Innovation and waste in supply chain management

We study a supply chain relationship in which the buyer outsources production of a component to the supplier. The buyer also produces a component and combines it with the supplier's input to yield the final output. The supplier can upgrade production of his input via costly innovation. Neither the supplier's effort for innovation nor the result of the innovative activity can be publicly verified. We show that, when the cost of innovation is large, the buyer's optimal contract may induce ‘wasting’ a fraction of the supplier's input.

► When R&D investment is small, no waste takes place in supply chains.
► When R&D investment is large, waste may take place in supply chains.
► As R&D investment becomes larger, the amount of waste increases.