Product Quality and the Value of Asymmetric Information Under Supplier-Speci fied Contracts

Original equipment manufacturers (OEMs) sometimes face the decision of whether to make a critical component for a product in-house or to source it from a supplier. Though sourcing from a supplier with a more favorable cost structure than the OEM would be more efficient for the supply chain, the supplier could be in a position to specify contract terms and thus leave a lower share of the profit for the OEM. In this paper, we investigate implications of the relative cost efficiencies of the supplier and the OEM's in-house option on the OEM's choice of product design quality and on contract outcomes. We model the problem as a dynamic game, wherein the OEM chooses product quality (determined by the design quality of a critical component), followed by the supplier offering a contract for supplying the component. The OEM either accepts the supplier’s offer or uses her in-house option, and sells the product to consumers. Interestingly, we find that the supplier’s ability to offer a two-part tariff contract, compared to the price-only contract, may hurt not only the OEM (as expected) but also the supplier. We also investigate the impact of asymmetric information regarding the cost structure of the OEM’s in-house option. Counterintuitively, we show that, under certain conditions, asymmetric information may be desirable not only for the OEM, but also for the supplier -- the less-informed player.