Incentive Mechanism Design in Operations and Supply Chain Management

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TITLE: Incentive Mechanism Design in Operations and Supply Chain Management Supply chains consist of interconnected businesses managed by decision makers with possibly divergent goals and asymmetric information about each other's objectives. Incentive mechanism design takes into account such asymmetry where the principal (e.g., retailer) is less informed than the agent (e.g., manufacturer) about some aspect of the problem. In moral hazard-type problems the principal cannot observe the agent's action and thus the reward must be based on a verifiable variable such as the sales level. The principal must design a contract so that the agent behaves in a way that is compatible with her incentives and also benefits the principal. There are several applications of this theory in economics, but the applications in operations and supply chain management seem to be very few. In this proposal I will focus on mechanism design and develop models which will be relevant in operations and supply chain management applications. Supply (or, yield) uncertainty and the related problem of product recalls are common, and costly, phenomena in many industries. The recent recall of more than 1 million Takata airbags installed in Honda and Toyota vehicles sold in Canada and the U.S. has resulted in large losses for these companies, and substantial inconvenience for owners. Last year's recall of beef products from XL Foods in Alberta has resulted in massive costs for both XL and the grocery store chains such as Metro and Wal-Mart, and potential health hazard for consumers. Most of the existing literature on supply uncertainty investigates methods for reducing the influence of yield randomness on the effectiveness of supply chains by considering supplier diversification. I propose an alternative approach to this problem by employing a moral hazard-type incentive structure which will benefit both the retailer (principal; "he") and manufacturer (agent; "she"). This arrangement will result in a transfer (payment) to the agent and will improve the agent's reliability thereby lowering the principal's supply uncertainty. The principal cannot directly observe the agent's effort to improve the reliability of her operations, thus the problem is one of asymmetric information. The principal's problem is to offer the agent a menu of rewards for different levels of reliability which satisfy a set of incentive compatibility constraints (so that she provides her best possible effort), and a participation constraint (so that she will agree to participate in this incentive scheme). My first goal is to formulate and solve this incentive problem assuming that the decisions are made only once. Different from many of the existing models of mechanism design where the principal's menu consists of a few options, I will consider the more realistic case of a continuum of effort levels that are available to the agent. Once I understand the properties of the solution for this static problem, I will consider the extension where the interaction between the principal and the agent extends to multiple periods. This dynamic version of the moral hazard problem with a continuum of effort levels is likely to be very challenging since there is little published work on such problems where the incentive design involves interaction over time. Application of incentive mechanism design theory would benefit Canadian companies and consumers (as the principals) by providing suitable incentives for the agents (such as Takata and XL Foods quoted above). Reducing uncertainty in supply while increasing the quality and safety of consumer products is a desirable goal which can be achieved with a judicious application of mechanism design theory.