Group Warranty Contracts to Coordinate Assembly Supply Chains With Nontestable Components

Abstract

We consider a supply chain where multiple suppliers and a manufacturer contribute to the assembly of a product (through providing components or labor). The product fails if any of its components (or elements of work) fails, but finding the faulty component can be prohibitively difficult. We study group warranty contracts for the manufacturer to induce suppliers to improve their quality levels. When information is symmetric and the manufacturer can contract on his own quality level, we show that a group warranty contract can achieve the first-best outcome. When the manufacturer’s quality level is not contractible, we show that the manufacturer and all the suppliers under-invest in qualities. We then extend our model to the asymmetric information case where suppliers have private quality cost information. Further, we consider whether the manufacturer benefits from sourcing multiple components from a single supplier, that is, supply consolidation. We find that supply consolidation benefits the manufacturer when his quality level is not contractible, but hurts him in the presence of asymmetric quality cost information of the suppliers.