Decision Support Quality investment and price decision in a risk-averse supply chain Gang Xie a,⇑ , Wuyi Yue b , Shouyang Wang a , Kin Keung Lai c a Academy of Mathematics and Systems Science, Chinese Academy of Sciences, Beijing 100190, China b Department of Intelligence and Informatics, Konan University, 8-9-1 Okamoto, Kobe 658-8501, Japan c Department of Management Sciences, City University of Hong Kong, Hong Kong article info Article history: Received 17 September 2010 Accepted 27 April 2011 Available online 4 May 2011 Keywords: Quality investment Supply chain strategy Preference theory Make-to-order Risk tolerance abstract In this paper, we investigate quality investment and price decision of a make-to-order (MTO) supply chain with uncertain demand in international trade. Due to volatility of orders from buyers, the supplier and the manufacturer in the supply chain are subject to financial risk. In contrast to the general assump- tion that players in a supply chain are risk neutral in quality investment and price decision, we consider the risk-averse behavior of the players in three different supply chain strategies: Vertical Integration (VI), Manufacturer’s Stackelberg (MS) and Supplier’s Stackelberg (SS). The study shows that both supply chain strategy and risk-averse behavior have significant impacts on quality investment and pricing. Compared to a risk-neutral supply chain, a risk-averse supply chain has lower, same and higher quality of products in VI, MS and SS, respectively. Also, we derive the conditions under which the supply chain strategy is implemented in a decentralized setting. A numerical study is used to illustrate some related issues. Ó 2011 Elsevier B.V. All rights reserved. 1. Introduction In recent years, rapid increase of China’s share in global trade has been a significant feature of international trade. In the back- drop of globalization of trade, benefiting from its low labor cost, China has become one of the world’s primary manufacturing cen- ters. A typical trade scenario is that supplier-manufacturer supply chains in China produce goods according to orders placed by buy- ers from around the world. Compared with make to stock, make to order might be a pattern with lower cost but higher variability (Grosfeld-Nir et al., 2000; Rajagopalan, 2002; Gunasekaran and Ngai, 2009). Based on China’s Customs Express data, due to the changes in economic and busi- ness conditions, orders from buyers are seen to be fluctuant. In par- ticular, many small-and-medium-sized manufacturers catering to overseas buyers have closed down due to a reduction in orders fol- lowing the global financial crisis in 2008. Supply chain quality is a key component in achieving a compet- itive advantage, and quality management practices are signifi- cantly correlated with players’ strategies which influence tangible business results, and customer satisfaction levels (Lin et al., 2005). Although higher quality can be a reason for higher price, it can also cause higher costs. At the same time, quality and price influence demand and profits (Banker et al., 1998; Bai- man et al., 2000). As a consequence, quality investment and price decision are important for players in a supply chain. Enlightened by the procurement process of Wal-Mart, we inves- tigate quality investment and price decision of a make-to-order (MTO) supply chain where quality of products is mainly decided by that of raw materials or spare parts provided by the supplier. The examples include automobile, electronic appliances assembly industries and food processing industries such as vegetables, fruits, milk and meat. During the course of procurement, the manager from Wal-Mart checks samples of products provided by the manu- facturer. If the product is acceptable, considering market demand, the manager places an order on the basis of quality and price of products (Wal-mart, 2009). Usually, the order is stochastic because of volatility of market demand. Then, the manufacturer organizes production along with its suppliers with respect to the order. As raw materials are usually processed into products not by a single firm but by firms throughout a supply chain, the quality of a manufacturer’s products depends not only on its own process quality but also on the quality of its suppliers (Robinson and Malhotra, 2005; Hwang et al., 2006; Foster, 2008; Hsieh and Liu, 2010). For simplicity of analysis, we consider the case that quality of products is decided by the raw materials provided by the sup- plier in this study. The quality problem has received intensive attention. Forker (1997) linked quality management with process optimization to address both effectiveness and efficiency concerns. The study sug- gested that system performance was affected by transaction-spe- cific investments in coordination. Reyniers and Tapiero (1995) modeled the effect of price rebates and after-sales warranty costs on the choice of quality by a supplier, inspection policy of a man- ufacturer, and the resulting end product quality. They explored 0377-2217/$ - see front matter Ó 2011 Elsevier B.V. All rights reserved. doi:10.1016/j.ejor.2011.04.036 ⇑ Corresponding author. Tel.: +86 10 62545830; fax: +86 10 62541823. E-mail address: gxie@amss.ac.cn (G. Xie). European Journal of Operational Research 214 (2011) 403–410 Contents lists available at ScienceDirect European Journal of Operational Research journal homepage: www.elsevier.com/locate/ejor