Information, Contracting, and Quality Costs
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.
Volume (Year): 46 (2000)
Issue (Month): 6 (June)
|Contact details of provider:|| Postal: 7240 Parkway Drive, Suite 300, Hanover, MD 21076 USA|
Web page: http://www.informs.org/
More information through EDIRC
References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Nöldeke, Georg & Schmidt, Klaus M., 1995.
"Option contracts and renegotiation: A solution to the Hold-Up Problem,"
Munich Reprints in Economics
19329, University of Munich, Department of Economics.
- Georg Noldeke & Klaus M. Schmidt, 1995. "Option Contracts and Renegotiation: A Solution to the Hold-Up Problem," RAND Journal of Economics, The RAND Corporation, vol. 26(2), pages 163-179, Summer.
- Georg Nöldeke & Klaus M. Schmidt, 1992. "Option Contracts and Renegotiation - A Solution to the Hold-Up Problem," Discussion Paper Serie A 417, University of Bonn, Germany, revised Aug 1993.
- Donald B. Hausch & Yeon-Koo Che, 1999.
"Cooperative Investments and the Value of Contracting,"
American Economic Review,
American Economic Association, vol. 89(1), pages 125-147, March.
- Che, Y.K. & Hausch, D.B., 1997. "Cooperative Investments and the Value of Contracting," Working papers 9714, Wisconsin Madison - Social Systems.
- Aaron S. Edlin & Stefan Reichelstein, 1995.
"Holdups, Standard Breach Remedies, and Optimal Investment,"
NBER Working Papers
5007, National Bureau of Economic Research, Inc.
- Edlin, Aaron S & Reichelstein, Stefan, 1996. "Holdups, Standard Breach Remedies, and Optimal Investment," American Economic Review, American Economic Association, vol. 86(3), pages 478-501, June.
- Neary Hugh M. & Winter Ralph A., 1995. "Output Shares in Bilateral Agency Contracts," Journal of Economic Theory, Elsevier, vol. 66(2), pages 609-614, August.
- Emons, Winand, 1988. "Warranties, moral hazard, and the lemons problem," Journal of Economic Theory, Elsevier, vol. 46(1), pages 16-33, October.
- Diane J. Reyniers & Charles S. Tapiero, 1995. "The Delivery and Control of Quality in Supplier-Producer Contracts," Management Science, INFORMS, vol. 41(10), pages 1581-1589, October.
- Sugato Bhattacharyya & Francine Lafontaine, 1995. "Double-Sided Moral Hazard and the Nature of Share Contracts," RAND Journal of Economics, The RAND Corporation, vol. 26(4), pages 761-781, Winter.
When requesting a correction, please mention this item's handle: RePEc:inm:ormnsc:v:46:y:2000:i:6:p:776-789. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Mirko Janc)
If references are entirely missing, you can add them using this form.