A mechanism design approach to a buyer's optimal auditing policy to induce responsible sourcing in a supply chain

Responsible sourcing refers to the compliance of suppliers with environmental and social standards. In today's supply chains, buyers and external stakeholders use auditing mechanisms to induce responsible sourcing. For the first time, this paper investigates the effect of a buyer's audits on the tactical decisions of supply chains. We address a repeated game with one buyer and one critical supplier. At the strategic stage, the buyer chooses the optimal auditing efforts to induce responsible sourcing. At the tactical stages, the buyer and supplier compete with each other for their profit margins, while the buyer also determines the quantity of production. Moreover, the supplier chooses between responsible and irresponsible production. Two auditing mechanisms are defined for the buyer: strong incentive compatibility (SIC) and weak incentive compatibility (WIC). The effectiveness and backfiring conditions for these auditing mechanisms are identified. The former denotes that the mechanism can induce responsible sourcing, while the latter denotes the conflict between supply chain transparency and responsible sourcing. The results show that the supplier requires an efficiency wage for compliance with responsible sourcing standards. We find that auditing mechanisms in supply chains face an unintended consequence. Higher auditing efforts by the buyer reduce the supplier's wholesale price. This reduction may offset the greater potential for discovery obtained by higher auditing efforts. We also show that the effect of consumer awareness on responsible sourcing is not straightforward and depends strongly on the buyer's auditing mechanism. If the buyer chooses the SIC (WIC) auditing mechanism, consumer awareness always favors (threatens) responsible sourcing. Finally, this research suggests that coordination between buyers and external stakeholders contributes greatly to responsible sourcing.