Quality and Environmental Regulation: Verifying Compliance along the Supply Chain

Among the factors providing incentives to monitor the behaviour of input suppliers are the regulatory requirements to which downstream firms are subject. We develop a formal economic model to examine the relationship between the strictness of the regulatory environment and downstream firms' incentives to act as inspectors of their sub-contractors. We consider the interaction between a downstream producer and an upstream input supplier. The downstream chooses the probability with which to monitor the upstream's compliance and the upstream chooses a compliance level which determines compliance of the end product with quality or environmental regulation. We find that the strictness of regulation affects the downstream's monitoring strategy in combination with the level of quality or environmental standards. If the standards are sufficiently low then the strictness of regulation increases incentives to monitor the upstream. Contrary, if the standards are sufficiently high then the pressure on the downstream to monitor the upstream is relaxed and the strictness of regulation decreases incentives to monitor. We argue that the strictness of regulation should not be treated in isolation as a factor determining the choice of downstream firms to monitor their input suppliers.