Collaboration with a supplier to induce fair labor practices

The reputation of a multinational firm (a “buyer”) is hurt if its offshore supplier flagrantly violates fair labor practices. How should a buyer manage the consequent risk of reduced sales? This paper answers the question by analyzing a dynamic Stackelberg game in which the buyer offers financial incentives to the supplier to treat its work force fairly. This tactical approach to risk management corresponds to a strategic approach in which the buyer first determines its risk posture, and then identifies the most profitable financial incentives that are consistent with that risk posture. The buyer’s problem corresponds to optimizing a Markov decision process with a discounted criterion over an infinite horizon. Analytical and numerical analysis of the model shows that the buyer should rely on a contingent bonus as the primary incentive, and set the wholesale price at the supplier’s reservation price; the organization of the supply chain affects the mean severity of a flagrant violation of fair labor practices; and the buyer’s value function is approximated well by an affine function of reputation.