Quality Management by Warranty Contract Under Dual Asymmetric Information

Product failure resulting from sourcing supplier's defective component has compelled a brand owner to enhance quality management, especially when the supplier has informational advantage. In this article, we examine a brand owner's problem of screening a certain supplier's inherent quality level with an attempt to induce supply chain partners' quality efforts using the warranty contract based on information acquired from inspection technology. A supplier's inherent quality level is herein determined by the private information held by the supplier and is typically characterized as an uncertain variable. The optimal warranty contracts and the expected profits of the brand owner and the supplier are derived from four different scenarios under the framework of uncertainty theory and principal-agent theory. We find that under the condition of pure double moral hazard or pure adverse selection, the first-best outcomes can be achieved without incurring agency cost under the designed contract. However, double moral hazard combined with adverse selection often leads to underinvestment in quality efforts as the supplier can shirk by misreporting her type. Consequently, we present the menu of warranty contracts to screen the supplier's private information. Finally, we provide empirical managerial recommendations on mitigating potential adverse impacts caused by information asymmetry, supported with numerical investigations.