Introduction

In buyer-supplier relationships, firms often expect a level of performance and adaptability that goeswell beyond contractual requirements. In fact, supply relations are often governed by so-called relational contracts. These are informal agreements sustained by the value of future cooperation. Although relational contracts persist in practice, research on these types of contracts is only emerging in Operations and Supply Chain Management. This treatise studies a two-firm supply chain, where repeated transactions via well-established supply chain contracts and continued quality-improvement efforts are governed by a relational contract. We are able to characterize an optimal relational contract, i.e., to develop policies for supplier and buyer that structure investments in quality and flexibility in a way that no other self-enforcing contract generates higher expected joint surplus. For this purpose, we study an infinite horizon dynamic game with Markovian dynamics modeling the stochastic influence of the firms’ actions on quality. We examine both quantity-based (quantity flexibility contracts) and price-based returns (buy backs) mechanisms. Hence, a second goal is to compare the performance of different returns mechanisms in the context of relational contracting.