Int. J.

Production Economics ()

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Int. J. Production Economics

journal homepage: www.elsevier.com/locate/ijpe

Pricing strategy of environmental sustainable supply chain

with internalizing externalities
Huiping Ding n, Qilan Zhao, Zhirong An, Jia Xu, Qian Liu
School of Economics and Management, Beijing Jiaotong University, Beijing 100044, China

art ic l e i nf o

a b s t r a c t

Article history:
Received 15 April 2014
Accepted 7 May 2015

The negative impact of business activities on resources and sustainability include pollution and
environmental externalities, which are becoming more severe and attracting worldwide attention. This
study investigates a mechanism for motivating supply chain members to collaboratively produce
environmentally friendly products (EFPs), with an investment in pollution reduction and prevention
and by considering environmental regulations and incentive policies From the perspective of supply
chain members, we focus on studying optimal pricing strategies for environmentally sustainable supply
chains and the relationship between rm performance and environmental policy incentives. By treating
the EFP as an investment project, its economic feasibility can be evaluated in the context of the supply
chain. Unlike traditional supply chain models, in our model, government policy incentives are shared
within the supply chain through transfer price negotiations between manufacturers and suppliers. This
study addresses the impact of government policy incentives on value transition and prot allotment in
the collaborative supply chain system.
& 2015 Elsevier B.V. All rights reserved.

Keywords:
Sustainable supply chain
Externality
Environmental performance
Price strategy
Government policy

1. Introduction
With increasing environmental problems and the failure of
treatment after pollution strategies, business activities have
accumulated signicant negative externalities. These negative
environmental externalities refer to the damage caused by environmental pollution to the public when business rms have not
undertaken their responsibilities to compensate for the damage to
the society and environment. In traditional cost accounting,
product cost only includes direct material cost, labor cost, manufacturing cost, and so on; however, it does not consider the
environmental resource cost to the rm. Ignorance regarding huge
environmental externality cost incurred by the rms' environmental unfriendly activities in the traditional accounting system
leads to market failure. Therefore, the mechanism and measures to
control and prevent environmental pollution should be explored
at source. The internalization of negative externalities is the most
effective method to correct market failure (Coase, 1960). In other
words, rms are required to focus on preventing pollution at the
source, undertaking investment in environmental protection,
decreasing or even eliminating pollution and environment damage
caused by the production and consumption of the rm's environmentally unfriendly products, and reducing or clearing the costs

Corresponding author. Tel.: 86 10 51687177; fax: 86 10 51683577.

E-mail address: hpding@bjtu.edu.cn (H. Ding).

borne by the public. Environmental management is more than just

separate actions of an individual rm and requires the participation and cooperation of groups of rms. A focus on environmental
responsibility in the supply chain leads to new ways of collaborating with suppliers in terms of developing environmentally friendly
technologies with critical suppliers, and providing training for all
suppliers from second-tier suppliers to sub-tier suppliers (Kovacs,
2008). Assuming environmental responsibility in the context of a
supply chain requires the joint efforts of supply chain members,
government, and consumers and depends on the overall effectiveness and efciency of the supply chain members' collaborations. It
is meaningful to study the coordination mechanism of having
business rms participate in environmental technology investment in the supply chain context. This reects pressure from the
stakeholders' environmental interests and also inuences the
value transmitted among the channel members.
Internalizing environmental externality cost requires the supply chain members to invest collaboratively in environmental
pollution prevention; consequently, this leads to additional costs
and higher prices for environmental friendly products (EFPs)
compared with environmentally unfriendly products (EUFPs),
and presents a challenge for producing EFPs in terms of cost or
price disadvantage in the competitive market. Under situations
where government regulations and incentive policies are lacking,
supply chain rmsdriven by the pursuit of protlack the
impetus to invest in environmentally cleaner production. As
overseer and supervisor of natural resources and the environment,

http://dx.doi.org/10.1016/j.ijpe.2015.05.016
0925-5273/& 2015 Elsevier B.V. All rights reserved.

Please cite this article as: Ding, H., et al., Pricing strategy of environmental sustainable supply chain with internalizing externalities.
International Journal of Production Economics (2015), http://dx.doi.org/10.1016/j.ijpe.2015.05.016i

H. Ding et al. / Int. J. Production Economics ()

the government has a responsibility to regulate rm activities in

favor of environmental sustainability. Besides, imposing a penalty
on pollution activities, government should also induce and stimulate rms to invest in environmental protection via incentivebased policies. The nes collected for pollution activities can be
used to stimulate environmental protection investment. Obviously,
there are several questions that should be addressed in this
domain. For example, what are the major factors and conditions
to have supply chain members participate in environmental
protection investment? What are the effects of government
regulations and policy incentives on the supply chain's pricing
decisions in terms of negotiating transfer price between members? Nevertheless, supply chain pricing is the core issue when
pollution prevention investments are jointly made by the members, and the impact of government policies on environmental
performance of the supply chain is worthy of exploration. This
study primarily focuses on supply chain pricing strategy from the
perspective of motivating supply chain members cooperatively to
produce EFPs and thereby promote environmental sustainability.
As driving factors of promoting environmental technology investment, regulations and policy incentives are explicitly introduced in
the context of supply chain management to study their impacts on
the supply chain's environmental performance. These issues draw
public attention worldwide, particularly in developing countries.
The investigation of collaborative mechanisms for properly sharing
policy incentives through transfer price and value conductive
relations in the sustainable supply chain context remains sparse
in the literature. This is the signicance of this study.

2. Literature review
As environmental issues continue to emerge, research linking
supply chain management to environment issues has attracted
attention worldwide. Seuring and Muller (2008) provided an
excellent literature review on sustainable supply chain management and identied two distinct strategies for sustainable supply
chain management: supplier management for risks and performance and supply chain management for sustainable products.
Kosugi et al. (2009) simulated the internalization of externality
costs for major global environmental issues and assessed the
results with a life cycle impact assessment model. This model
indicated that internalizing the externality cost increases forest
preservation and reduces fossil-fuel consumption. Mitra and
Webster (2008) analyzed the effects of government subsidies on
competition in the remanufacturing market with a two-period
model. They introduced a subsidy scheme that shares the subsidy
between the manufacturer and remanufacturer and increases total
remanufacturing activities. Ding et al. (2014) conducted a study on
the ways to encourage rms to voluntarily produce EFPs to remedy
negative externalities by focusing on the relationship between
government policies, the economic performance of EFPs, and the
impact of policy incentives on the commercial feasibility of EFPs
using a life cycle approach. Holmgren and Amiri (2007), Nguyen
(2008) and Longoa et al. (2008) also conducted a study on
internalizing environmental externality cost from different
perspectives.
Studies of supply chain pricing strategies related to environmental issues largely focused on reverse or closed supply chain
product pricing decisions. For the resolution of supply chain
environmental issues, business partnership requires members'
mutual cooperation and coordination to decide the retail and
wholesale prices, prot margins, and inventory levels to obtain a
greater market share and hence higher revenues (Chauhan and
Proth, 2005). Supply chain coordination can be pursued by adopting a centralized or decentralized decision-making approach; the

former option occurs when there is a unique decision maker in the

supply chain and the latter when several independent actors make
decisions at different supply chain stages (Giannoccaro and
Pontrandolfo, 2004). Vachon and Klassen (2008) conducted a
study that focused on the impact of environmental collaboration
in the supply chain on manufacturing and environmental performance. Their empirical results demonstrated that upstream practices were more closely linked with process-based performance,
whereas downstream collaboration was associated with productbased performance. Hsueh (2014) proposed a revenue sharing
contract by embedding corporate social responsibility (RS-CSR) for
coordinating a two-tier supply chain. A mathematical model was
employed to determine the optimal CSR investment, the wholesale
price, and the revenue sharing ratio needed to achieve channel
coordination. The game theory approach is widely used in
research on the supply chain pricing problem. Cai et al. (2009)
examined the inuence of price discount contracts on dualchannel supply chain competition. The result showed that a
consistent pricing scheme could decrease channel conicts
through bringing more prots to retailers. Using Stackelberg game
theory, Yu et al. (2009) discussed how a manufacturer and its
retailers interact with each other to optimize their individual net
prots by adjusting product marketing (advertising and pricing)
and inventory policies in an information-asymmetric vendor
managed inventory (VMI) supply chain. Cai et al. (2011) studied
optimal pricing and ordering with partial lost sales from a twostage game theory perspective. Nagarajan and Soi (2008) surveyed applications of cooperative game theory to supply chain
management, especially supply chain prot allocation and stability; the study also reviewed negotiation models, including the
Nash bargaining problem in a typical newsvendor setting, cooperative bargaining, and negotiation power.
There are numerous studies focusing on the operations management level of green or reverse supply chains. Tsoulfas and
Pappis (2006) emphasized that environmental factors should be
considered when designing supply chains and discussed product
design, packaging, transport, recycling, disposal, and greenness
in terms of environmental management. It was considered that
environmental friendliness could be effectively improved through
environmental management during the whole life cycle. Chaabane
et al. (2012) introduced mixed integer linear programming, based
on a framework of sustainable supply chain design that considers
life cycle assessment (LCA) principles, in addition to the traditional
material balance constraints at each node in the supply chain.
Their results suggested that current legislation and Emission
Trading Schemes (ETSs) must be strengthened and harmonized
at the global level to drive a meaningful environmental strategy.
Mahapatra et al. (2013) proposed a new mode to realize minimum
consumption of product materials through reproduction. Paulraj
(2011) empirically evaluated the effect of rm-specic resources
and/or capabilities on sustainable supply management and sustainability performance.
Several studies have argued that rms have no intention to
internalize these externalities. More commonly, rms are compelled to reduce their impacts on the natural environment by both
regulatory and non-regulatory pressures from the government,
market, or even community (Hall, 2000). Vermeulen and Kok
(2012) showed how competition between various sustainable
supply chain governance systems in The Netherlands has resulted
in recent market breakthroughs, although initial government
interventions were very limited and diverse. Chen and Sheu
(2009) proposed that well-designed environmental pricing strategy regulations can promote extended product responsibility
(EPR) for green supply chain members in a competitive market.
Most relevant studies focus on specic operational aspects of
the supply chain; however, little research has extended to

Please cite this article as: Ding, H., et al., Pricing strategy of environmental sustainable supply chain with internalizing externalities.
International Journal of Production Economics (2015), http://dx.doi.org/10.1016/j.ijpe.2015.05.016i

H. Ding et al. / Int. J. Production Economics ()

investigating sustainable supply chains from the perspective of

motivating supply chain members to cooperate in pollution prevention investment decisions. Unlike the current literature, by
taking a view of assessing economic feasibility of joint environmental technology investment by supply chain members, this
study explores a mechanism and pathway for resolving environmental externalities using a quantitative approach, which provides
a comprehensive measure for analyzing the environmental sustainability of supply chains. Specically, we analyze the impact of
supply chain members' decision-making drivers and government
policy factors on supply chain collaborative pricing decisions, with
a focus on pricing strategies that could realize the optimized
performance of sustainable supply chains and unication of supply
chain members' satisfaction under the context of different supply
chain modes and prot allotment decisions. The remainder of the
study is organized as follows: Section 3 constructs decentralized,
centralized, and collaborative supply chain pricing decision modes
by introducing EFPs to internalize environmental externalities;
Section 4 presents a case analysis, including discussions; and the
nal section presents the conclusions.

3. Supply chain pricing model with internalizing

environmental externality
3.1. Model assumptions
The process of internalization is depicted in Fig. 1, which shows
a closed loop with a dotted line that comprises an environmentally
sustainable supply chain while considering government regulation
and policy incentives. The government's policies promote the
supply chain members to invest in an EFP that replaces an EUFP,
which helps reduce negative externalities incurred by the EUFP.
The following assumptions are made:
1) The supply chain comprises a single product manufacturer and
a single supplier. The manufacturer's production of one unit
product needs m units of intermediate product from the
supplier. As a core member of the supply chain, the manufacturer sells products directly to consumers. The manufacturer
produces products based on make-to-order, and the nished
products equal sales. The supplier is aware of the demand
information of the manufacturer. The manufacturer and the
supplier adopt a vendor managed inventory (VMI) model to
manage their inventory. The supplier manages the inventory
level without stock out and bears the inventory cost. Inventory
is replenished in batches on a just-in-time basis, an average of k
times per year.
2) Consider an imperfect competitive market environment as
the EFP is not the same as the EUFP. Consumer preference likely

Fig. 1. Internalization process of environmental sustainable supply chain.

has an impact on price differentials and demand (sales quantity) may increase as the price falls. Consider a pricing strategy
for promoting EFP sales: the product price starts high and
decreases with increasing of sales during its market diffusion
process, and then kept steady after a limited time period. For
simplicity, we assume a linear demand function of price (or
vice versa) for the EFP and that the manufacturer's product
annual sales quantity Q and price P are in the relation of
Qa  bP (a 40, b40) during limited time periods; that is,
when the EFP reaches economic breakeven, its price remain
steady and does not decrease.
3) The products produced are the EUFP before the supply chain
introduces the EFP, and the production runs at capacity in
accordance with market share. After the EFP is introduced, the
EUFP is gradually replaced within a limited time period and EFP
sales increase with growth rate g through its market diffusion.
Supply chain members also seek to maximize their own interests
when they make their additional investments in environmental
technologies for pollution reduction and prevention.
4) Government provides regulations and incentive-based policies
that impose penalties on EUFPs while subsidizing EFPs. We
assume that the government grants subsidies directly (or,
alternatively, through consumers) to the manufacturer, which
motivates the supplier to collaboratively invest in the EFP. The
manufacturer shares the subsidy with the supplier through
transfer price negotiation.
To facilitate our analysis, the following notations are used:
ec
P em ; P ei
m ; P m Sales price of EFP in the case of decentralized,
centralized, and collaborative decision-making modes, respectively (decision variables);
ec
P es ; P ei
s ; P s Supply chain transfer price of intermediate product
for EFP in the case of decentralized, centralized, and collaborative
decision-making modes, respectively; these are functions of the
supplier's marginal prot (decision variables);
ec
Q em ; Q ei
m ; Q m Annual sales quantity of EFPs in the case of
decentralized, centralized, and collaborative decision-making
modes, respectively (dependent variables);
Bm Policy incentive per unit of output of EFP in proportion to
average incremental environmental protection cost (dependent
variable);
Q um Average annual demand (market share) of EUFP that
matches with manufacturer's production capacity;
P um Sales price of EUFP;
P us Supply chain transfer price of intermediate product
for EUFP;
Coefcient of policy incentive proportionally related to
average incremental cost of environmental protection per unit
output of manufacturer (0 o o1);
Policy incentive transmitted to the supplier based on its
average incremental cost of environmental protection per unit
output;
Coefcient of policy incentive transmitted to the supplier
through the manufacturer;
C Average incremental environmental protection cost per unit
of EFP;
I m ; I s Project initial investment on pollution reduction and
prevention by manufacturer and supplier, respectively;
C em ; C um Manufacturer's variable operating cost of EFP and
EUFP per unit, respectively (excluding procurement cost);
C es ; C us Supplier's variable operating cost of intermediate product for EFP and EUFP per unit, respectively;
F um ; F us Penalty (non-compliance) cost per unit of output
imposed on EUFP and intermediate product for EUFP, respectively;
C eo ; C uo Supplier's delivery cost per batch quantity of EFP and
EUFP, respectively, with VMI mode;

Please cite this article as: Ding, H., et al., Pricing strategy of environmental sustainable supply chain with internalizing externalities.
International Journal of Production Economics (2015), http://dx.doi.org/10.1016/j.ijpe.2015.05.016i

H. Ding et al. / Int. J. Production Economics ()

C eh ; C uh Supplier's inventory holding cost of EFP and EUFP per

unit, respectively, with VMI mode;
m Number of units from supplier that manufacturer consumes to produce one nal product;
k Annual number of delivery times for supplying intermediate
products to manufacturer, with each batch quantity of mQm/k;
g Average annual growth rate of EFP;
n1 Time point at which supply chain reaches economic breakeven with the EFP;
r Risk-adjusted discount rate during initial development period of EFP project;
TC Supplier's incremental inventory cost of EFP with
VMI mode;
NPV m ; NPV s ; NPV sc Net present value of EFP project for
manufacturer, supplier, and supply chain system, respectively, in
decentralized decision-making mode;
NPV im ; NPV is ; NPV isc Net present value of EFP project for
manufacturer, supplier, and supply chain system, respectively, in
centralized decision-making mode;
NPV cm ; NPV cs ; NPV csc Net present value of EFP project for
manufacturer, supplier, and supply chain system, respectively, in
collaborative decision-making mode.
As mentioned above, as introducing an EFP requires additional
investment, supply chain members bear an increased product cost,
which leads to a cost disadvantage for the EFP in the competitive
market; therefore, supply chain members lack motivation to make
an environmental protection investment. For the EFP to be
economically feasible, the government imposes a penalty on the
EUFP to let it bear the costs of pollution, and offers an incentivebased policy to reduce the product cost so that the EFP's price
can be competitive. Actually, the reason for the government to
have an incentive policy is that it has a major responsibility to
encourage and drive all business activities in the direction of
environmental protection in every possible way while creating a
harmonious relationship between business development and
environmental sustainability. In our analysis, we treat producing
and marketing the EFP as a product investment project and the
NPV model (a common approach) is used to evaluate the investment project. Government policy incentives aim at offering
modest compensation for the incremental cost of the EFP, which
helps the supply chain system achieve breakeven for a limited
time period at tn1, namely, NPV 0. After this point, the
government will cease subsidies. According to the principle of
only compensating for the investment cost of pollution reduction
and prevention, logically the government subsidy should be based
on average incremental pollution prevention cost. As assumed, the
amount of policy incentive, denoted by Bm, is offered to the
manufacturer to compensate the incremental cost of the EFP. Let
C denote the manufacturer's average incremental pollution prevention unit cost and Bm be measured per unit of the EFP and in
proportion to C. Referring to Ding et al. (2014), we dene the
following:
(
)
n1
n1
X
X
C
C emt  C umt mP est  P ust Q emt I m =
Q emt
1:1
t1

t1

technologies, the effectiveness and efciency of their usage for

energy saving and pollutant reduction, and business risk; t n1 is
the time point at which the supply chain system achieves
economic breakeven with NPV 0; P est is the transfer price of
intermediate product for the EFP. It is assumed that the manufacturer takes an initiative to motivate a sustainable supply chain.
As the supplier intends to increase the transfer price to compensate for its increased cost due to producing the EFP, the manufacturer would share the government subsidy with the supplier
through the transfer price negotiation, i.e., the government policy
incentive is transmitted to the supplier through the transfer price.
We also assume that the portion of the government subsidy
shared by the supplier is proportional to its average annual
incremental cost during n1 periods, meaning that the incremental
cost is partially compensated. Rationally, the transfer price of the
EFP should comprise the EUFP's transfer price plus the supplier's
incremental cost, where the latter includes incremental variable
cost, incremental inventory cost, and initial investment cost. For
simplifying the calculation, we take C em , C um , P es , and P us as annual
mean values of C emt , C umt , P est , and P ust , respectively, and rewrite Eq.
(1.1) as follows:
C C em  C um mP es P us I m =

n1
X

Q emt

Our study will focus on how a policy incentive can affect the
pricing strategies of the manufacturer and the supplier, and its
impact on the supply chain's value conduction relationship, which
has a signicance that differs from previous studies.
3.2. Environmentally sustainable supply chain model analysis
This section discusses environmentally sustainable supply
chain pricing strategies of the manufacturer and the supplier in
the cases of decentralized, centralized, and collaborative decisionmaking modes while introducing the EFP. With the consideration
that economic feasibility of investment in environmental technology is mainly reected during early periods of the EFP project, we
will only focus our analysis on the initial development stage (up to
achieving breakeven) of the EFP.
3.2.1. Supply chain pricing strategy analysis of decentralized
decision-making mode
In the case of the decentralized decision-making mode, the
manufacturer and the supplier each develop their pricing strategies based on maximizing their own prots. As we treat introducing the EFP as a product investment project involving by both the
manufacturer and the supplier, we evaluate their net prots by
employing a cash ow approach using net present value (NPV).
NPV measures the incremental cash ow of the EFP project
(compared with the EUFP); here, the net prot of the replaced
EUFP is the opportunity cost of the EFP. The net cash ows of the
manufacturer of the EFP and the EUFP, denoted by Rem and Rum ,
respectively, can be expressed as follows:
Rem

n1
X


n1
X

 u
P emt  mP est  C emt Bmt Q emt
P mt  mP ust

t1

Bm C;

0o r1


 C emt  F mt Q um  Q emt  I m

1:2

where Q emt is annual sales quantity of the EFP at time period t; C

comprises additional (initial) investment cost amortized per unit
of the EFP during n1 periods, incremental variable cost per unit of
the EFP and incremental purchasing cost per unit (transfer price)
of the EFP; is the coefcient of policy incentives per unit of the
EFP and is negotiable between the government and the manufacturer. Its determination depends on market demand for the EFP,
the
investment
intensity of
innovative
environmental

t1

Rum

n1
X



P umt  mP ust  C emt F mt Q um

t1

3:1
3:2

t1

where, as shown in Eq. (3.1), we assume the government subsidy

only goes to the manufacturer. Notice also that we assume the
EUFP is gradually replaced by the same amount as the EFP during
the initial development stage for Q emt r Q um . To capture the impact
of opportunity cost while replacing the EUFP, by taking difference

Please cite this article as: Ding, H., et al., Pricing strategy of environmental sustainable supply chain with internalizing externalities.
International Journal of Production Economics (2015), http://dx.doi.org/10.1016/j.ijpe.2015.05.016i

H. Ding et al. / Int. J. Production Economics ()

Remt Rumt , the NPV of the manufacturer is expressed as follows:

n1
X


NPV m

P emt  P umt


 


 m P est  P ust  C emt  C umt Bmt F umt Q emt e  rt  I m

t1

3:3
where the manufacturer's product price and the transfer price are
decision variables. In a similar way, we can also derive the NPV of
the supplier, including the opportunity cost of replacing the EUFP,
as follows:
NPV s

n1
X



mP est  P ust  C est  C ust F ust Q emt  TC t e  rt  I s

3:4

t1

where we assume the supplier manages the inventory by means of

VMI (meaning that it bears the inventory cost), TCt is the
supplier's incremental inventory cost associated with the EFP.
With VMI mode, the manufacturer and the supplier jointly set a
target of a minimum inventory cost based on market demand and
the manufacturer's inventory is managed by the supplier in an
agreed common framework. Considering that inventory ordering
and holding costs remain unchanged, the total incremental inventory cost of the EFP is expressed as follows:

manufacturer as follows:
Xn1  e




NPV m
P mt  P um  m1  P es  P us  1  C em  C um
t1
i
Xn1
I m =
Q e F um Q emt e  rt  I m
6
t 1 mt
On the substitution of the product sales quantity and sales price
relation Qa  bP and Eq. (5) into Eq. (6) and maximizing the
manufacturer's NPV by having NPV m =P emt  0 and, for
 ease of
notation, let M a=b  P um m1  P us 1  C em  C um F um , we
can obtain the EFP's preliminary price as follows:
P emt a=b   m1  P es =21 g t  1

By substituting Eq. (7) back into Qa  bP, we can further

obtain the EFP's preliminary annual sales quantity as follows:
Q em1 b  m1  P es =2

(2) In the second phase, the manufacturer shares the EFP's

demand information with the supplier and the supplier accordingly determines the transfer price by maximizing its NPV. Substituting Eq. (8) into Eq. (3.4) we can have the supplier's NPV as
follows:

8
9
n2 < mbP e  P u  C e C u F u  m1  P e 1 g t  1  =
X
st
st
st
st
st
st
2
e
u
e
NPV s
e  rt  I s


:  k C e  C u mb  m1  P st C h  C h 1 g t  1
;
t1
o
o
4k



TC t kC eo mQ emt C eh =2k  kC uo mQ emt C uh =2k




k C eo C uo mQ emt C eh  C uh =2k

where k denotes the annual numberof delivery times for supplying intermediate products,
k C eo  C uo is the incremental ordering
e
e
u
cost, and mQ mt C h  C h =2k is the incremental holding cost. As
assumed, the EFP gradually replaces the EUFP with an average
annual growth rate g through a market diffusion process; it is
further assumed that the sales quantities for two consecutive time
periods follow the relation Q mt Q mt  1 1 g. The sales quantity
relations during n1 periods are
8
>
Q Q m1 1 gt  1
>
< mt
n
X
Q mt Q m1 1 gn1  1=g
>
>
:

Taking the second-order derivative of Eq. (9) with respect to

the transfer price, we obtain 2 NPV s =2 P es bm2 1  o 0,
which means NPVs is concave and has its maximum value. By
having NPV s =P est 0 we then obtain the optimal transfer price
in the decentralized case as follows:
P es n

M
P u C es  C us  F us C eh  C uh
s

2m1 
4k
2

10

Noticing that for maximizing NPV s , the value of k (annual

inventory replenishment times) is given and has not been justied: this issue will be dealt with later in this section. On the
substitution of P es n into Eqs. (7) and (8), we can obtain the optimal
sales price and annual sales quantity of the EFP based on optimal
pricing strategy of the supplier as follows:


n
P emt

a M m1  P us C es  C us  F us  m1  C eh  C uh


1 g t  1
b 4
4
8k

11

t1

In the decentralized case, the transfer price is determined

without cooperation of the manufacturer and the supplier, and
the process may be divided into two phases. As product price
depends on market demand, we consider that depending on the
market demand the manufacturer determines the EFP's (nal
product) sales price or sales quantity for a given (preliminary)
transfer price in Phase 1. This is followed by the supplier
determining its optimal transfer price (only optimal for itself) in
Phase 2 based on available information of the EFP's sales price and
quantity. We implicitly assume that the manufacturer takes the
initiative to motivate the EFP through the supply chain. In these
two phases, the backward induction method could be used. In the
following part, the optimal pricing strategies of the manufacturer
and the supplier under the context of the decentralized case are
analyzed by the backward induction method.
(1) In the rst phase, assuming a given value of the transfer
price P es , the manufacturer determines the optimal price of the EFP
with this given supplier's pricing strategy. On the substitution of
Eqs. (1.2) and (2) into Eq. (3.3), we obtain the NPV of the

Q em1

u 

 u
Ce  Ch
bM
P C es  C us  F us
bm1  s
 h
4
8k
4

12

When the prices and quantities for both the manufacturer and
the supplier are known, we can then determine the amount of
government subsidy needed to reach breakeven of the supply
chain system according to Eqs. (1.2) and (2). To simplify the
calculation, we take the mean values of the cost and price
parameters. On the substitution of Eqs. (10)(13) into Eqs.
(2) and (1.2), and Eqs. (3.3)(3.4), respectively, we obtain the
optimal amount of the government subsidy for the EFP per unit,
the maximized NPVs for the manufacturer and the supplier in the
decentralized case are denoted by NPV nm and NPV ns , respectively, as follows:


n
Bnm C em C um mP es n  P us  I m =Q em1
1 gn1  1=g
13
NPV nm

Xn1
t1





 

n
P emt
 P umt  m P es n P us  C em  C um Bnm

 n
1 gt  1 e  rt  I m
F umt Q em1

14:1

Please cite this article as: Ding, H., et al., Pricing strategy of environmental sustainable supply chain with internalizing externalities.
International Journal of Production Economics (2015), http://dx.doi.org/10.1016/j.ijpe.2015.05.016i

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NPV ns

Xn1

n
mP es n  P us  C es  C us F ust  C eh  C uh =2kQ em1
1
i
14:2
gt  1 kC eo  C uo e  rt  I s

t1

price that maximizes NPV iscn ; however, by taking the secondorder derivative of Eq. (18.3) with respect to the transfer price we
have
2 NPV iscn =2 P es bm2 =2 4 0

3.2.2. Supply chain pricing strategy analysis of centralized decisionmaking mode

In the centralized case, overall NPV of the sustainable supply
chain system, including the opportunity cost of replacing the EUFP,
can be expressed as follows:
Xn1  e


 

NPV isc
P mt  P umt  m C est  C ust  C emt  C umt
t1

Bmt F umt mF ust Q emt e  rt 
Xn1   e




k C o  C uo mQ emt C eh  C uh =2k e  rt  I s  I m

t1
15
It is noted that, different from the traditional supply chain
model found in the literature, when considering the policy
incentive, the transfer price exists as the decision variable in the
centralized mode as above, which explicitly presents that the
policy incentive shared by the supplier for promoting a sustainable
supply chain is transmitted via the transfer price. One question
that has to be addressed is how to properly distribute the
government subsidy between the manufacturer and supplier
through the transfer price. On the substitution of Eq. (1.2)
(representing the government subsidy) and (2), Eq.(4) (representing the incremental inventory cost) and Qa  bP into Eq. (15),
then having NPV isc =P emt 0, we can obtain the optimal price of
the EFP that maximizes the NPV of the supply chain system as
follows:






a 1h a
n
P um  m C es  C us  1  C em  C um m P es  P us
P ei
mt 
b 2 b


m C eh  C uh
1 gt  1
16
F um mF us 
2k
With Qa  bP, we then obtain the optimal sales quantity of
the EFP as follows:






b ha
n
 P um  m C es C us  1  C em  C um m P es  P us F um
Q ei
m1
2 b


m C eh C uh
17
mF us 
2k
Substituting Eqs. (16) and (17) into Eqs. (3.3)(3.4) and (15),
respectively, we obtain the NPVs for the manufacturer, supplier,
and supply chain system in the centralized case as follows:

Xn1 h
ein

 

NPV imn
P mt  P umt  m P es  P us  C em  C um
t1
i
n
t  1  rt
Bimn F umt Q ei
e
 Im
18:1
m1 1 g
NPV isn

NPV iscn

Xn1


mP es  P us  C es  C us F ust
t1
o
n
t1
 kC eo  C uo e  rt I s
 C eh  C uh =2kQ ei
m1 1 g

18:2


 e
u  e
u 
n
u
P ei
mt  P mt m C st  C st  C mt  C mt
i


n
n
t1
F umt mF ust  m C eh  C uh =2k Q ei
Bimt
m1 1 g
 e

 k C o  C uo e  rt  I s  I m
18:3
Xn1

t1

n
where Bimn is determined by Eqs. (1.2) and (2) and based on P ei
mt and
ein
n
Q m1 . We see from Eqs. (16) and (17) and Eqs. (18.1)(18.3) that P ei
mt ,
n
Q ei
,
the
NPVs
of
the
manufacturer,
supplier,
and
supply
chain,
all
m1
depend on the transfer price P es that incorporates the government
policy incentive; therefore, we need to determine the optimal
values of sales price and quantity of the EFP through justifying the
transfer price. One might consider working out an optimal transfer

18:4

NPV iscn

is a convex function of the

The above means that
transfer price and it cannot be maximized through its rst-order
derivative condition NPV iscn =P es 0; thus, we then need to
employ an alternative approach to nd the optimal transfer price
that ensures a higher NPV of the EFP project for the supply chain
than the decentralized case and simultaneously satises both the
manufacturer and the supplier. As assumed, the government
subsidy is only provided to the manufacturer and there is a need
to properly allot the government subsidy between the members
through collaborative negotiation, which is also connected with
the transfer price determination. This means that the central issue
is the transfer price negotiation, including allotment of the
government subsidy between the manufacturer and the supplier,
on which the determination of the optimal price and sales
quantity of the EFP is based. In the following sections, as an
alternative approach, Rubinstein game theory (Rubinstein, 1982) is
adopted for obtaining the optimal transfer price in our model; that
is, we conduct a collaborative decision process of the transfer price
through negotiation between the members.
3.2.3. Supply chain pricing strategy analysis of the collaborative
decision-making mode
n
Logically, optimal sales quantity Q ei
mt in the centralized case is
n
normally larger than Q emt
in the decentralized case, which means
that there exists room for more sales, more potential prots, and
possibly resulting in a higher NPV iscn ; however, the way of sharing
increased net prots to satisfy both the manufacturer and the
supplier usually occurs through negotiation. That is, sharing the
increased net prots gained from the centralized supply chain in a
collaborative manner depends on the transfer price negotiation
between these members. To clarify the interconnection between
the transfer price and government policy incentive, we dene the
transfer price for the EFP as follows:
P es P us

nXn

t1

o
Xn1
C est  C ust mQ emt TC t  Is =m
Q emt
t1

Z0

19:1
where is the policy incentive transmitted to the supplier based
on its average incremental cost of environmental protection per
unit output. As seen in Eq. (19.1), the transfer price P es depends on
the average annual incremental cost. Government policy incentives change supply chain's value transition and affect the supply
chain's pricing strategy, the impact of which is mainly reected in
two aspects: rst, compensation for part of the incremental cost
would have the supplier not price the intermediate product for the
EFP too high, which weakens the cost disadvantage of the EFP;
second, the manufacturer and the supplier negotiate the allotment
of the government subsidy through adjustment of the transfer
price. On the substitution of Eq. (19.1) into Eq. (2), we rewrite
Eq. (1.2) as follows:
h

i
h

Xn1
Xn1
Bm C em  C um I m =
Q e m C es  C us t 1 TC t
t 1 mt

i
Xn1
Q emt
I s =m
t1

; 0 o o 1

19:2

where the cost parameters take their annual mean values. The
above expression reects the government subsidy offered to
compensate the supply chain's incremental costs for the EFP: the
rst term on the right-hand side is to the manufacturer, the second
term is to the supplier. Since the manufacturer may not obtain
enough subsidy from the government that could fully compensate
its incremental cost (o1), o1 means the manufacturer would

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unlikely compensate the supplier's incremental cost fully. In the

collaborative case, based on its incremental cost, the manufacturer
negotiates the transfer price with the supplier through adjustment
of the proportion of subsidy shared with the latter and the negotiation result should satisfy the following conditions:
NPV cm ZNPV nm ; NPV cs Z NPV ns

20:1

where NPV cm and NPV cs denote feasible NPVs of the EFP project
for the manufacturer and the supplier in the collaborative case, and
NPV nm and NPV ns are the decentralized optimal NPVs, respectively.
The above inequalities simply mean that in the collaborative case, net
prots shared by each of individual supply chain member should not
be less than that earned in the decentralized case. The conditions
NPV cs Z NPV ns and NPV cm Z NPV nm , respectively, determine the
lower and upper bounds of the transfer price that are feasible for a
collaboration. Since solving the above two inequalities for the lower
and upper bounds of the transfer price is very complex by nature (i.e.,
less meaningful in a practical sense), we turn to a more feasible
alternative method to determine them. Noticing from Eq. (19.1) that
the transfer price depends on the coefcient and the supplier's incremental cost, the lower bound of the transfer price can be expressed
as follows:
P es min P us and Q es 0

for

20:2

Compared with the decentralized case, logically the centralized

n
en
optimal sales quantity Q ei
mt 4 Q mt is normally larger and corren
en
sponds to a lower transfer price P ei
s o P s ; thus, the upper bound
of the transfer price is as follows:
P es max P es n

20:3

Eqs. (20.2) and (20.3) mean that in the collaborative case, the
transfer price takes its minimum (lower bound) when no EFP is
produced without a government policy incentive, and takes its
maximum (upper bound), which corresponds to the supplier's
maximized interests, in the decentralized case. We can then infer
that P es min o P es o P es max . However, these lower and upper bounds
may not satisfy Eq. (20.1) and, therefore, might not be valid.
Noticing from Eq. (18.4) that the NPV of the integrated supply
chain NPV isc is convex, we can show that the transfer price that
corresponds to its minimum value, denoted by P esl , is less than P us
(see Appendix), i.e., P esl o P us P es min oP es o P es max , which means the
valid lower and upper bounds of the transfer price must be along
the right part of the NPV isc curve that moves up. Noticing that for
other given parameters Eqs. (16) and (17) and Eqs. (18.1)(18.3) are
the general functions of the transfer price for an integrated supply
chain, for the collaborative case, as the transfer price P ec
s increases
NPV csc will also increase; correspondingly, NPV cs increases and
NPV cm decreases, respectively, as can be shown for NPV cs =
P es 4 0 and NPV cm =P es o 0 forP es 4 P us . It follows that there are
ec
valid lower and upper bounds, denoted by P ec
s min and P s max , which
correspond to NPV cs ZNPV ns (for P us oP ec
o
P ec
and
s min
s )
ec
e
NPV cm ZNPV nm (for P ec
o
P
oP
),
respectively.
We
then
s
s max
s max
have:
ecn
ec
P ec
s max 4 P s 4 P s min

20:4

n
P ec
s

is the collaborative optimal transfer price. Heuristically,

where
ec
we can obtain P ec
s min and P s max by examining the increase in the
n
transfer price followed by nding the optimal transfer price P ec
s
via collaborative negotiation through the following logic:
ec
1) Noticing that both P ec
mt and Q m1 will change as the transfer price
c
changes, in turn, NPV sc ; NPV cs and NPV cm will change as
well. For the collaborative case, NPV cs increases and NPV cm
decreases, respectively, as the transfer price increases (as can
be shown for NPV cs =P es 4 0 and NPV cm =P es o0 for P es 4P us ).

2) Assume the transfer price increases (starting from P es min ) or

decreases (starting from P es max ). In the former case, NPV cs will
increase up to the level NPV cs NPV ns that corresponds to
c
the lower bound P ec
s min ; in the latter case, NPV m will increase
up to the level NPV cm NPV nm that corresponds to the upper
bound P ec
s max . The processes above will be explained further in
Figs. 2 and 3 in Section 4.
ec
3) [P ec
s min , P s max ] is the transfer price interval that satises Eq.
(20.1) and is feasible for the collaborative case.
4) Within this feasible interval, when the transfer price increases
ec
i
c
up to P ec
s P s max , the value of NPV sc (or NPV sc ) reaches its
maximum; however, this is not optimal since, in such a situation, the most increased net prots gained from the integrated supply chain are taken by the supplier and the manufacturer would not be happy with just the same as the
decentralized case (no gain from collaboration).
5) Therefore, for a collaboration to be successful, the manufacturer
and supplier must each be satised with their prots sharing
via the transfer price negotiations. In our model, the optimal
n
transfer price P ec
is obtained through the Rubinstein game
s
n
approach and, in turn, the optimal price P ec
mt and sales quantity
ecn
ecn
Q m1 are determined based on P s .
The collaborative process is a bargaining process to allocate the
supply chain benet between the members in a proper manner. By
adopting the Rubinstein game approach to determine negotiated
transfer price in an indenite bargain game with two participants,
the unique sub-game perfect Nash equilibrium, namely, the optimum of the transfer price can be achieved. The ratio of the supply
chain benet allotment between the members in terms of the
transfer price can then be expressed as follows:
ecn
P ec
1  2
s max  P s

ecn
ec
P s  P s min 2 1  1

21:1

Rewriting the above equality yields:

n
P ec
s

ec
2 1  1 P ec
s max 1  2 P s min
1  1 2

21:2

where 1 and 2 (0 r r 1) represent the discounting factors

(degree of patience) of the manufacturer and the supplier, respectively. Assume the manufacturer and the supplier bear a xed cost
for each bargaining period and each of them has a xed discounting factor that can be considered as the cost of bargain. The major
inuential factors for the degree of patience include market
position, core competence, utility function, negotiation cost,
degree of risk aversion, etc. In the collaborative case, on the
n
substitution of P ec
into Eqs. (16) and (17) and Eqs. (18.1)(18.3),
s
ecn
n
we obtain the EFP's optimal sales price P ec
m and sales quantity Q m ,
and the NPVs of the EFP project for the manufacturer, supplier, and
supply chain system.
3.2.4. Justication of VMI policy
In the above analysis of optimizing the EFP project to realize
breakeven, the number of supplier delivery times k is given, which
may not mean the inventory management policy is optimal. The
inventory management policy can be optimized through adjusting
k and by doing so we can also examine whether inventory
management policy is sensitive to the EFP sales quantity required
for breakeven. The method adopted here is to set a value of k
n
initially, then solve for an optimal sales quantity Q ei
mt that satises
both the collective and individual interests according to Eqs. (16)
and (17). Next, we use an economic ordering quantity (EOQ) model
to determine the value of k, denoted by kn, that corresponds to
ordering cost equal to holding cost (recognizing that for the EOQ

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Fig. 2. Lower bound of the transfer price.

Fig. 3. Upper bound of the transfer price.

model, the total inventory cost is at the minimum when ordering

cost equals holding cost):
n

n
e
u
ein
e
u
e
u
kC eo C uo mQ ei
mt C h  C h =2k; k mQ mt C h  C h =2C o  C o

22

Alternatively, we may regard k as a variable and let

NPV isc =k 0; thus, kn can be derived as above. On the substitution of kn into Eqs. (16), (17) and (21), we redo the optimization of
the transfer price, sales price, and sales quantity of the EFP. We

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then further repeat the optimization process to obtain the new

value of kn until the difference between two adjacent values of kn
is less than a certain given error. Up to this point, kn is the optimal
inventory management policy and the corresponding values of the
transfer price, sales price, and sales quantity of the EFP are optimal
in the centralized model.

Table 1
Initial investment cost and operating data.

3.2.5. Impact of the government policy incentive on pricing strategies

As described above, government policy incentives compensate
for the incremental cost associated with producing the EFP; thus,
it has an impact on the supply chain members' pricing strategies.
To further analyze the relations of coefcients of policy incentive
with the transfer price, sales price, and sales quantity of the EFP,
for Eqs. (10)(12), (16) and (17), we take their rst-order partial
derivatives with respect to , respectively, as follows:

Item Thousand/ Item Thousand/ Item

Unit
Unit

P estn =

a=b  P um F um

40
2m1  2
hC e  C u mC e  C u F u  mC e  C u i
n
s
m
m
s
s
h
h
P emt
= 

1 g t  1 o 0
4
8k
hC e  C u F u C e  C u i
bC em  C um
n
s
h
s
bm s
40
 h
Q em1
=
4
8k
4
h
i
e
u
n
e
u
t 1
P ei
=2 o 0
mt =  C m  C m mP s  P s 1 g
h
i
ein
e
u
e
u
Q m1 = b C m  C m mP s P s =2 40

As seen in the above, in both decentralized and centralized

cases, by increasing coefcient , the sales price of the EFP will
decrease and thus its sales quantity will increase. This is consistent
with the government's intention of providing a subsidy to enlarge
the EFP's market proportion by reducing its cost. The transfer price
increases with increasing , which implies that the manufacturer
shares the government subsidy with the supplier. In analyzing Eqs.
(14.1) and (14.2), we can also see that with increasing , the NPVs
of both the manufacturer and the supplier increase.
In a similar way, we can further analyze the impact of penalty
cost on the pricing strategies and performance of investing in the
EFP. By taking the rst-order partial derivatives of the transfer
price, sales price, and sales quantity with respect to F um and F us ,
respectively, we obtain:

Pollution prevention initial investment cost

items
Investment of manufacturer (Im)
Investment of supplier (Is)
Operating data items

P um

120

C em

50

P us
F um
F us
C eh
C eo

60
5
4
0.15
0.65

C um
C es
C us
C uh
C uo

40
30
20
0.1
0.6

1
2
r
g

Million
4000
3000

Item

0.15 k (initial
value)
0.1 m
0.3 Item
10% Q em
15% Q um

times

48
1
Quantity
210; 000  0:72P em
100,000

Table 2
Optimal values of Q em ; P em ; P es and NPV: comparison of decentralized and collaborative pricing strategies ( n1 3 years).
Item (thousand
/unit)

Decentralized Collaborative Justication of VMI policy

(kn 192 times)

C
Bm
P es
P emn1

65.41
9.81
144.76
218.23

43.00
6.46
105.39
170.00

42.99
6.45
105.39
170.00

Q em1 (thousand
vehicles)
Q emn1 (thousand

26.78

55.92

55.92

35.42

73.96

73.96

vehicles)

NPV m (million)
NPV s (million)
NPV sc (million)

0.51
712.44
1062.47
1774.91

0.27
1546.92
1417.55
2964.47

0.27
1546.92
1417.59
2964.52

4.2. Numerical analysis

P es n =F us  1=2 o 0
n
P emt
=F um  1 g t  1 =4 o 0
n
=F um b=4 4 0
Q em1
n
u
t 1
P ei
=2 o 0
mt =F m  1 g
n
u
Q ei
m1 =F m b=2 4 0

From the above we can see that the EFP's sales quantity
increases with penalty cost, which implies that more rigorous
legislation drives the tendency to produce more EFPs, which in
turn lowers both the sales price and transfer price.

4. Case analysis and discussions

In this section, we present a case analysis of a hybrid vehicle
project from an auto company to quantify the impact of policy
incentives on the environmental performance of a sustainable
supply chain.
4.1. Data collection
The related data are estimated based on the market situation
shown in Table 1.

The analytical results for the data presented above are shown
in Table 2. The process of searching for the lower and upper
bounds of the transfer price are shown in Figs. 2 and 3.
In the centralized case, NPV cs (or NPV is ) is convex and
NPV cm (or NPV im ) is concave with respect to the transfer
price for P es 4P us (2 NPV cs =P es 2 bm2 and 2 NPV cm =P es 2
 bm2 1 =2); thus, for a valid transfer price, NPV cm decreases
and NPV cs increases with P es . Figs. 2 and 3, respectively, present
the determination of the lower and upper bounds of the transfer
price, where the dotted curves, respectively, represent NPV s and
NPV m in the decentralized case and the solid curves, respectively,
represent NPV cs (or NPV is ) and NPV cm (or NPV im ), respectively,
in the centralized case. As seen in Fig. 2, the NPV s (decentralized)
takes its maximum at point A1 (P es n 144.76) with NPV ns
1062.47. We can nd point B1 at which NPV cs NPV ns with
P es 102.09. When P es 4102.09, NPV cs 4 NPV ns , i.e., P es min 102.09
is the lower bound of the transfer price. As shown in Fig. 3, at point
A2 we have P es n 144.76 and NPV nm 712.44; correspondingly, we
can nd point B2 at which NPV cm NPV nm , with P es 113.94.
When P es o 113.94, NPV cm 4NPV nm , i.e., P es max 113.94 is the
upper bound of the transfer price. Fig. 4 shows the process of
determining the lower and upper bounds of the collaborative transfer price, where the shadow part on the horizontal axis shows
ec
the feasible collaborative transfer price interval [P ec
s min , P s max ].

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10

Fig. 4. Process of determining the lower and upper bounds of the collaborative transfer price.

Table 3
Comparison of NPV for decentralized and collaborative pricing strategies.
Decentralized

t 1
t 2
t 3 n1
t 4
t 5

Collaborative

SC

SC

 2645.94
 1665.74
712.44
848.95
991.00

 1091.42
894.57
1062.47
1237.19
1418.99

 3737.37
 771.17
1774.92
2086.14
2409.99

 1912.92
 595.45
1546.93
1831.99
2128.61

 1006.96
1066.93
1417.55
1782.40
2162.04

 2919.88
471.47
2964.48
3614.38
4290.65

M manufacturer, Ssupplier and SC supply chain.

Notice that there are three NPV breakevens corresponding to

the manufacturer, the supplier, and the supply chain system,
respectively; however, for a given value of the transfer price they
may not happen at the same time. We dene n1 as the time point
at which the latest breakeven is realized, which is considered the
supply chain system breakeven in the numerical analysis. At the
end of the initial development stage (tn1), the manufacturer, the
supplier, and the supply chain with the hybrid vehicle project will
all make breakeven, i.e., their NPVs become nonnegative. These
results are shown in Table 2, with n1 3 years for comparison.
As shown in Table 2, compared with the decentralized case, the
collaborative case is better overall. In the collaborative case, the
average incremental cost and government subsidy are less, the
sales quantity of the EFP is larger, and the sales price is less;
readjusting the transfer price creates a higher overall NPV of the
EFP project for the supply chain and also improves the benets
gained by each of its members. After breakeven, the transfer price
becomes P es P us C es  C us , including only the increment variable
cost per unit of output.
From Eq. (22), we obtain kn 192 times, meaning that inventory
should be delivered around every two days. Following up the
substitution of kn 192 into Eqs. (16), (17), and (21.2), we obtain
ein
n
new values (P ei
mt 170051.95 RMB/unit, Q m1 55923.20 vehicles),
n
which are very close to the results when k 48 times (P ei
mt
ein
170052.19 RMB/unit, Q m1 55923.06 vehicles), showing that the
pricing strategy of the supply chain may not be sensitive to the
inventory replenishment times calculated with the VMI model.
This may infer that when inventory delivery and holding costs are

relatively small, the NPV of the supply chain is less sensitive to

inventory replenishment times. With the VMI mode, the manufacturer and the supplier can settle the inventory replenishment
times and quantities suitable to both sides.
As shown in Table 3, it happens that under both the decentralized and collaborative models, n1 3 years (for all of the three
NPVs to become positive). In reality, n1 may differ with different
pricing strategies and it likely becomes shorter in the collaborative
case, showing that collaboration between members improves the
supply chain's performance. We see that collaboration not only
improves integrated supply chain performance but also the members' performances.
The discounting factors are inuenced by the supply chain
members' market positions, core capacities, bargaining costs, risk
preferences, etc.; in practice, these can be estimated based on
supply chain members' experiences. We can show the impact of
changing bargaining position on the transfer price. For instance,
when changing the discounting factor of the supplier from 2 0.2
n
to 0.3 while keeping 1 0.1, the optimal transfer price P ec
will
s
increase from 104265.60 RMB/unit to 105387.73 RMB/unit; on the
other hand, when changing the discounting factor of the manun
facturer from 1 0.2 to 0.3 while keeping 2 0.1, P ec
will
s
decrease from 103056.19 RMB/unit down to 102943.98 RMB/unit,
which implies that with the supplier's bargain position becoming
better the transfer price increases, whereas when the manufacturer's bargain position gets better the transfer price decreases.
The impacts of the policy incentive and penalty cost on pricing
strategies and supply chain performance in the collaborative mode

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can be tested through sensitivity analysis. The results are shown in

Tables 4 and 5, respectively.
4.3. Discussion
From the results shown in Table 4, we can see that with
increasing the government subsidy ratio , the EFP's sales quantity
increases as the sales price decreases; meanwhile, the transfer
price increases. This implies that the more the incremental cost is
compensated by the increased government subsidy, the less the
cost disadvantage to the manufacturer. The manufacturer then has
more room to lower the sales price while increasing the sales
quantity, as long as its total prot can be increased. The fact that
the transfer price increases with means that more incremental
costs of the supplier are compensated by sharing the government
subsidy. As shown in Table 5, with increasing the manufacturer's
penalty cost, the EFP's sales quantity increases, sales price decreases, the government subsidy decreases, and, similarly, the
transfer price decreases with the supplier's penalty cost as well.
This is intuitively true since the more penalty cost on the EUFP, the
more EFPs are preferred to replace the EUFP and consequently less
government subsidy is needed. The NPVs of the members and the
supply chain increase because of increasing EFP sales quantity.
As a focused issue connected with the effect of the government
policies on promoting environmentally friendly activities, our
study nds that the preferential policy incentive positively impacts EFP project performance. The implication is that due to the
crucial role of supply chain members in reducing environmental
externalities, it is essential for the government, by offering effective incentives, to have the supply chain members voluntarily
accept their environmental responsibilities. While readjusting the
transfer price to balance the supply chain benet allotment
between members, the distribution of the government subsidy is
logically interrelated with the transfer price. Our results show that
the transfer price of the collaborative case is lower than that of the
decentralized case, which means that in the former, it makes sense
for the supplier to share the government subsidy to compensate
for its increased cost of preventing environmental pollution while

11

reducing the tendency to overcharge the purchasing cost of the

manufacturer.
In our model, the transfer price presented in the centralized case
interrelates to the policy incentive and affects the supply chain members' payoffs. One may consider that the transfer price should be
regarded as a decision variable and its optimal value should be
obtained in the centralized decision-making model. However, our
results come out with the nontrivial ndings that the NPV of the
integrated supply chain is convex with respect to the transfer price.
This means the optimal transfer price cannot be worked out through
a conventional optimality conditions method; therefore, we have to
seek an alternative approach to a collaborative solution. The implication is that within a supply chain context, when introducing a policy
incentive in terms of compensating extra cost, the members might
face a complex problem connected with prot allotment, and more
likely the members will work out a satisfactory solution through
collaborative negotiation. In our study, we present a heuristic method
to obtain a negotiated collaborative solution that is satisfactory for
the members through nding out the lower and upper bounds of the
feasible transfer price together by adopting the Rubinstein game
approach.
In the context of a supply chain, an often-mentioned issue
relates to how much the government will offer as a policy
incentive to compensate supply chain members' incremental costs
associated with producing the EFP. In our model, the value of
coefcient is assumed as ( o1), meaning that is negotiated
between the government agency and the manufacturer and the
incremental cost of the manufacturer will not be fully compensated. The implication is that the government agency realizes a
moral hazard effect that might be created if the manufacturer
claims a disproportionate incremental cost; on the other hand, the
intention of the government's policy incentive is actually to
promote the supply chain members to take the initiative to
improve their environmental performances through technological
innovation; consequently, such initiatives enable the supply chain
to move towards its economic breakeven by gaining consumers'
acceptance in environmental interests Related to this aspect,
a connected issue arises regarding the factors that should be

Table 4
Impact of the policy incentive on pricing strategies and NPV in the collaborative mode.
Government subsidy rate

0.10
0.15
0.20
0.25

Collaborative model for n1 3

Bm (thousand)

P es (thousand)

P em (thousand)

Q em (unit)

NPV m (million)

NPV s (million)

NPV sc (million)

4.34
6.45
8.51
10.52

103.74
105.39
107.18
109.13

171.99
170.00
167.98
165.77

72405.91
73958.24
75612.52
77382.64

1199.88
1546.93
1884.66
2210.66

1157.96
1417.55
1705.21
2025.96

2357.84
2964.48
3589.87
4236.62

Table 5
Impact of penalty costs on pricing strategies and NPV in the collaborative mode.
Penalty cost (thousand/unit)

F um 5
F um 6
F um 7
F um 8

F us 4
F us 5
F us 6
F us 7

Collaborative model for n1 3

Bm (thousand)

P em (thousand)

Q em (unit)

NPV m (million)

NPV s (million)

NPV sc (million)

6.45
6.43
6.40
6.38

73958.24
74511.57
75064.90
75618.23
NPV s (million)

1546.93
1616.50
1686.60
1757.22
NPV sc (million)

1417.55
1482.50
1547.92
1613.81

2964.48
3099.00
3234.52
3371.04

P es (thousand)

170.00
169.36
168.67
167.98
NPV m (million)

105.39
104.39
103.39
102.39

1546.93
1584.5
1622.19
1659.98

1417.55
1499.54
1582.21
1665.56

2964.48
3084.04
3204.40
3325.54

Please cite this article as: Ding, H., et al., Pricing strategy of environmental sustainable supply chain with internalizing externalities.
International Journal of Production Economics (2015), http://dx.doi.org/10.1016/j.ijpe.2015.05.016i

12

H. Ding et al. / Int. J. Production Economics ()

considered for determining the transfer price through negotiation

between the members. From the manufacturer's point-of-view,
only the supplier's incremental cost can possibly be compensated
partially ( o1), and the compensated proportion will be the
focal issue. However, from the supplier side, as shown in the
results of case example for the decentralized case and based on
maximizing its own prot, the supplier often intends to charge a
higher price by adding more than its incremental cost on top of
the EUFP's transfer price, which in turn drives the sales price of the
EFP higher than expected. The implication is that, as a core issue,
the transfer price negotiation should be mediated through an ongoing collaboration between the members to achieve success in
producing the EFP.
In our model, inventory delivery frequency seems to have little
impact on operational performance when the VMI model is used.
Our numerical results show that the EFP's sales price or sales
quantity may not be sensitive to inventory replenishment times
with the VMI model. The implication is that business decisions,
such as product investment projects, are taken at a strategic level
and annual sales quantity and sales price are decision variables
concerning economic breakeven. This differs from the traditional
operations management model, where these variables are normally treated as given parameters. For instance, plant-level operational decisions are made under given product sales orders and
price, and more often concern cost minimization with efciency of
shop oor daily operations, such as inventory control, production
schedule, order quantity, service level, etc.: these are the decisions
made at the shop oor-level that may have little impact on
strategic level decision making.

supply chain as a whole but also individual benet of the

supply chain members.
3) Due to incorporating the government policy incentive, in the
centralized case the NPV of the supply chain turns out to be
convex with respect to the transfer price in our model, so that
we need an alternative collaborative approach to determine a
transfer price that is acceptable for the supply chain members.
Employing the Rubinstein game approach, the collaboration
between supply chain members can be realized and a satisfactory transfer price determined that will unify the interests of
both the collective group and individuals.
4) Incremental costs of both the manufacturer and the supplier
associated with producing the EFP are partially compensated
by the government subsidy through transfer price negotiation,
and the motivation mechanism is worked out by realizing the
NPV breakeven of the supply chain system. By doing so,
investment in the EFP can become economically feasible.
There are open issues that remain to be examined. For instance,
this study is limited by considering only one manufacturer and one
supplier in a sustainable supply chain, whereas extending this framework to a more complex supply chains and other industries would
improve generalizability of these results and expand the research
potential. Alternatively, the question of whether, without government
policy incentives, supply chain members' environmental pollution
prevention investments can jointly make breakeven through innovations in the competitive market could be another avenue for future
research.

Acknowledgments
5. Conclusions
Environmental pollution reduction and prevention is the eternal topic: the process of reducing environmental externalities is
much more complex in reality. Taking perspectives from both
supply chain members and the government, our study constructs a
sustainable supply chain model to evaluate the economic and
environmental performance of a supply chain. By explicitly introducing regulations and policy incentives in the context of a supply
chain, the contribution lies in the investigation of the mechanism
for motivating rms to collaboratively produce EFPs with environmental technology investment, and a quantitative analysis of government policies on reducing negative externalities. Based on the
prospect of an EFP project investment decision, we establish an
environmentally sustainable supply chain pricing strategy model
of the EFPs in the cases of decentralized, centralized, and collaborative decision-making. Our study nds that, unlike the traditional supply chain model when considering policy incentives, the
transfer price plays its role in the centralized supply chain mode,
which explicitly presents that the government policy incentive
shared between members is transmitted via the transfer price. Our
study reaches the following conclusions:
1) With cooperation between manufacturer and supplier in promoting environmental pollution prevention investment, the
overall performance of the environmentally sustainable supply
chain can be improved and, through further collaborative adjustment of the transfer price that incorporates the government
policy incentive, both collective and individual interests can be
unied with satisfaction.
2) Government incentive policies impact the environmentally
sustainable supply chain pricing strategy. A reasonably distributed government subsidy helps the EFP price to adapt to
market competition with less cost disadvantage, enlarging the
sales quantity and increasing not only the overall benet of the

The authors would like to thank the anonymous referees for

their valuable comments and suggestions to improve the work of
this paper.
This research is supported by the National Natural Science
Foundation of China with Grant no. 71372012, partially supported
by the Research Fund for the Doctoral Program of High Education
of China with Grant no. 20130009110038, and the Beijing Planning
Ofce of Philosophy and Social Science Foundation of China with
Grant no. 13JGB021.

Appendix

P esl

From Eq. (15), by having NPV isc =P es 0, we can obtain

P us  A, where

A a=b P um F um mF us  mC es  C us  1  C em  C um
mC eh  C uh =2k=m
Since a=b=  P um is positive and relatively larger, and incremental costs are relatively smaller, we can normally infer A 40 so that
P esl o P us .
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International Journal of Production Economics (2015), http://dx.doi.org/10.1016/j.ijpe.2015.05.016i