Producer-supplier contracts with incomplete information

This paper investigates the contract design problem of a producer when he p urchases parts from a supplier, and there is incomplete information regardi ng the quality of the parts. This is the first game-theoretic model of qual ity control tl;at captures this informational asymmetry. We focus on two co mpensation schemes embedded in the contract, namely, price rebate (when ins pection is done upon receipt of the parts) and warranty. We show that when a full-price rebate is not possible and the producer and the supplier have to share the damage costs, an optimal contract is such that the:supplier co mpensates the producer by the same amount, regardless of his quality type. However, a supplier with low quality is more likely to be offered a contrac t with an inspection scheme, while a supplier with high quality is constrai ned with a warranty scheme. We also show that when the producer need not sh are the cost in exactly one of the compensation schemes, he may still offer the other compensation scheme to a supplier type depending on the relative costs involved, the maximum compensation cost acceptable by all supplier t ypes, and his ex ante beliefs about the quality level of the supplier.