Moral hazard strategy and quality contract design in a two-echelon supply chain |
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Authors: | Lilong Zhu Jianxin You |
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Institution: | 1. School of Economics and Management, Tongji University, Shanghai 200092, China;College of Business, University of Illinois at Urbana-Champaign, IL 61820, USA 2. School of Economics and Management, Tongji University, Shanghai 200092, China |
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Abstract: | Based on game theory and principal-agent theory, this paper focuses on how to control product quality and design quality contract
in supply chain when moral hazard exists. We set up the supplier and buyer’s expected profits function model, in which the
supplier makes production process investment-level decision and decides on the product quality prevention level, whereas the
buyer makes quality evaluation decision and decides on the product quality inspection level. The supplier with a moral hazard
of reducing investment level may lack investment in the production process; thus, the buyer will pay the information rent
to incentivize the supplier to improve the investment level. The buyer creates the moral hazard of exaggerating the product
quality defective rate, who may overinvest in the inspection process. We use the optimal condition to solve supplier’s first-best
investment level, product quality prevention level, and buyer’s first-best quality inspection level, internal penalty, and
apportionment ratio of external failure cost. We also conduct a simulation test that shows the following: When the supplier
improves its investment level, its product quality prevention level will increase, and the buyer’s quality inspection level
will decrease. With the improvement in the buyer’s product quality inspection level, its internal penalty will increase, and
the supplier’s external failure cost will also increase while its expected profits will decrease. Hence, the buyer will design
an incentive contract, the expected profits of which will increase, and the whole supply chain’s joint expected profits function
may become an inverse U shape. Finally, we develop a simulation example and propose suggestions for quality control strategy
and contract design in the supply chain under the conditions of asymmetric information. |
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Keywords: | Supply chain moral hazard quality control contract design principal-agent relationship |
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