Supply Diagnostic Incentives in New Product Launch


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Abstract

In this paper, we evaluate the impact of a diagnostic test in a new product development project. We build a dyadic supply chain model with one buyer who contracts the manufacturing of a new product to a supplier. Due to the lack of experience in manufacturing, the extent of the supply risk is unknown to both the buyer and the supplier at the time of the contract. However, the supplier may invest in a costly diagnostic test to acquire information about his true reliability, and use this information when deciding on a process improvement effort. Using this setting, we identify the operational and strategic benefits and drawbacks of the diagnostic test. Operationally, the diagnostic test helps the supplier to take the first-best level of improvement effort, which increases the efficiency of the total supply chain. Strategically, it enables the buyer to reduce the agency costs associated with implementing the process improvement on the supplier. Besides these benefits, the diagnostic test increases the degree of information asymmetry along the supply chain. This in turn provides the supplier with proprietary information, whose rent would be demanded from the buyer in equilibrium. A cost-benefit analysis reveals two key factors in determining the value of the diagnostic test: (i) the informational content of the test and (ii) its relative cost with respect to the process improvement cost. Our results indicate that when both factors are high, the mere presence of the diagnostic test can result in a less reliable supply chain. This implies that, when incentives are not properly aligned, the amplification of the information asymmetry due to the diagnostic test neutralizes all its benefits.