Coordinating research and development efforts for quality improvement along a supply chain

Abstract The optimal design of two-part tariffs is investigated in a dynamic model where two firms belonging to the same supply chain invest in R&D (research and development) activities to increase the perceived quality of the final product. It is shown that the replication of the vertically integrated monopolist’s performance can be attained using a two-part tariff in which the fee is a linear function of either the upstream R&D effort or product quality itself. The possibility of relying on R&D figures appearing in the upstream firm’s balance sheet is desirable as quality enhancement might not be observable or verifiable.