Quality Investment Through Buyer-Direct Financing

We consider a retailer who sources her product from a sole supplier. The end market demand is influenced by the quality provided by the supplier. Both supplier and retailer incur costs whenever a low-quality item is sold to the customer. Therefore, both of them have incentive to improve quality. However, the supplier is financially constrained and does not have enough funds to invest in quality. This paper investigates a scenario when the retailer decides to finance the supplier via ‘buyer-direct financing’. In this arrangement, the retailer extends the loan directly to the supplier, and thus accepts the risk of a default. The repayment of the loan is dependent upon the performance of the supplier. We show that there is a unique optimum investment from the retailer which will maximize the retailer’s profit while the supplier is not worse off. We also find the specific level of investment required to reach a pre-defined proportion of damaged units. The study is further exemplified with a numerical.