Contracting for Product Support Under Information Asymmetry

60 Pages Posted: 8 Dec 2016 Last revised: 14 Sep 2022

See all articles by Dong Li

Dong Li

School of Business, Sun Yat-sen University

Nishant Mishra

UCLouvain

Serguei Netessine

University of Pennsylvania - The Wharton School

Date Written: September 13, 2022

Abstract

In after-sales product support, both literature and practice have highlighted the advantages of paying for performance under Performance-based Contracts (PBC) over the more traditional Transaction-based Contracts (TBC) that tie supplier payments to each repair incident. Although PBC is believed to better align incentives in the supply chain when the supplier's private effort is difficult to verify, emerging technologies can make the repair process more transparent, which can eliminate the supplier's moral hazard problem. Meanwhile, fast growth of service outsourcing for established products makes information asymmetry with regards to product failure rates a new challenge for MRO operations.
To analyze this changing environment, we build a stylized adverse selection model and explore which contract is more efficient in dealing with information asymmetry. We assume that equipment failure rates are only known by the customer, whose outside options are type-dependent. The uninformed supplier has to design appropriate mechanisms to overcome the disadvantages of this information structure, while maximizing profits. We show that the two contracts demonstrate different screening ability and TBC may be preferred over PBC. Type-dependent outside options can lead to countervailing incentives, making PBC immune to information asymmetry and enabling it to achieve the First-Best outcome. When the differential of outside options has a relatively stronger effect compared to the differential of failure rates, TBC can bring the supplier a higher ex ante payoff than PBC. Our paper brings to light a heretofore unknown advantage of TBC, and we demonstrate when these contracts are likely to be observed in the third-party MRO market.

Keywords: service contracts, MRO operations, emerging technologies, information asymmetry, adverse selection, countervailing incentives

Suggested Citation

Li, Dong and Mishra, Nishant and Netessine, Serguei, Contracting for Product Support Under Information Asymmetry (September 13, 2022). Available at SSRN: https://ssrn.com/abstract=2881356 or http://dx.doi.org/10.2139/ssrn.2881356

Dong Li

School of Business, Sun Yat-sen University ( email )

135 Xingang West Road
Sun Yat-Sen University
Guangzhou, Guangdong 510275
China

Nishant Mishra

UCLouvain ( email )

Chaussée de Binche, 151
Mons, 7000

Serguei Netessine (Contact Author)

University of Pennsylvania - The Wharton School ( email )

3730 Walnut Street
Philadelphia, PA 19104-6367
United States
(215) 573 3571 (Phone)

HOME PAGE: http://www.netessine.com

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