Similarly, a higher CS effort sensitivity 2 results in a higher CS effort investment if t < t. That is, when the patience (R) or the CS effort

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sensitivity (2) of the retailer increases, the retailer will increase CS effort investment if the subsidy rate is sufficiently small (t < t). If the subsidy rate is sufficiently high (t t), the retailer obtains a higher benefit and subsidy than its own CS effort investment such that it would like to raise the CS effort investment, which may harm the benefit of the manufacturer because the return of the CS effort investment for the manufacturer diminishes. Thus, the manufacturer would like to specify the upper bound of the CS effort investment if t t. Specifically, if the CS effort investment of the retailer is strictly higher than I 2 and t t, the manufacturer will lower the subsidy rate, even not subsidise the investment to induce the retailer to invest I 2 in the CS effort. Furthermore, when the patience (M) of the manufacturer or the CS sensitivity (2) increases, the optimal CS effort investment I 2 will increase. When the SS effort sensitivity (1) increases, the retailer increases the SS effort investment to attract customers and raises the retail price to achieve a higher unit profit. However, the manufacturer keeps its unit wholesale price in Period 1. That is, the retailer gains the most of the benefit from SS effort investment and the manufacturer derives a part of the benefit through a higher expected order quantity. Propositions 1 and 2 imply that, when the discount factor (R or M) or the CS effort sensitivity increases, the equilibrium retail price and wholesale price in Period 2 will increase due to a higher CS effort investment.

A numerical example

In this section, we will investigate how the equilibrium decisions (in particular, two types of effort investments) and CEs of both risk averse players depend on some main parameters by using a numerical example. In Section 4, we have considered the effects of the effort sensitivity of demand and the manufacturers discount factor. Moreover, Propositions 1 and 2 imply that the effects of the market scale and the unit production cost on the equilibrium outcome are intuitive. Thus, we do not consider the effects of these parameters. In Subsection 4.1, we have considered the effects of some factors on the optimal decisions in Period 2. Thus, in the following, we only focus on the equilibrium decisions in Period 1 and the CE of the present profit of each player. In order to focus on the effect of the SS effort investment, we assume that the discount factor of the manufacturer is larger than that of the retailer, i.e., M > R. It is 2 2 ) in Period 2 is larger than that ( 1 ) in obvious that the demand uncertainty ( 2 Period 1 due to a longer time in advance, i.e., 2 > 1. In general, occasional events have similar effects on the market scales in two periods, which allows us to assume a positive correlation coefficient ( > 0). In addition, we assume that 1 = 2 and M = R to better focus on the effects of the other parameters on the equilibrium decisions. We will also analyse the effects of the change of the parameters. Figures 19 illustrate how the pricing and effort investment decisions and the CE of the random present profits depend on some main factors, where the default values of the parameters are used as:
a = 50, c = 5, t = 0.6, R = 0.6, M = 0.9, 1 = 2 = 1, 1 = 1, 2 = 2,

= 0.5 and M = R = 1.

Pricing and effort investment decisions of a supply chain

Figure 1 The optimal effort investments versus 2 and R

11

I
70 60 50 40 30 20 10 0.5 1 1.5 2
I2

R = 0.4 R = 0.8
I1 I1

2.5

Figure 2

The optimal effort investments versus and t

I
250 200 150 100 50
I2 I2

t = 0 .4 t = 0 .8

I 1
0.5 1

-1

-0.5

Figure 3

The optimal effort investments versus R and M

I
60 50 40 30 20 10

M = 1 M = 2

I2 I2

12
Figure 4

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The optimal prices p1 and w1 versus 2 and R

price
30 28 26 24 22 20 18 0.5 1 1.5

R = 0.4 R = 0.8

p1

p1

w1

2.5

Figure 5

The optimal prices p1 and w1 versus and t

40 35 30 25 20

price

t = 0.4 t = 0.8

p1 p1 w1

-1

-0.5

0.5

w1

Figure 6

The optimal prices p1 and w1 versus R and M

price
30 27.5 25 22.5 20 17.5 1 12.5 2

M = 1 M = 2
p1
p1

w1

Pricing and effort investment decisions of a supply chain

Figure 7
The equilibrium CE PCER and PCEM versus 2 and R

13

profit
500 450 400 350 300
PCEM PCEM
PCER PCER

R = 0.4 R = 0.8

0.5

1.5

2.5

Figure 8

The equilibrium CE PCER and PCEM versus and t

profit
550
PCEM

t = 0.4 t = 0.8

500 450

PCE

PCEM PCER

400 350 300 0.5 1

-1

-0.5

Figure 9

and PCEM versus R and M The equilibrium CE PCER

profit
400 350 300 250 200 150 100 1 2

M = 1 M = 2
PCEM

PCEM
PCER PCER

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The above values satisfy the assumptions of a > c and 0 t 1. From Figures 19, we derive the following observations: 1 From Figure 1, we know that when the demand uncertainty (2) is sufficiently small, the increase of the demand uncertainty will strengthen the effect of the retailers discount factor on the effort investments; otherwise, weaken the effect. The retailers discount factor positively influences the CS effort investment, while negatively influences the SS effort investment. That is, a part of the SS effort capital is transferred to the CS effort investment. In reality, the retailer with higher patience more focuses on the future demand and profitability by setting up reputation. The wholesale price and retail price in Period 1 are first decreasing and then increasing in the demand uncertainty. The retailers discount factor negatively influences the retail price in Period 1, while has only a small effect on the unit wholesale price in Period 1 (see Figure 4). That is, when the patience of the retailer increases, the retailer would like to decrease the retail price in Period 1 to access a higher demand, while the manufacturer may ignore the change of the retailers patience. From Figure 7, we know that the CE of the retailers present profit is first increasing and then decreasing in the demand uncertainty due to the effect of the demand uncertainty on the effort investments. The CE of the manufacturers present profit is decreasing in the demand uncertainty due to the increase of the risk cost. When the discount factor of the retailer increases, the CE of the present profit of each player increases. Thus, the manufacturer would like to encourage the retailer to increase the patience. The two players may have motivation to cope with the uncertainty collaboratively. When the correlation coefficient () increases, the retailer will lower the effort investments and retail price in Period 1 due to a higher risk cost and the manufacturer also lowers the wholesale price due to a higher risk cost (see Figures 2 and 5). Furthermore, the CE of each player decreases. The negative effect of the increase of the correlation coefficient on the CE of the manufacturer is larger than that of the retailer due to a higher discount factor for the manufacturer (see Figure 8). A higher subsidy rate (t) will induce a higher CS effort investment. However, a larger correlation coefficient () will decrease the positive effect of subsidy rate on the CS effort investment because a higher risk cost weakens the effect of the decrease of the CS effort investment on the retailers CE (see Figure 2). When the correlation coefficient is negative (positive), a higher subsidy rate will result in higher (lower) prices in Period 1 for two players (see Figure 5). That is, the effect of the subsidy rate depends on whether the random market scales are correlative or not. From Figures 3, 6 and 9, we know that when the risk sensitivity of the retailer increases, the retailer will lower the effort investments and retail price in Period 1 due to a higher risk cost for the retailer and the manufacturer increases the wholesale price to access a higher unit profit, which results in a lower CE for the retailer, but a higher CE for the manufacturer. When the risk sensitivity of the manufacturer increases, the retailer will increase the effort investments and lower the retail price to

Pricing and effort investment decisions of a supply chain

15

stimulate demand due to a lower wholesale price, which results in a higher CE for the retailer. Thus, when the risk sensitivity of one player increases, the CE of the player will decrease, while the CE of the other player will increase. That is, a player likes a partner with higher risk sensitivity.

Conclusions

Customer satisfaction is an important topic in the business world because it influences the future demand and profitability of firms. We develop a dynamic game model of a supply chain consisting of one manufacturer and one retailer and incorporate customer satisfaction to investigate the price and effort investment decisions of the retailer and the wholesale price decisions of the manufacturer. We differentiate the effort of the retailer into SS effort and CS effort according to their effects on the demand. We find that when the CS effort sensitivity increases, the manufacturer has a stronger incentive to stimulate the CS effort investment of the retailer through providing a CS effort subsidy because this induces the retailer to focus more on future profit. That is, the manufacturer should share more the benefit from increased demand with the retailer by paying a CS effort subsidy. The effect of the retailers discount factor on the unit wholesale price in Period 1 is very small, which means that the manufacturer may determine the unit wholesale price regardless of the retailers patience. The CS effort investment positively depends on the retailers discount factor and the manufacturers risk sensitivity and negatively depends on the correlation coefficient and the retailers risk sensitivity. The SS effort investment negatively depends on the retailers discount factor and risk sensitivity. The retail price negatively depends on the risk sensitivity and correlation coefficient. In addition, the cross-effects among the factors should also be considered. In this paper, we assume that there is only one retailer in the downstream industry. However, in reality, the retailers often compete for customers by improving effort levels. One can extend it to the duopoly-retailer setting to consider the effect of the competition between retailers. We assume that the players are risk averse. However, risk aversion reflected by mean-variance cannot well describe the retailers preference for a higher profit than a reference level, while this can be well described by loss aversion (Shi and Xiao, 2008; Ma, 2008). The pricing and effort investment decisions of a supply chain with loss averse players may be interesting, but challenging. We assume that the retailer undertakes effort investments only in Period 1, which does not consider the accumulative effect of the CS effort level. One can extend the two-period model to the multiple-period model where the retailer undertakes effort investments in multiple periods by the aid of computer.

Acknowledgements
This research was supported in part by: the National Natural Science Foundation of China under Grants 70671055 and 70731002; programme for New century excellent talents in university (NCET-07-0426) of the Ministry of Education, China; and the Provincial Natural Science Foundation of Jiangsu under Grant BK2008273.

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Appendix
Proof of Proposition 1: Differentiating CER2 with respect to p2, we can obtain the first-order condition
2 2 CER 2 / p2 = a + w2 (1 + R 2 ) + 2 I 2 p2 (2 + R 2 )=0

(10)

Solving the first-order condition (10) for p2, we have

p2 ( I 2 , w2 ) =
2 a + 2 I 2 + w2 (1 + R 2 ) 2 2 + R 2

(11)

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Expecting the reaction of the retailer, in Period 2, the manufacturer will determine w2 to maximise its CE
2 CEM 2 = ( w2 c)(a + 2 I 2 p2 ( I 2 , w2 )) 1 ( w2 c) 2 2 , 2 M

(12)

which is a concave function of w2. Solving the first-order condition of CEM2 for w2, we 2 (1 + R 2 )(a c + 2 I 2 ) . Inserting w2(I2) into equation (11), we have w2 ( I 2 ) = c + 2 4 2 + 2(R + M ) 2 + R M 2 can obtain p2 ( I 2 ) = p2 ( I 2 , w2 ( I 2 )) given in Proposition 1. Proof of Proposition 2: From R = M = 0 and equation (8), it follows that the first-order conditions are
PCER / p1 = a 2 p1 + w1 + 1 I1 = 0

(13) (14) (15)

PCER / I1 = 1 ( p w1 ) I11/2 1 = 0 2 1 1
1 PCER / I 2 = 16 R 2 [(a c) I 21/ 2 + 2 ] 1 + t = 0

Solving the first-order conditions (13) and (14), we obtain

p1 ( w1 ) = 2a + w1 (2 12 ) 4 12 1 + t = 0 and I1 ( w1 ) =

12 (a w1 ) 2 (4 12 ) 2

Solving

1 2 16 R 2

2 1 . If t t, we have for t, we obtain t = 1 16 R 2

PCER / I 2 > 0. Thus, the retailer would like to increase the CS effort investment, which may harm the benefit of the manufacturer due to a higher investment subsidy. From equation (9), it follows that
1/2 PCEM ( p1 ( w1 ), I1 ( w1 ), I 2 , w1 ) / I 2 = 1 [(a c) I 2 + 2 ] t 8 M 2

(16)

From t t, 0 R , M 1 and 2 < 2, it follows that solving PCEM ( p1 ( w1 ), I1 ( w1 ), I 2 , w1 ) / I 2 = 0

I 2 =
2 2 M 2 (a c) 2 2 2 (8t M 2 )

1 2 8 M 2

t is negative. Thus,

for I2, we obtain its unique root

. Equation (16) is positive if I 2 < I 2 and negative if I 2 > I 2 . Thus,

from the manufacturers perspective, the optimal CS effort investment is I 2 . The manufacturer would like to specify the upper bound of the CS effort investment to induce the retailer to invest I 2 if t t. Furthermore, the optimal unit wholesale price is
w1 =1 (a + c). 2 , solving equation (15) for I2, we have I 2 = If t < t 2 2 R 2 (a c) 2 . 2 2 (16 16t R 2 )

Furthermore, the Hessian matrix of PCER on (p1, I1, I2) is

Pricing and effort investment decisions of a supply chain

2 H= 1 2 I1 0

19

1
2 I1

1 ( p1 w1 )
3/2 4 I1

0 (a c) R 2 3/2 32 I 2 0

From a > c and 1 < 2, it follows that the Hessian matrix H is negatively definite at the point satisfying the first-order condition. Thus, the solution satisfying the first-order condition is optimal. into equation (9), and solving its first-order If t < t, inserting p1(w1), I1(w1) and I 2
=1 (a + c). condition for w1, we have w1 2