Product quality improvement under retailer-direct financing: Effects of attitudes toward extreme weather

Firms face market volatilities caused by events such as extreme weather. While realistic firm managers can accurately estimate the probability of extreme weather, optimistic ones tend to underestimate it. The different attitudes (i.e., realistic and optimistic) will lead the firms to make different decisions, thus affecting the firms' profits. We develop a game-theoretic model consisting of a capital-constrained manufacturer and a non-capital-constrained retailer, either of which can be realistic or optimistic. The retailer can provide a loan for the manufacturer to improve product quality. We show that this supply chain suffers the well-known double-marginalization effect as well as an under-capitalization effect (i.e., the manufacturer asks for an insufficient loan from the retailer, thus setting its quality lower than that can maximize the supply chain's expected profit). The retailer's optimism aggravates both effects, harming the supply chain. The manufacturer's optimism, though aggravating the double-marginalization effect, mitigates the under-capitalization effect by motivating the manufacturer to borrow more money from the retailer to improve product quality. If consumers' quality sensitivity is high relative to their price sensitivity, the manufacturer's optimism benefits the retailer and the supply chain. However, the manufacturer is worse off from either member's optimism. This paper highlights the importance of the supply chain members' attitudes toward market potential under the possibility of extreme weather.