Contract Types and Supplier Incentives for Quality Improvement

When firms outsource production to suppliers, a key concern is how to control product quality and motivate the supplier to invest in quality improvement. In practice, several kinds of quality management contracts are found. We classify and formalize various quality contracts used in practice, and compare their effectiveness in motivating supplier's quality improvement. We focus on a supply chain with one buyer and one supplier. The buyer faces deterministic market demand and the supplier has an imperfect batch production process. Each contract induces a Stackelberg game with the buyer as the leader. We examine and compare the equilibrium behaviors of the supply chain under different contracts with either complete or asymmetric information about the supplier's status-quo process quality level. We characterize the contract terms in closed form, which facilitate the contract design in practice. These expressions also demonstrate, both qualitatively and quantitatively, how economic factors affect the contract terms and the supplier's quality improvement decisions. We identify conditions under which a particular contract is most appropriate for the buyer, under both complete and asymmetric information about the supplier's initial quality level.