A model of strategic product quality and process improvement incentives

Abstract

In many production firms it is common practice to financially reward managers for firm performance improvement. The use of financial incentives for improvement has been widely researched in several analytical and empirical studies. Literature has also addressed the strategic effect of incentives, in particular what the effect of certain incentive structures would be on the behavior of a firm's competitor(s). Most of these studies, however, focus on sales incentives. In this paper we investigate the effects of strategic incentives for product quality and process improvement using a game theoretic model that considers two owner–manager pairs in competition. We find that if one of the managers is told to only maximize firm profits (which in fact is similar to profit incentives), the other manager will be offered positive incentives for product quality and process improvement. These product quality and process improvement incentives result in increased profits, at the expense of the profits of the other firm. Also we find that if both firm owners have the possibility to offer incentives for product quality and process improvement, they will both do so. However, this equilibrium essentially entails a prisoner's dilemma, in which the two firms earn lower profits compared to a situation in which the owners instruct their managers only to maximize firm profits. Insights into the normalization of the problem and the aggregation of multiple product quality and process improvement variables are also discussed.