The value of product recall insurance in a price competition with financially constrained suppliers

Abstract

We study the horizontal benefits of product recall (PR) insurance by considering a Bertrand competition with financially constrained suppliers. In the model, two suppliers produce homogeneous products and a buyer purchases from whoever offers the lowest price. Product’s quality is random and defective products would cause a product recall associated with a random recall cost for the faulty supplier. We find that PR insurance eases the suppliers’ financial constraints by reducing their external financing costs and intensifies the price competition. Interestingly, the more intensified price competition may not lead to lower profits for both suppliers. PR insurance enables the suppliers to use financial constraints more efficiently by charging higher prices and improve their profits. We also reveal how asymmetric financial capacities and production costs affect the role of the PR insurance in the price competition. PR insurance restrains the predation effect caused by the financial advantage. However, when the suppliers’ financial capacities are sufficiently high, PR insurance strengthens the predation effect initiated by the cost advantage. Finally, we conduct a numerical study with exponential and Pareto distributions.