A Principal-Agent Model for Product Specification and Production

Abstract

This paper develops and analyzes a principal-agent model for product specification and production motivated by Ücore buyingÝ decisions at an automobile manufacturer. The model focuses on two important elements of the ÜcoreÝ buyer's responsibility: (1) assessing the supplier's capability, and (2) allocating some or all of a fixed level of some buyer-internal resource to help the supplier. Under the contracting scheme we model, the buyer (principal) delegates the majority of product specification and production activity to the supplier (agent), but retains the flexibility to commit a given, observable amount of an internally available, limited resource (e.g., engineering hours) to help the supplier. The supplier, in turn, allocates his resource (e.g., engineering hours) to produce the finished product. As in the motivating scenario, both the supplier's resource allocation and capability are assumed to be hidden from the buyer. Hence, the principal's problem is to determine a menu of (resource-commitment, transfer-price) contracts to minimize her total expected cost. Our analysis demonstrates that if buyer resource and supplier capability are substitutes, then the buyer's second-best involvement in the supplier's production process will be greater than first-best. The opposite is true if they are complements. Further, when the opportunity cost for the buyer's resource is zero, then in the substitutes case the buyer will commit all of its resource, while in the complements case the buyer may withhold some resources to screen the supplier type. We describe two applications of the modelÔone in inventory management and one in pharmaceutical drug discoveryÔto illustrate its applicability and versatility. Finally, we use insights from the model to suggest hypotheses for empirical study.production outsourcing, hidden information, adverse selection, contract menu, complements, substitutes

Endogenous Selection and Moral Hazard in Compensation Contracts

“…Although the models developed in our analysis relate to executive compensation, they can be applied in other principal-agent settings such as supply chains and procurement (e.g., Baiman et al 2001, Cachon 2004, Iyer et al 2005, Zenios 2004). Two notable applications come to mind.…”

Management science in the era of smart consumer products: challenges and research perspectives

“…Some analytical, game-theoretical research has been published on joint R&D in the supply chain that might serve as a starting point for an analysis of these questions in the context of smart products. For example, Iyer et al (2005) analyze a model in which the manufacturer delegates part of the product specification and production activities to a supplier but may assist the supplier with his/her own engineering resources. Their results depend significantly on whether the (engineering) resources of the supplier and the manufacturer are substitutes or complements, which echoes the situation just discussed for the supply chain for smart products.…”

Procurement in Supply Chains When the End-Product Exhibits the 'Weakest Link' Property

“…Our paper is closely related to the recent contracting on quality literature in supply chain management, e.g., Reyniers and Tapiero (1995), Baiman et al (2000Baiman et al ( , 2001, Lim (2001), Iyer et al (2002), and Balachandran and Radhakrishnan (2003). These papers analyze a situation in which a manufacturer contracts with a single supplier for a single part, while we consider the case of contracting for multiple parts provided by multiple suppliers.…”