Incentive contract design for supplier reliability: The role of asymmetric information on reliability level and improvement costs

Abstract

We study a supply chain subject to supply disruptions, where the supplier can exert costly effort to mitigate the impact of disruptions and improve reliability. The supplier's current reliability level and the cost of improving reliability can each be high or low and are privately known only to the supplier. We investigate which type of information—the reliability level or the improvement cost—is more valuable to a buyer who designs incentive contracts to induce the desired supplier effort. We develop a framework to compare expected profits based on two partial asymmetric information settings: in each, the buyer observes one type of information while having only incomplete information about the other. Our analysis reveals that when product value is relatively high, information about the supplier's initial reliability is more valuable, as ensuring production success is critical for high‐value products. However, when product value is moderate and the supplier has high improvement potential, the buyer is more sensitive to whether the supplier can cost‐effectively enhance its reliability, making improvement cost information more valuable. We extend the base model to incorporate partial disruptions and continuous effort choices by the supplier, and find that our key insights remain robust. Our results offer practical guidance for firms on where to focus their efforts in acquiring accurate information about suppliers' production processes and reliability improvement capabilities.