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A Principal-Agent Model for Product Specification and Production

Author

Listed:
  • Ananth V. Iyer

    () (Krannert School of Management, Purdue University, West Lafayette, Indiana 47907)

  • Leroy B. Schwarz

    () (Krannert School of Management, Purdue University, West Lafayette, Indiana 47907)

  • Stefanos A. Zenios

    () (Graduate School of Business, Stanford University, Stanford, California 94305)

Abstract

This paper develops and analyzes a principal-agent model for product specification and production motivated by Ücore buyingÝ decisions at an automobile manufacturer. The model focuses on two important elements of the ÜcoreÝ buyer's responsibility: (1) assessing the supplier's capability, and (2) allocating some or all of a fixed level of some buyer-internal resource to help the supplier. Under the contracting scheme we model, the buyer (principal) delegates the majority of product specification and production activity to the supplier (agent), but retains the flexibility to commit a given, observable amount of an internally available, limited resource (e.g., engineering hours) to help the supplier. The supplier, in turn, allocates his resource (e.g., engineering hours) to produce the finished product. As in the motivating scenario, both the supplier's resource allocation and capability are assumed to be hidden from the buyer. Hence, the principal's problem is to determine a menu of (resource-commitment, transfer-price) contracts to minimize her total expected cost. Our analysis demonstrates that if buyer resource and supplier capability are substitutes, then the buyer's second-best involvement in the supplier's production process will be greater than first-best. The opposite is true if they are complements. Further, when the opportunity cost for the buyer's resource is zero, then in the substitutes case the buyer will commit all of its resource, while in the complements case the buyer may withhold some resources to screen the supplier type. We describe two applications of the modelÔone in inventory management and one in pharmaceutical drug discoveryÔto illustrate its applicability and versatility. Finally, we use insights from the model to suggest hypotheses for empirical study.

Suggested Citation

  • Ananth V. Iyer & Leroy B. Schwarz & Stefanos A. Zenios, 2005. "A Principal-Agent Model for Product Specification and Production," Management Science, INFORMS, vol. 51(1), pages 106-119, January.
  • Handle: RePEc:inm:ormnsc:v:51:y:2005:i:1:p:106-119
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    File URL: http://dx.doi.org/10.1287/mnsc.1040.0214
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    References listed on IDEAS

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    1. Kim B. Clark, 1989. "Project Scope and Project Performance: The Effect of Parts Strategy and Supplier Involvement on Product Development," Management Science, INFORMS, vol. 35(10), pages 1247-1263, October.
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    7. Guesnerie, Roger & Laffont, Jean-Jacques, 1984. "A complete solution to a class of principal-agent problems with an application to the control of a self-managed firm," Journal of Public Economics, Elsevier, vol. 25(3), pages 329-369, December.
    8. Arora, Ashish & Gambardella, Alfonso, 1990. "Complementarity and External Linkages: The Strategies of the Large Firms in Biotechnology," Journal of Industrial Economics, Wiley Blackwell, vol. 38(4), pages 361-379, June.
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