Supplier Capability Signaling Through Investment in Quality Improvement: Roles of Cost of Quality and Inequity Aversion

Identifying a supplier’s capability in delivering high-quality consignments is critical for a manufacturer who might incur a noncontractable hidden cost of poor quality if the selected supplier is of low-capability type. A supplier’s investment in quality improvement through defect reduction can be a useful signal. However, the manufacturer is misled by the signal if the effect of preventive investment in reducing the cost of quality (COQ) is ignored. We analyze a signaling game between a manufacturer and a supplier, factoring in the decrease in COQ through a reduction in appraisal and failure costs resulting from investment in quality improvement. If the manufacturer is a payoff maximizer, then a high-capability supplier lacks incentive to signal type. However, surplus sharing, induced by the manufacturer’s inequity aversion, incentivizes the high-capability supplier to signal type through investment in defect prevention. Separating perfect Bayesian equilibrium (PBE) exists if the capability gap between types of suppliers, or the noncontractable hidden cost to the manufacturer, is not too small. The likelihood of separating PBE increases with an increase in the capability gap and the supplier’s equitable share of the surplus. Our analysis helps manufacturers avoid the hidden cost of poor quality by identifying a high-capability-type supplier correctly, factoring in the effects of investment in the supplier’s appraisal and failure costs. Finally, our numerical simulation provides operational guidelines to the manufacturer for designing an effective signaling game, while ensuring an equitable distribution of supply chain surplus. Supplemental Material: The online appendix is available at https://doi.org/10.1287/deca.2025.0470 .