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Information, Contracting, and Quality Costs

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  • Stanley Baiman

    ()
    (The Wharton School, University of Pennsylvania, Philadelphia, Pennsylvania 19104)

  • Paul E. Fischer

    ()
    (Smeal College of Business Administration, Pennsylvania State University, University Park, Pennsylvania 16802)

  • Madhav V. Rajan

    ()
    (The Wharton School, University of Pennsylvania, Philadelphia, Pennsylvania 19104)

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    Abstract

    This article analyzes the relation between product quality, the cost of quality, and the information that can be contracted upon. We consider a setting where a risk neutral supplier sells an intermediate product to a risk neutral buyer. The supplier incurs prevention costs to reduce the probability of selling a defective product, and the buyer incurs appraisal costs to identify defects. Both decisions are subject to moral hazard. We show that the first-best outcome can be obtained if either: (i) the supplier's prevention decision is contractible; or (ii) the buyer's appraisal decision and either internal failure (i.e., the product's failing the buyer's appraisal test) or external failure (i.e., the product's failing after being sold by the buyer) are contractible events; or (iii) both internal and external failure are contractible events. We then focus on the second-best setting where actions and failures are not contractible and study the effect of making the buyer's appraisal result contractible. Relative to first-best, if a buyer's return decision is contractible (but not his appraisal result), the supplier incurs lower prevention costs, the buyer incurs higher appraisal costs, expected internal failure costs are higher, and the total cost of quality is higher. The expected costs of external failure, however, may actually be lower relative to first-best. We then show that installing an information system that makes the appraisal result contractible reduces the inefficiency associated with the seller's prevention activity, increases the inefficiency associated with the buyer's quality appraisal activity, and unambiguously improves product quality.

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    File URL: http://dx.doi.org/10.1287/mnsc.46.6.776.11939
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    Bibliographic Info

    Article provided by INFORMS in its journal Management Science.

    Volume (Year): 46 (2000)
    Issue (Month): 6 (June)
    Pages: 776-789

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    Handle: RePEc:inm:ormnsc:v:46:y:2000:i:6:p:776-789

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    Related research

    Keywords: information; incentives; quality costs; supply chain;

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    Cited by:
    1. Löffler, Clemens & Pfeiffer, Thomas & Schneider, Georg, 2012. "Controlling for supplier switching in the presence of real options and asymmetric information," European Journal of Operational Research, Elsevier, vol. 223(3), pages 690-700.
    2. Xie, Gang & Yue, Wuyi & Wang, Shouyang & Lai, Kin Keung, 2011. "Quality investment and price decision in a risk-averse supply chain," European Journal of Operational Research, Elsevier, vol. 214(2), pages 403-410, October.
    3. Pun, Hubert & Sebastian Heese, H., 2014. "Outsourcing to suppliers with unknown capabilities," European Journal of Operational Research, Elsevier, vol. 234(1), pages 108-118.
    4. Dionisia Tzavara and Adrienne Héritier, 2011. "Quality and Environmental Regulation: Verifying Compliance along the Supply Chain," EUI-RSCAS Working Papers 16, European University Institute (EUI), Robert Schuman Centre of Advanced Studies (RSCAS).
    5. Corbett, Charles J. & DeCroix, Gregory A. & Ha, Albert Y., 2005. "Optimal shared-savings contracts in supply chains: Linear contracts and double moral hazard," European Journal of Operational Research, Elsevier, vol. 163(3), pages 653-667, June.
    6. Freiesleben, Johannes, 2010. "Proposing a new approach to discussing economic effects of design quality," International Journal of Production Economics, Elsevier, vol. 124(2), pages 348-359, April.
    7. Lauren Xiaoyuan Lu & Jan A. Van Mieghem & R. Canan Savaskan, 2006. "Incentives for Quality through Endogenous Routing," Discussion Papers 1436, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
    8. Xie, Gang & Wang, Shouyang & Lai, K.K., 2011. "Quality improvement in competing supply chains," International Journal of Production Economics, Elsevier, vol. 134(1), pages 262-270, November.
    9. Dionisia Tzavara & Adrienne Héritier, 2011. "Quality and Environmental Regulation: Verifying Compliance along the Supply Chain," RSCAS Working Papers 2011/16, European University Institute.
    10. Yim, Andrew, 2010. "Quality Cost and Failure Risk in the Choice of Single versus Multiple Sourcing," MPRA Paper 27858, University Library of Munich, Germany.
    11. Lee, Chang Hwan & Rhee, Byong-Duk & Cheng, T.C.E., 2013. "Quality uncertainty and quality-compensation contract for supply chain coordination," European Journal of Operational Research, Elsevier, vol. 228(3), pages 582-591.
    12. Li, Yongjian & Xu, Lei & Li, Dahui, 2013. "Examining relationships between the return policy, product quality, and pricing strategy in online direct selling," International Journal of Production Economics, Elsevier, vol. 144(2), pages 451-460.
    13. Kurata, Hisashi & Yue, Xiaohang, 2008. "Trade promotion mode choice and information sharing in fashion retail supply chains," International Journal of Production Economics, Elsevier, vol. 114(2), pages 507-519, August.
    14. Gurnani, Haresh & Gerchak, Yigal, 2007. "Coordination in decentralized assembly systems with uncertain component yields," European Journal of Operational Research, Elsevier, vol. 176(3), pages 1559-1576, February.
    15. Aust, Gerhard & Bräuer, Ina & Buscher, Udo, 2014. "A note on “Quality investment and inspection policy in a supplier-manufacturer supply chain”," European Journal of Operational Research, Elsevier, vol. 234(3), pages 910-915.
    16. Iida, Tetsuo, 2012. "Coordination of cooperative cost-reduction efforts in a supply chain partnership," European Journal of Operational Research, Elsevier, vol. 222(2), pages 180-190.

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