Non-contractible Quality Research Articles

Organizational Design with Non-Contractible Quality

When contracting with an agent who is a worker of non-contractible quality, a principal considers mechanisms with an informed third party, a manager. To induce the manager to report worker quality truthfully, the principal devises the first-order alignment, an aligned contract based on first-order condition optimality. We show that the mechanism contracting simultaneously with the manager and the agent can dominate the optimal selling the project mechanism. This dominance, combined with the manager's information acquisition costs, results in three optimal organizational structures: simultaneous contracting, ex ante contracting, or partial revelation.

Disclosing products’ freshness level as a non-contractible quality: Optimal logistics service contracts in the fresh products supply chain

The growth of digital shopping for fresh products necessitates the provision of cold chain logistics services. The present study constructs an optimal control model to investigate how to incentivize logistics service providers’ efforts to preserve product freshness during transport. The freshness level constantly evolves, unobservable and unverifiable, and thus cannot be explicitly specified in the contract. We study a two-echelon supply chain consisting of a retailer and a logistics service provider. Our research aims to design a menu of contracts that will induce the logistics service provider to pick the actions desired by the retailer in the absence of information on product freshness. The results suggest that a flexible revenue-sharing policy is preferable, as it increases alignment on the target of delivering fresh products. It essentially coordinates the supply chain regardless of whether the retailer has sufficient oligopoly power to dictate sales prices. In contrast, a simple transfer payment contract and fixed lump-sum bonus policy are also useful for aligning the freshness-keeping action, but they rely on the retailer’s sufficient oligopoly power. The findings have managerial significance in decreasing the occurrence of customer complaints about product freshness. Retailers may be able to predict the regions that can offer a freshness guarantee.

Organizational Design with Non-Contractible Quality

When contracting with an agent who is a worker of non-contractible quality, a principal con- siders mechanisms with an informed third party, a manager. To induce the manager to report worker quality truthfully, the principal devises the first-order alignment, an aligned contract based on the first-order condition with an interval structure. We show that the mechanism contracting simultaneously with the manager and the agent dominates the optimal “selling the project” mechanism. In addition, we characterize the optimal number of intervals for such an alignment. This dominance, combined with the manager’s information acquisition costs, results in three optimal organizational structures: simultaneous contracting, ex ante contracting, or partial revelation. Lastly, we apply this model to explain what may cause the difference in the firm structure across three types of labor market.

Gratitude, conscience, and reciprocity: Models of supplier motivation when quality is non-contractible

Standard game-theoretic models that apply principal-agent problems to analyse buyer–supplier relations have postulated that in a single-period game, the agent will not choose non-contractible quality. However, evidence exists that suppliers (or service providers) choose costly quality in non-contractible dimensions, even in absence of reputation concern, if they are offered a premium. Such actions violate the axiom of ‘individual rationality’ and are not subgame perfect in standard game theory, wherein only material payoffs are considered. This paper builds three models of supplier behaviour in a single-period Stackelberg-like buyer–supplier game by using the framework of psychological game theory and explains supplier motivations to choose quality on non-contractible dimensions in absence of any reputation effect. If the buyer offers a price higher than the market price, the supplier may be motivated to choose non-contractible quality due to a sense of gratitude, or because of his conscience, or in order to reciprocate kindness. The results show that maximum possible quality is chosen by the supplier only in the presence of a sufficiently strong sense of gratitude or a sufficiently strong conscience. However, the buyer is better-off with a fair supplier who is motivated to reciprocate than a supplier having a very poor sense of gratitude or one having a weak conscience, because the buyer can choose an optimal premium above market price to ensure that a fair and reciprocal supplier chooses an optimal quality.

Non-Contractible Quality in Absence of Reputation Effect: What Motivates Service Providers to Be Ethical?

Standard game-theoretic analysis of a principal-agent problem postulates that in a one-period game the agent will not choose non-contractible quality. However, evidence exists that service providers choose costly quality in non-contractible dimensions, even in absence of reputation concern, if they are offered a premium. Such actions are not sub-game perfect, if only material payoffs are considered. This paper builds three models of agent behaviour, applying the framework of psychological game theory in one-period principal-agent problems. The models reveal what motivates the service provider to choose quality on non-contractible dimensions in absence of any reputation effect. If the customer (principal) offers a price higher than the market price, the service provider (agent) may be motivated to choose non-contractible quality due to a sense of gratitude, or because of his conscience, or in order to reciprocate kindness. The results show that maximum possible quality is chosen by the service provider only in the presence of a sufficiently strong sense of gratitude or a sufficiently strong conscience. However, the customer is better-off with a fair service provider who is motivated to reciprocate than one having a very poor sense of gratitude or one having a weak conscience, because the customer can choose an optimal premium above market price to ensure that a fair and reciprocal service provider chooses an optimal quality.

Privatization and quality: Evidence from elderly care in Sweden

Non-contractible quality dimensions are at risk of degradation when the provision of public services is privatized. However, privatization may increase quality by fostering performance-improving innovation, particularly if combined with increased competition. We assemble a large data set on elderly care services in Sweden between 1990 and 2009 and estimate how opening to private provision affected mortality rates – an important and not easily contractible quality dimension – using a difference-in-difference-in-difference approach. The results indicate that privatization and the associated increase in competition significantly improved non-contractible quality as measured by mortality rates.

Contracting Out the Last-Mile of Service Delivery: Subsidized Food Distribution in Indonesia

Outsourcing government service provision to private firms can improve efficiency and reduce rents, but there are risks that non-contractible quality will decline and that reform could be blocked by vested interests exactly where potential gains are greatest. We examine these issues by conducting a randomized field experiment in 572 Indonesian localities in which a procurement process was introduced that allowed citizens to bid to take over the implementation of a subsidized rice distribution program. This led 17 percent of treated locations to switch distributors. Introducing the possibility of outsourcing led to a 4.6 percent reduction in the markup paid by households. Quality did not suffer and, if anything, households reported the quality of the rice improved. Bidding committees may have avoided quality problems by choosing bidders who had relevant experience as traders, even if they proposed slightly higher prices. Mandating higher levels of competition by encouraging additional bidders further reduced prices. We document offsetting effects of having high rents at baseline: when the initial price charged was high and when baseline satisfaction levels were low, entry was higher and committees were more likely to replace the status quo distributor; but, incumbents measured to be more dishonest on an experimental measure of cheating were also more likely to block the outsourcing process. We find no effect on price or quality of providing information about program functioning without the opportunity to privatize, implying that the observed effect was not solely due to increased transparency. On net, the results suggest that contracting out has the potential to improve performance, though the magnitude of the effects may be partially muted due to push back from powerful elites.

Non-contractible value creation in buyer-supplier networks - a case study

The investigation of buyer supplier networks has been popular in both information systems and supply chain management literature. This study first discusses the background of how and why the buyer-supplier network structure and size changed with increased adoption of information systems in purchasing. Then it focuses on how supplier consolidation can lead to the initiation of vendor value management programs, which presents opportunities for the co-creation of non-contractible value for both the buyer and supplier. The study explores the relevance of the key sources of non-contractible value, i.e., non-contractible quality, supplier technological investments, information exchange, responsiveness, trust, and flexibility; through a case study. While exploring theses sources for non-contractible value, the focus has been limited to the context of direct sourcing only. This descriptive study was conducted in one of the largest steel manufacturers, in close liaison with the vendor value management team within the procurement practice of the firm.

Soft budget constraints and ownership: Empirical evidence from US hospitals

Consistent with the property rights theory of ownership incorporating soft budget constraints (SBCs), we find that controlling for SBCs, for-profit hospitals drop safety-net services more often and exhibit higher mortality rates, suggesting aggressive cost control that damages non-contractible quality.

Quality risk in outsourcing: Noncontractible product quality and private quality cost information

AbstractThis article addresses the concept of quality risk in outsourcing. Recent trends in outsourcing extend a contract manufacturer's (CM's) responsibility to several functional areas, such as research and development and design in addition to manufacturing. This trend enables an original equipment manufacturer (OEM) to focus on sales and pricing of its product. However, increasing CM responsibilities also suggest that the OEM's product quality is mainly determined by its CM. We identify two factors that cause quality risk in this outsourcing relationship. First, the CM and the OEM may not be able to contract on quality; second, the OEM may not know the cost of quality to the CM. We characterize the effects of these two quality risk factors on the firms' profits and on the resulting product quality. We determine how the OEM's pricing strategy affects quality risk. We show, for example, that the effect of noncontractible quality is higher than the effect of private quality cost information when the OEM sets the sales price after observing the product's quality. We also show that committing to a sales price mitigates the adverse effect of quality risk. To obtain these results, we develop and analyze a three‐stage decision model. This model is also used to understand the impact of recent information technologies on profits and product quality. For example, we provide a decision tree that an OEM can use in deciding whether to invest in an enterprise‐wide quality management system that enables accounting of quality‐related activities across the supply chain. © 2009 Wiley Periodicals, Inc. Naval Research Logistics 2009

Privatization of Credence Goods: Theory and an Application to Residential Youth Care

A wide range of services provided by the public sector are credence goods, i.e., services for which the producer has private information whether a certain treatment is needed or not. This paper studies how ownership affects the incentives for producers to reveal such information to public procurers. I develop a model where procurers buy a more extensive treatment in case quality is high. Private firms have strong incentives to reduce cost and must be given rents in order not to shirk on non-contractible quality. The existence of rents makes private firms induce demand for unnecessary treatments. Public sector managers have no incentive to cut cost, implying that optimal contracts don't entail rents unless quality is very important. Public sector managers instead use their informational advantage to avoid unpleasant tasks. Empirical evidence from residential care for teenagers with behavioral problems supports the model's predictions. Private ownership prolongs the duration of treatment by more than a year, doubling total cost. Unlike private facilities, public facilities are much more likely to initiate treatment breakdowns for teenagers that are particularly burdensome to treat.

Does a Hospital’s Profit Status Affect its Operational Scope?

We empirically evaluate whether a hospital’s organizational form (for-profit vs. not-for-profit or public) affects its operational scope (distribution of supplied medical procedures). Our results suggest that scope depends more on local demographics than causal forces from organizational form. This suggestion is consistent with differences in objectives (e.g., altruistic motives) ultimately exerting a stronger influence on operational scope than does the organizational advantage of not-for-profits in producing higher levels of non-contractible quality. It also offers information about how the availability of different medical services might change if the hospital sector continues its trend toward for-profit organization. Here, hospital conversions to for-profit status appear less likely to alter the mix of available services than do outright exits of not-for-profits.

Does a Hospital's Profit Status Affect its Operational Scope?

We empirically evaluate whether a hospital's organizational form (i.e., for-profit vs. not-for-profit or public) affects its operational scope (i.e., distribution of supplied medical procedures). Our results suggest that operational scope depends more heavily on demographic characteristics of local populations than on causal forces from organizational form per se. This suggestion is consistent with differences in objectives (e.g., altruistic motives) ultimately exerting a stronger influence on operational scope than does the organizational advantage of not-for-profits in producing higher levels of non-contractible quality. It also offers information about how the availability of different medical services might change if the hospital sector continues its trend toward for-profit organizational forms. Here, our evidence suggests that hospital conversions to for-profit status are less likely to alter the mix of available services than do outright exits of not-for-profits. Taken together, these results should appeal to readers who are broadly interested in the relationship between industrial organization and the real economy, and particularly interested in competition and health policy.

Government and the Reverse-Holdup Problem

When the government bargains with a private firm, the firm cares about only its own profits, but the firm's profits may also enter into the government's utility function. As a result, the government will not bargain as aggressively for a low price. This can lead the government to over pay for quality. In contrast to the standard holdup problem, this reverse-holdup problem can give the firm an incentive to overinvest in non-contractible quality.

Incomplete Contracts. Non-Contractible Quality, and Renegotiation

Abstract The paper reconsiders the hold-up problem in long-term bilateral trade with specific investments. In our framework, the parties face several trading opportunities (goods) whose characteristics cannot be described at the start of the relationship. Specifically, there exists an investment responsive `innovative' good, and (at least one) non-responsive `standard' good. In line with Hart and Moore (1988), renegotiation takes place as outside option bargaining. We first establish a first-best outcome for the case where trading the innovation is always efficient. This results contrasts with findings in Segal (1999) and Hart and Moore (1999) who adopt an alternative view of renegotiation. Then, we consider a setting where final trade is not always efficient, and show that a properly chosen at-will contract still implements the first best for a non-empty set of parameterizations. Finally, we show that at-will contracts strictly outperform option or specific-performance contracts.

The Proper Scope of Government: Theory and an Application to Prisons

When should a government provide a service in-house, and when should it contract out provision? We develop a model in which the provider can invest in improving the quality of service or reducing cost. If contracts are incomplete, the private provider has a stronger incentive to engage in both quality improvement and cost reduction than a government employee has. However, the private contractor's incentive to engage in cost reduction is typically too strong because he ignores the adverse effect on noncontractible quality. The model is applied to understanding the costs and benefits of prison privatization.

Opportunism and the Dynamics of Incomplete Contracts

This paper studies a buyer-seller relationship where quality is not contractible but is affected by effort and the seller's privately known innate value. The seller's cost of effort is also private knowledge. Assuming constant outside opportunities, we show that more than two contracts is redundant, the sequence of contracts exhibits increasing prices and durations, and commitments for prices beyond the actual contract invite opportunism, not effort. The seller uses effort during the screening process, which improves noncontractible quality. As a result, type-related information may have negative value when contracts are incomplete. Copyright 1993 by Economics Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Research Association.