Responsible audit and consumer awareness under collusion risk

Abstract

While sourcing from emerging economies can significantly reduce a buying firm’s operating costs, it may cause great financial or reputational damages due to supplier violations (e.g., child labor and environmental damage). In practice, multinational firms often employ third-party audits as an important approach to ensure their suppliers’ compliance prior to procurement. Unfortunately, in countries with lax law enforcement, collusion between suppliers and auditors often occurs, which helps suppliers pass audits with a lower compliance level, thus lowering consumers’ expectations of supply chain compliance. In this paper, we develop a game theoretic model to study a firm’s contracting strategy under supplier–auditor collusion risk when consumers have rational expectations. First, we show that the firm’s equilibrium contracting strategy takes three different forms depending on the collusion penalty. Interestingly, in contrast to the well-established results in the literature, we show that the firm may reduce the equilibrium compliance requirement. Second, we show that decreasing the supplier’s compliance effort cost, increasing their ethical level, or increasing consumers’ awareness of responsibility may lead to more rampant collusion, although all of them increase the supplier’s compliance level and the firm’s profit. In contrast, increasing the penalty always leads to a higher profit for the firm, a higher supplier’s compliance level, and lower collusion risk. Finally, we extend our model to examine the impacts of uncertainty about the auditor’s ethical level, bargaining power, and mandatory external standards.